Lessons From the Great Inflation

Paul Volcker and Ronald Reagan's forgotten miracle created a quarter century of prosperity--and a dangerous bubble of complacency

If you asked a group of scholars to name the most important landmarks in the American story of the last half-century, they would list some or all of the following: the war in Vietnam, the civil rights movement, the assassinations of the Kennedys and Martin Luther King, Watergate, the sexual revolution, the invention of the computer chip, Ronald Reagan’s election in 1980, the end of the Cold War, the creation of the Internet, the emergence of AIDS, the terrorist attacks of September 11, and the two wars in Iraq. Looking abroad, these scholars might include other developments: the rise of Japan as a major economic power in the 1970s and ’80s, the emergence of China in the 1980s from its self-imposed isolation, and the spread of nuclear weapons.

Missing from most lists would be the rise and fall of double-digit U.S. inflation. This would be a huge oversight.

We have arrived at the end of a roughly half-century economic cycle dominated by inflation, for good and ill. Its rise and fall constitute one of the great upheavals of our time, though one largely forgotten and misunderstood. From 1960 to 1979, annual U.S. inflation increased from a negligible 1.4 percent to 13.3 percent. By 2001 it had receded to 1.6 percent, almost exactly what it had been in 1960. For this entire period, inflation’s climb and collapse exerted a dominant influence over the economy’s successes and failures. It also shaped, either directly or indirectly, how Americans felt about themselves and their society; how they voted and the nature of their politics; how businesses operated and treated their workers; and how the American economy was connected with the rest of the world. Although no one would claim that inflation’s side effects were the only forces that influenced the nation during these decades, they counted for more than most historians, economists, and journalists think. It’s impossible to decipher our era, or to think sensibly about the future, without understanding the Great Inflation and its aftermath.

Stable prices provide a sense of security. They help define a reliable social and political order. Like safe streets, clean drinking water, and dependable electricity, their importance is noticed only when they go missing. When they did just that in the 1970s, Americans were horrified. From week to week, people couldn’t know the cost of their groceries, utility bills, appliances, dry cleaning, toothpaste, and pizza. People couldn’t predict whether their wages would keep pace with prices. People couldn’t plan; their savings were at risk. And no one seemed capable of controlling inflation. The inflationary episode was a deeply disturbing and disillusioning experience that eroded Americans’ confidence in their future and their leaders.

There were widespread consequences. Without double-digit inflation, Ronald Reagan almost certainly would not have been elected president in 1980; the conservative political movement that he inspired would have emerged later or, conceivably, not at all. High inflation incontestably destabilized the economy, leading to four recessions (those of 1969-70, 1973-75, 1980, and 1981-82) of growing severity. High inflation stunted the increase of living standards through lower productivity growth. High inflation caused the stock market to stagnate; the Dow Jones Industrial Average was no higher in 1982 than in 1965. And it led to a series of debt crises that afflicted American farmers, the U.S. savings and loan industry, and developing countries.

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Afterward, declining inflation-“disinflation”-led to lower interest rates, which led to higher stock prices and, much later, higher home prices. This disinflation promoted the last quarter century’s prosperity. In the two decades after 1982, the business cycle moderated so that the country suffered only two relatively mild recessions (those of 1990-91 and 2001), lasting a total of 16 months. Monthly unemployment peaked at 7.8 percent in June 1992. As stock and home values rose, Americans felt wealthier and borrowed more or spent more of their current incomes. A great shopping spree ensued, and the savings rate declined. Trade deficits-stimulated by Americans’ ravenous appetite for cars, computers, toys, and shoes-ballooned. At the same time, this prolonged prosperity helped spawn complacency and carelessness, which ultimately climaxed in a different sort of economic instability and the financial turmoil that assaulted the economy in 2007 and 2008.

Who Was to Blame?

Double-digit inflation was not an act of nature or a random accident. It was the federal government’s greatest domestic policy blunder since World War II, the perverse consequence of well-meaning economic policies, promoted by some of the nation’s most eminent academic economists. These policies promised to control the business cycle but ended up making it worse.

The episode invites comparison with the war in Vietnam, the biggest foreign policy blunder in the post-World War II era. Both arose from good intentions: The one would preserve freedom; the other would expand prosperity. Both had intellectuals as advocates, whether economists or theorists of limited war. Both suffered from overreach and simplification; events on the ground constantly confounded expectations. But there is a big difference. One (Vietnam) occupies a huge space in historic memory. The other (inflation) does not.

This inflation had no comparable precedent in American history. Sudden bursts of inflation had occurred before, almost always during wars when the government printed more money to pay for guns, soldiers, ships, and ammunition. What happened in the 1960s and ’70s was different. America’s most protracted peacetime inflation was the unintended side effect of policies designed to reduce unemployment and eliminate the business cycle. It was a product of the power of ideas.

In the 1960s, academic economists argued-and political leaders accepted-that the economy could be kept permanently near “full employment” (initially defined as 4 percent unemployment). Booms and busts, recessions and depressions, had long been considered ugly and unavoidable aspects of industrial capitalism. But once people accepted the idea that the business cycle could be mastered, the self-restraint that had silently kept prices and wages in check gradually crumbled. New assumptions emerged. If government could prevent recessions, then companies could always count on strong demand for their products. All higher costs (including higher labor costs) could be recovered through higher prices. Similarly, if the economy was always near “full employment,” then workers could press for higher wages without facing job loss. If their current employers wouldn’t pay, someone else would. Government wouldn’t tolerate substantial unemployment; that was its promise. The result was a stubborn wage-price spiral. Wages chased prices, which chased wages. Inflation became self-fulfilling and entrenched.

Everything rested on an illusion, the Phillips Curve: the notion that there was a fixed tradeoff between unemployment and inflation. If true, that meant a society could consciously decide how much of one or the other it wanted. If, say, 4 percent unemployment and 4 percent inflation seemed superior to 5 percent unemployment and 3 percent inflation, then we could choose the former. The trouble was that the tradeoff didn’t exist, except for brief periods. In an important 1968 paper, the economist Milton Friedman explained that, if government tried to hold unemployment below some “natural rate,” the result would simply be accelerating inflation. Another economist, Edmund Phelps of Columbia University, developed the concept almost simultaneously. By their logic, governmental efforts to push unemployment down to unrealistic levels were doomed to failure.

What would actually happen in the 1970s-the constant acceleration of inflation-was foretold by Friedman and Phelps. But good ideas could not spontaneously displace the bad until actual experience demonstrated the differences, especially because the bad ideas were more politically attractive. For inflation to be reversed, the underlying politics and psychology had to change.

Americans detested inflation. We seemed to have lost control, both as individuals and as a society, over our fate. Since 1935, the Gallup Poll has regularly asked respondents, “What do you think is the most important problem facing the country today?” In the nine years from 1973 to 1981, “the high cost of living” ranked No. 1 every year. In some surveys, an astounding 70 percent of the respondents cited it as the major problem. In 1971 it was second behind Vietnam; in 1972 it faded only because wage and price controls artificially and temporarily kept prices in check. In 1982 and 1983, it was second behind unemployment (and not coincidentally: the high joblessness stemmed from a savage recession caused by inflation).

Among government officials, there was a widespread fatalism about continued inflation. President Carter often seemed forlorn at the prospect. Early in 1980, he was asked at a press conference what he planned to do about the problem. He replied, “It would be misleading for me to tell any of you that there is a solution to it.” His resignation was common. Inflation had so insinuated itself into the fabric of everyday life, the thinking went, that it could not be easily extracted. The standard remedy would be a horrific recession, or a depression, that would reduce wage and price increases. Inflation was rationalized as a reflection of the deeper ills of American society. It was not a cause of our problems; it was a consequence of our condition. Specifically, it was said to show that the nation was becoming ungovernable. Americans had more wants (for higher pay, more government programs, a cleaner environment) than could be met.

When Ronald Reagan won in a near landslide-50.7 percent of the popular vote against Carter’s 41 percent-inflation was the dominating concern. Voters didn’t know that Reagan could control it; but they did know that Carter couldn’t. Later, Carter himself judged that inflation had been the decisive issue against him, more important than his mishandling of the Iranian hostage crisis. Exit polls showed that 47 percent of Reagan’s voters rated “controlling inflation” as the most important issue, followed closely by 45 percent who valued “strengthening America’s position in the world.” In the Gallup Poll in September, 58 percent rated inflation as the No. 1 problem.

How Inflation Was Subdued

The subjugation of inflation was principally the accomplishment of two men: Paul Volcker and Ronald Reagan. If either had been absent, the story would have unfolded differently and, from our present perspective, less favorably. Reagan, president from 1981 to 1989, and Volcker, chairman of the Federal Reserve Board from 1979 to 1987, forged an accidental alliance that was largely unspoken, impersonal, and misunderstood. There was no particular personal chemistry between the men. Nor was there any explicit bargain-you do this, and I’ll do that. Although Reagan supported Volcker, many officials in his administration openly criticized him. Even while the alliance flourished, it sometimes seemed a mirage.

But the alliance was genuine, a compact of conviction. Both men believed that high inflation was shredding the fabric of the economy and of American society. The country could not thrive if it persisted. Buttressed by these beliefs, they broke with the past. Each had a role to play, and each played it somewhat independently of the other.

Volcker took a sledgehammer to inflationary expectations. He raised interest rates, tightened credit, and triggered the most punishing economic slump since the 1930s. In December 1980, banks’ “prime rate” (the loan rate for the worthiest business borrowers) hit a record 21.5 percent. Mortgage and bond rates rose in concert. By the summer of 1981, consumers had trouble borrowing for homes and cars. Many companies couldn’t borrow for new investment. Industrial production dropped 12 percent from mid-1981 until late 1982. In many industries, declines were steeper. In autos, it was 34 percent (from June 1981 to January 1982), and in steel it was 56 percent (from August 1981 to December 1982). By 1982 the number of business failures had tripled from 1979. Construction starts of new homes in 1982 were 40 percent below the 1979 level. Worse, unemployment exploded. By late 1982, it was 10.8 percent, which remains a post-World War II record.

It is doubtful that, aside from Reagan, any other potential president would have let the Fed proceed unchallenged. Certainly Carter wouldn’t have, had he been re-elected, nor would his chief Democratic rival, Sen. Edward M. Kennedy (D-Mass.). Both would have faced intense pressures from the party’s faithful, led by unionized workers-especially auto- and steelworkers-who were big victims of Volcker’s austerity. Nor is it likely that any of the major Republican presidential contenders in 1980 would have acquiesced, including George H.W. Bush, Howard Baker, and John Connally. Reagan’s initial economic program promised to reduce the money supply to curb inflation. He was the first president to make that part of his agenda, and he never retreated from it. As the economy deteriorated, he kept quiet. He refused to criticize Volcker publicly, to urge a lowering of interest rates, or to work behind the scenes to bring that about.

When the president did speak, he supported Volcker. At a press conference on February 18, 1982-with unemployment near 9 percent-Reagan called inflation “our No. 1 enemy” and referred to fears that “the Federal Reserve Board will revert to the inflationary monetary policies of the past.” The president pledged that this wouldn’t happen. “I have met with Chairman Volcker several times during the past year,” he said. “We met again earlier this week. I have confidence in the announced policies of the Federal Reserve.” Reagan’s patience enabled the Federal Reserve to maintain a punishing and increasingly unpopular policy long enough to alter inflationary psychology.

There was an outpouring of bills and resolutions to impeach Volcker, roll back interest rates, or require the appointment of new Fed governors sympathetic to farmers, workers, consumers, and small businesses. Rep. Jack Kemp (D-N.Y.), a prominent Republican “supply-sider,” wanted Volcker to resign. In August 1982, Sen. Robert C. Byrd of West Virginia, the Democratic floor leader, introduced the Balanced Monetary Policy Act of 1982, which would have forced the Fed to reduce interest rates.

Reagan’s popularity ratings collapsed. In May 1981, early in his presidency, Reagan’s approval had reached a high of 68 percent. By April 1982, it was 45 percent (46 percent disapproved); by January 1983, it was 35 percent, the low point (56 percent disapproved). As the economy sank, Reagan was advancing an economic program of across-the-board tax cuts, widely portrayed as favoring the rich, and spending cuts, widely portrayed as hurting the poor. He was portrayed as spearheading an economic assault against ordinary Americans.

On inflation, Reagan was clear-eyed. “Unlike some of his predecessors, he had a strong visceral aversion to inflation,” Volcker later said. Reagan was “influenced by people like Milton Friedman and understood that inflation was always a monetary phenomenon,” that it was “too much money chasing too few goods,” said William Niskanen, a member of Reagan’s Council of Economic Advisers. “He was the first president who understood that.…He knew that controlling inflation by regulation [controls] was absurd.”

Even now, the social costs of controlling inflation seem horrendous. Over a four-year period (1979-82), the U.S. economy’s output barely increased. It nudged ahead in the first two years and then fell back in the last two. Since 1950, there had been nothing like that. Unemployment peaked in 1982 near 11 percent-a figure that, a few years earlier, would have been widely judged inconceivable. Although lower inflation benefited most people, the casualties were numerous and broadly dispersed geographically and socially: small business owners, overextended farmers, industrial workers. The number of business failures in 1982 (24,908) was nearly 50 percent higher than in any other year since World War II, and it would double to 52,078 by 1984. From 1979 to 1983, farm income declined almost 50 percent.

But against these heartbreaking costs, there were larger long-term gains. Once the recession lifted, the economy and productivity growth revived impressively. When Reagan left office, Americans still worried about inflation, but it no longer gripped them with fear. Inflation was one problem among many, not a scourge shredding the social fabric. The taming of inflation reinvigorated the economy as nothing else; the expansion lasted from early 1983 until the late summer of 1990. At the time, it was the second longest peacetime expansion in U.S. history.

The Volcker-Reagan campaign discredited many of the ideas that had misgoverned national economic policy for nearly two decades. The notion that the Federal Reserve couldn’t control inflation was discredited. The notion that a little less unemployment could be exchanged for a little more inflation was discredited. In their place, a consensus slowly developed that “price stability”-a vague term that both Volcker and his successor, Alan Greenspan, defined as inflation so low that it barely affected people’s decisions-was desirable and would promote a more stable and productive economy.

The Forgotten Crisis

One of the dilemmas of a democratic society is how to take actions that, though immediately painful and unpopular, seem essential to the society’s long-term well-being. Coping with double-digit inflation posed precisely this problem. Any realistic program was bound to hurt millions of Americans, almost all innocent victims. This was so obvious that in the late 1970s a frontal assault on inflation seemed impossible.

What Volcker and Reagan wrought now seems ancient history: an isolated episode with little relevance to our present condition. This is utterly wrong. For every nation, there are crucial demarcation points that fundamentally alter society. The greatest of these for the United States was the Civil War. The Great Depression and World War II created another massive chasm. In our era, the fall of double-digit inflation is one of those separation points, though on a smaller scale-a gorge, not a canyon. Something profound and pervasive occurred: what I call the restoration of capitalism. Much of what we now consider routine and normal originated in the tumultuous transition from high to low inflation.

A majority of today”Americans have never experienced double-digit inflation. In 2008 slightly more than 60 percent of today’s roughly 300 million Americans were born in 1962 or later, meaning that the oldest of them would have been only 17 or 18 when inflation peaked in 1979 and 1980. They were too young for it to have made much of an impression. Even for some of those who lived through it, the memory of inflation has faded.

In a very superficial way, that provides a serviceable explanation for the way inflation’s memory has faded. But the same arithmetic applies to Vietnam-indeed more so, since it was an earlier event-and yet Vietnam retains a powerful grip on the national consciousness. Something else must be at work.

Closer to the truth, I think, is a collective failure of communication and candor by the nation’s economists. At its base, double-digit inflation was their doing, a product of their bad ideas. There is now a widespread recognition of this, and although there are many technical studies of inflation and of the period of high inflation, there has not been much in the way of public apologies (from those who were complicit in the error) or reprimands (from those who were not, because they either dissented or were too young). There seems to be an unspoken pact of self-restraint to let bygones be bygones, perhaps out of collective embarrassment or a recognition that dwelling excessively on past failures might compromise economists’ prospects as government advisers and high-level appointees.

Over the course of 2008, inflation has risen to the uncomfortable level of about 5 percent, driven largely by higher prices for oil and food emanating from international markets. Whether it will go higher or subside to the negligible range of zero to 2 percent (a level at which most economists believe prices changes are so slight that they barely affect most consumers or businesses) is impossible to say. What is less uncertain is the similarity between our present predicament and the situation that led to higher inflation in the 1960s and ’70s. Then, a little inflation seemed unthreatening; but a little led to a little more, and a little more led to a lot.

This article is adapted from The Great Inflation and Its Aftermath: The Past and Future of American Affluence, written by Robert J. Samuelson and published by Random House. Samuelson, a columnist for Newsweek and The Washington Post, is also the author of The Good Life and Its Discontents: The American Dream in the Age of Entitlement. © 2008 by Robert J. Samuelson. Reprinted by arrangement with the Random House Publishing Group. This column first appeared at