The Great Inflation and Its Aftermath: the Past and Future of American Affluence

Book by Samuelson Robert J

Chapter 1

The Lost History

I

History is what we say it is. If you asked a group of scholars to name the most important landmarks in the American story of the past half century, they would list some or all of the following: the war in Vietnam; the civil rights movement; the assassinations of John Kennedy, Robert Kennedy and Martin Luther King, Jr.; Watergate and President Nixon’s resignation; 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, 2001; and the two wars in Iraq (1991 and 2003). Looking abroad, these scholars might include other developments: the rise of Japan as a major economic power in the 1970s and 1980s; the emergence of China in the 1980s from its self-imposed isolation; and the spread of nuclear weapons (to China, India, Pakistan and others). But missing from any list would be the rise and fall of double-digit U.S. inflation. This would be a huge oversight.

We have now 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 and much more. Inflation and its fall 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 over these decades, they counted for more than most people including 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. They are like safe streets, clean drinking water and dependable electricity. Their importance is noticed only when they go missing. When they did in the 1970s, Americans were horrified. During most of these years, large price increases were the norm, like a rain that never stopped. Sometimes it was a pitter-patter, sometimes a downpour. But it was almost always raining. 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 and salaries would keep pace. 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 would almost certainly not have been elected president in 1980 and 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; monthly unemployment peaked at 10.8 percent in late 1982. High inflation stunted the increase of living standards through lower productivity growth. And high inflation caused the stock market to stagnate the Dow Jones Industrial Average was no higher in 1982 than in 1965 and led to a series of debt crises that afflicted American farmers, the U.S. savings and loan industry and developing countries.

If inflation’s legacy were nothing more, it would merit a sizable chapter in America’s post-World War II narrative. But there is much more. Declining inflation--"disinflation"--led to lower interest rates, which led to higher stock prices and, much later, higher home prices. This disinflation promoted the past 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 sixteen 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, shoes--ballooned. Paradoxically, this prolonged prosperity also 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.

The very belief in the permanence of economic growth undid economic growth. Initially triggered by falling inflation and interest rates, the upward march first of stock prices and then of home values induced speculative dizziness. People began to believe that prices of stocks and homes could only rise. Once that intoxicating mind-set took hold, prices rose to silly and perilous heights, leading to "bubbles" that burst in 2000 (for stocks) and 2007 (for homes). Home loans were extended to buyers with weak credit and with little or no requirement for down payment. The presumption that homes would always be worth more tomorrow than today provided a false sense of security to the lenders and rationalized credit standards that, with hindsight, seemed self-evidently doomed. When these "subprime" mortgages began to default in large numbers, the homebuilding boom ended, housing prices fell, financial institutions--banks, investment banks--suffered large losses on securities backed by mortgages, and the economy tipped into (or teetered on the edge of ) another recession.*

The significant point for our story is that the economy’s present problems are yet another unappreciated consequence of inflation and its subsequent decline. The immediate cause of the housing collapse lay in lax lending practices; but the backdrop and inspiration for those lax practices were the expectations of perpetually rising real estate values that were sown in the climate of disinflation and falling interest rates. So it is with much else about our economic system that we now take for granted: The connections to inflation are there, but we simply refuse to see them. Take, for example, the way companies treat workers. In the first decades after World War II, government and big business joined in an unwritten alliance. Government promised to control the business cycle, to minimize or eliminate recessions. Big companies pledged to raise living standards and provide economic security for worker--safe jobs, adequate health insurance and reliable pensions.

But when inflation overwhelmed the government’s commitment to manage the business cycle, the implicit social contract broke down. The 1980s became a watershed in changed corporate behavior. If companies couldn’t raise prices, they would (and did) cut costs. Layoffs, "restructurings" and "buyouts" for early retirees became more widespread and acceptable. "Capitalism," a word that had essentially disappeared from common usage in the early postwar decades, reentered the popular vocabulary. The result was a paradox: Although the overall economy grew more stable after 1982, individuals’ sense of insecurity increased, because companies were less bound by the norms of earlier postwar decades to preserve jobs and shield workers from disruptive changes. The "new capitalism" controlled inflation in part by breeding anxiety that kept wages and prices in check. It also tolerated greater inequality-- growing gaps between the rich, the middle class and the poor.

Or consider "globalization": the thickening integration of national economies through trade, finance and information flows. Although we don’t connect that with inflation, we should. Had the U.S. economy remained as in the 1970s, beset by seemingly intractable inflation and ever-worsening recessions, America’s confident championing of globalization in the 1980s and 1990s wouldn’t have happened. American leaders wouldn’t have attempted it; and even if they had, no one would have listened. The restored stability and vitality of the economy, which stemmed from disinflation, empowered U.S. leaders to pursue internationalist policies. The same forces also gave the dollar a new lease on life in its role as the primary global currency used in international business. That companies and individuals thought they could rely on the dollar to buy and sell goods and as a store of wealth promoted both trade and cross-border finance.

Inflation is an example of how economics affects almost everything else, and the American story of the past half century can’t be realistically portrayed without recognizing its central role. Much of what we take as normal and routine either originated in the inflationary experience or was decisively influenced by it. The great shopping spree, the reemergence of capitalism and increased globalization are three examples. But we have now come to the end of this period. Just what the next economic cycle will bring is an open question that, in some ways, will involve dealing with the sequels of many of the effects of the Great Inflation. The great shopping spree has ended. What will replace it? Globalization seems threatening to many Americans, as does the new capitalism. Will we shape these forces to our advantage or find ourselves whipsawed by them? Can we maintain acceptabl...