This volume focuses on understanding the causes of the Great Inflation of the 1970s and ’80s, which saw rising inflation in many nations, and which propelled interest rates across the developing world into the double digits. In the decades since, the immediate cause of the period’s rise in inflation has been the subject of considerable debate. Among the areas of contention are the role of monetary policy in driving inflation and the implications this had both for policy design and for evaluating the performance of those who set the policy. Here, contributors map monetary policy from the 1960s to the present, shedding light on the ways in which the lessons of the Great Inflation were absorbed and applied to today’s global and increasingly complex economic environment.
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The Great Inflation
The Rebirth of Modern Central Banking
By Michael D. Bordo, Athanasios Orphanides
THE UNIVERSITY OF CHICAGO PRESSCopyright © 2013 National Bureau of Economic Research
All rights reserved.
The Great Inflation
Did the Shadow Know Better?
William Poole, Robert H. Rasche, and David C. Wheelock
The failure to control inflation was not inevitable. The policies did not fail because they were poorly executed. They failed because they were poorly conceived.
—Shadow Open Market Committee, August 23, 1973
The Shadow Open Market Committee (SOMC) held its first meeting on September 14, 1973. The SOMC was formed in response to rising inflation in the United States and the apparent failure of either the Nixon administration or the Federal Reserve to formulate effective policies to control inflation. Under the leadership of Karl Brunner and Allan Meltzer, the SOMC met twice a year to review US economic policy and discuss policy-related research. At the conclusion of every meeting, the committee issued a statement evaluating current policy and proposing an alternative course of action. In this chapter, we describe the monetary policy framework of the SOMC and the statements the committee issued during the Great Inflation period. Further, we simulate a New Keynesian macroeconomic model embedding a representation of the SOMC policy rule to evaluate whether the committee's proposals could have resulted in a lower average and more stable rate of inflation than actually occurred.
First, we describe the economic environment in which the SOMC was created and the policy views that the SOMC sought to counter. We then describe the SOMC policy framework by highlighting how the views of SOMC members differed from most Federal Reserve officials and many academic macroeconomists. That discussion is followed by a description of the SOMC policy rule. Importantly, the SOMC rule called for a transparent and gradual adjustment of money stock growth to a steady-state rate. We simulate a New Keynesian macroeconomic model embedding the SOMC policy rule to gauge how different the path of inflation might have been if the Federal Reserve had followed the SOMC's policy recommendations. Our simulations illustrate that a gradual adjustment of money stock growth similar to that advocated by the SOMC is likely to result in less impact on output growth and less variability in inflation or output growth than a large onetime adjustment.
1.1 The Great Inflation and the SOMC
When the SOMC first met in September 1973, the United States had already experienced eight years of rising and increasingly variable inflation. Whereas inflation averaged a mere 1.4 percent between January 1952 and December 1964, it averaged 3.9 percent between January 1965 and August 1973, and reached 7.4 percent for the twelve months ending in August 1973.
The Nixon administration's response to inflation, with the strong support of Federal Reserve Chairman Arthur Burns and many academic and professional economists, was to impose controls on wages and prices. A first round of controls was announced on August 15, 1971, and some controls remained in effect into 1974. Burns continued to champion wage and price controls even when most observers had concluded that they were not working. For example, in a speech on June 6, 1973, Burns argued that "the persistence of rapid advances in wages and prices in the United States and other countries, even during periods of recession, has led me to conclude that governmental power to restrain directly the advance of prices and money incomes constitutes a necessary addition to our arsenal of economic stabilization weapons."
Burns attributed the inflation of the late 1960s and early 1970s mainly to rising factor costs, especially labor and energy costs, as well as to government budget deficits, social programs, and regulations. He argued that wage and price controls were necessary to stem "cost-push" inflation. For example, in a 1970 speech, he contended that "[g]overnmental efforts to achieve price stability continue to be thwarted by the continuance of wage increases substantially in excess of productivity gains.... The inflation that we are still experiencing is no longer due to excess demand. It rests rather on the upward push of costs—mainly, sharply rising wage rates." He argued, moreover, that "monetary and fiscal tools are inadequate for dealing with sources of price inflation such as are plaguing us now-that is pressures on costs arising from excessive wage increases."
Burns's views about inflation were widely shared by leading economists and policymakers throughout the 1960s and 1970s. For example, Samuelson and Solow (1960, 181) argued that "the essence of the [inflation] problem" stemmed from the absence of perfect competition in factor and product markets, whereas Bronfenbrenner and Holzman (1963) cited the power of "economic pressure groups," such as labor unions and monopolistic firms. Throughout the 1960s, the Economic Report of the President blamed inflation on "excessive" wage and price increases. For example, the Economic Report for 1965 explained that "in a world where large firms and large unions play an essential role, the cost-price record will depend heavily upon the responsibility with which they exercise the market power that society entrusts to them" (1966, 179).
Like Burns, some economists and policymakers claimed that government budget deficits contributed to rising inflation. Federal Reserve Governor Sherman Maisel (1973, 12), for example, wrote that the increasing rate of inflation of the late 1960s and early 1970s was caused by "government deficits; ... speculative investment in plant, equipment, and labor by business corporations; ... use of economic power to raise wages and profits; ... But most significant were the government deficits."
The SOMC was formed to promote an alternative to these widely entrenched views about the causes of inflation and to recommend policies for restoring price stability. The policy analysis and recommendations of the SOMC reflected the monetarist orientation of its members. Accepting Milton Friedman's dictum that "inflation is always and everywhere a monetary phenomenon," the SOMC argued that price stability could be restored only by slowing the growth of monetary aggregates. The SOMC advocated a policy rule characterized by an announced, gradual reduction in money growth to a rate consistent with long-run price stability. The SOMC made specific recommendations for money stock growth at its twice-yearly meetings throughout the Great Inflation period and for several years thereafter (provided in appendix A).
1.2 The Shadow's Framework
The SOMC represented a monetarist challenge to the Keynesian views that dominated the economics profession and the Federal Reserve during the 1960s and 1970s. The fundamental differences between the monetarist and Keynesian views have been elaborated at length elsewhere. Here we highlight key differences between the SOMC and Federal Reserve policymakers about the causes of inflation and conduct of monetary policy to bolster our contention that monetary policy would have been radically different during the 1970s under a Shadow-led Fed.
1. Inflation is a monetary phenomenon: Fed officials often blamed inflation on labor unions, monopolistic pricing, energy price shocks, and government budget deficits and dismissed the notion that money growth and inflation are closely connected. Burns, for example, testified in 1974 that "[t]he role of more rapid monetary turnover rates ... warns against assuming any simple causal relation between monetary expansion and the rate of inflation either during long or short periods." Burns acknowledged that "excessive increase in money and credit can be an initiating source of excess demand and a soaring price level. But the initiating force may primarily lie elsewhere, as has been the case in the inflation from which this country is now suffering."
By contrast, SOMC members and other monetarists dismissed "special factors" explanations for inflation and remained adamant that inflation is caused solely by excessively rapid growth of the money stock. For example, Karl Brunner argued that "Persistent increases in the price level are hardly likely to occur ... without a similarly persistent monetary growth. Alternatively, in the absence of persistent and excessive monetary growth we will not experience any persistent inflation. Moreover, any persistent acceleration of the money stock eventually unleashes a rising inflation. On the other side, no inflation was ever terminated without lowering monetary growth to the relevant benchmark level."
2. The market system is inherently stable and economic growth reverts to a natural rate: Keynesians often argued that expansionary fiscal or monetary policy might be required to ensure that aggregate demand is sufficient to generate full employment, especially in the face of downwardly rigid wages and prices. Samuelson (1960, 265), for example, wrote that "with important cost-push forces assumed to be operating, there are many models in which it can be shown that some sacrifice in the requirement for price stability is needed if short-and long-term growth are to be maximized, if average long-run unemployment is to be minimized, if optimal allocation of resources as between different occupations is to be facilitated." Further, Samuelson and Solow (1960) argued that policies directed at limiting inflation in the short run might increase structural unemployment and reduce economic growth over the long term. The long-run trade-off between inflation and unemployment would worsen, they argued, because an increase in structural unemployment would increase the amount of inflation required to achieve a given reduction in the unemployment rate.
Monetarists held a very different view. Brunner, for example, argued that "the market system acts as a shock absorber and tends to establish a normal level of output. This means that we consider the market system to be inherently stable." Further, he argued that the trend in output "is dominated by real conditions and shocks summarized by technology, preferences, and institutions." And, "monetary impulses do not produce permanent real effects on output, employment, and real interest rates, apart from longer-run real effects exerted via the expected inflation rate or distortionary institutional constraints (e.g., tax rates specified in nominal terms)." In other words, as Friedman (1968) and Phelps (1967) argued, in the long run, output growth converges to a natural rate that is independent of the rate of inflation.
3. Monetary policy should focus on price stability: In addition to believing that monetary policy has little or no impact on output in the long run, monetarists were skeptical of using policy to "fine-tune" economic activity in the short run. Monetarists argued that the Fed's attempts to steer a path between inflation and unemployment in the face of inevitable uncertainty about the short-run impact of policy actions and other shocks had exacerbated instability in both inflation and unemployment. For example, William Poole (1975) argued that "By trying to do too much, policymakers have put themselves into a vicious 'stop-go' cycle with ever-widening oscillations. Each period of monetary expansion has been higher than the previous One—considering the 1965, 1967-68, and the 1972-73 expansions. Each of the inflations since 1965 has been worse than the previous one. And each setback in real activity since 1965 has been deeper than its predecessor-in the sequence 1967, 1968-70, 1974-75. This pattern must be broken, and the only method in which I have any confidence is that of stabilizing money growth."
Brunner argued similarly: "The best contribution monetary policy can make to lower the variability of output relative to normal output is the committed adherence to a predictable and stable monetary control path credibly understood by the mass of price and wage setters."
4. Adverse supply shocks reduce potential output: The SOMC members argued against basing policy actions on estimates of the gap between actual and potential output, noting that there was little evidence that doing so reduces fluctuations in output. For example, Brunner argued that "short-run adjustments of monetary growth to the magnitude of the gap in the context of an economy with long inflation experience contributes little to the closure of gaps over time." Furthermore, the occurrence of supply shocks "reminds us that we cannot infer from output movements alone whether or not a recession has occurred."
The decline in output and increase in unemployment that followed the first oil shock in 1973 prompted calls for expansionary monetary policy to return the economy to full employment. Brunner, however, argued that the shock had increased the natural rate of unemployment and lowered potential output. Further, he argued that "[t]he distinction between a 'real shock decline' in output and a 'cyclic decline' in output ... [is] important for policy making. The latter creates an 'output gap' absent from the former. A disregard of the two distinct processes thus magnifies estimates of the 'potential gap' to be removed by expansionary policies. An inadequate analysis of the decline in output observed since November 1973 thus reinforces the danger of inflationary financial responses on the part of policymakers." He also argued that if a decline in output reflects a decline in potential, then "no increase in money stock whatever its magnitude will raise output again." Allan Meltzer argued similarly: "Money cannot replace oil, and monetary policy cannot offset the loss of real income resulting from the oil shock. The attempt to do so converts the one-time increase in the price level into a permanently higher maintained rate of inflation." Although the impact of oil shocks on potential output was noted in the academic literature (e.g., Phelps 1978), Fed policymakers seem to have relied on overly optimistic estimates of full-employment output growth produced by the Council of Economic Advisers.
5. The cost of disinflation reflects the monetary authority's credibility: Whereas the SOMC argued that money growth should be gradually reduced to lower the inflation rate, Burns and many other economists often claimed that reducing money growth to the extent required to halt inflation would result in excessively high unemployment and lost output. For example, in testifying about the rise of inflation in the late 1960s and early 1970s, Burns argued that "an effort to use harsh policies of monetary restraint to offset the exceptionally powerful inflationary forces of recent years would have caused serious financial disorder and economic dislocation. That would not have been a sensible course for monetary policy."
Brunner countered that the cost of disinflation reflects the clarity and credibility of the announced policy, and, echoing Lucas (1976), argued that estimates of the resulting loss in output associated with tighter policy generated by standard models are highly suspect: "The structural properties and response patterns of an economic system are not invariant relative to different policies and policy patterns. The mechanical simulation of a policy program substantially different from the policy patterns prevailing over the sample period used to estimate the model yield ... little information about the consequences of the program proposed. In particular, the simulations of a model estimated over a period of accelerating inflation probably exaggerate the longer-run unemployment effects of an anti-inflationary program."
Brunner (1983) argued that "[t]he social cost of a disinflationary policy is not predetermined by the magnitude or duration of monetary retardation.... The social cost depends crucially on the public's belief in the persistence of the disinflationary action." And, "Credibility depends ... on the history of policymaking and the behavior of the policy institution. Low credibility offers little incentive to modify price-wage setting behavior, and the social cost of disinflation rises correspondingly." Further, "A dominant conviction by market participants that the Federal Reserve Authorities truly, unwaveringly and persistently lower monetary growth produces a decline in the rate of inflation with a comparatively small and rapidly eroding gap [between actual and potential output]. Emergence and magnitude of a gap in the context of an anti-inflationary policy depends foremost on the credibility of the policy."
6. Policy should be rules based and transparent: Most Fed officials rejected the call for rules-based policy, especially those involving control of monetary aggregates. Fed Governor Andrew Brimmer, for example, argued that "it would be a disastrous error for the Federal Reserve to try to conduct monetary policy on the basis of a few simple rules governing the rate of expansion of the money supply" (1972, 351). And Burns claimed that "[t]he appropriate monetary growth rates will vary with economic conditions. They are apt to be higher during periods of economic weakness ... than when the economy is booming.... Special circumstances may, however, call for monetary growth rates that deviate from this general rule."
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Table of ContentsIntroduction
Michael D. Bordo and Athanasios Orphanides
Panel Session I: Pioneering Central Bankers Remember Practical Experiences in Reducing Inflation: The Case of New Zealand
Don Brash Practical Experience in Reducing Inflation: The Case of Canada
John Crow Discussion
I. Early Explanations
1. The Great Inflation: Did the Shadow Know Better?
William Poole, Robert H. Rasche, and David C. Wheelock
Comment: Christina D. Romer
Discussion 2. The Supply-Shock Explanation of the Great Stagflation Revisited
Alan S. Blinder and Jeremy B. Rudd
II. New Monetary Policy Explanations
3. The Great Inflation Drift
Marvin Goodfriend and Robert G. King
Comment: Lars E. O. Svensson
Discussion 4. Falling Behind the Curve: A Positive Analysis of Stop-Start Monetary Policies and the Great Inflation
Andrew Levin and John B. Taylor
Comment: Bennett T. McCallum
Discussion 5. Monetary Policy Mistakes and the Evolution of Inflation Expectations
Athanasios Orphanides and John C. Williams
Comment: Seppo Honkapohja
III. Other Countries’ Perspectives
6. Opting Out of the Great Inflation: German Monetary Policy after the Breakdown of Bretton Woods
Andreas Beyer, Vitor Gaspar, Christina Gerberding, and Otmar Issing
Comment: Benjamin M. Friedman
Discussion 7. Great Inflation and Central Bank Independence in Japan
Comment: Frederic S. Mishkin 8. The Great Inflation in the United States and the United Kingdom: Reconciling Policy Decisions and Data Outcomes
Riccardo DiCecio and Edward Nelson
Comment: Matthew D. Shapiro
IV. International Perspectives
9. Bretton Woods and the Great Inflation
Michael D. Bordo and Barry Eichengreen
Comment: Allan H. Meltzer
Panel Session II: Lessons from History Lessons from History
Donald L. Kohn The Great Inflation: Lessons for Central Bank
Lucas Papademos Understanding Inflation: Lessons of the Past for the Future
Harold James Discussion