The Dangers of Inflation

“Every morning, when you look in the mirror, I want you to think, ‘What am I going to do today to increase the money supply?’”

— John Ehrlichman, assistant to President Richard Nixon,
apocryphally speaking to Charles Pardee,
a Federal Reserve governor,
sometime in the early 1970s


“This is clearly the worst financial problem we’ve had since the Great Depression,” as Joseph Stiglitz said on a radio show in New Zealand on Wednesday morning. (He’s there attending a conference.)

The Nobel-winning economist lined up behind Countrywide Financial (July ‘07), Wells Fargo (November ‘07), former Treasury adviser Nouriel Roubini (December ‘07), the National Association of Homebuilders (March ‘08), and pretty much everyone else in saying this is as bad as it gets.

As in, the worst ever — like finding nothing besides Of Mice and Men to order from Amazon and nothing but Seabiscuit to rent at Blockbuster.

The men now pulling the Fed’s monetary levers sure agree. And while Ben Bernanke might see the shadow of depression where the rest of us glimpse a shade, liquidating the malinvestments of 2002-2007 is certainly hurting.

Imagine the U.S. Treasury paid your wages each month; you’d jump to increase the money supply every chance you got, too. See, it’s the only way to stop the Nazis from taking over. Or the commies.

Or maybe even — oh, horror! — the Democrats…

“Involuntary unemployment,” as John F. Kennedy put it way back in 1962, “is the most dramatic sign and disheartening consequence of underutilization… We cannot afford to settle for any prescribed level of unemployment.”

Barely a generation after the worst recession in U.S. history, backing labor over capital like this — and thereby nabbing labor’s far weightier vote — meant JFK got to kick Richard Nixon around at the ballot box.

When his turn at the top finally came around at the end of the ‘60s, Tricky Dick didn’t forget the kicking. In fact, “I [already] knew from bitter experience how, in both 1954 and 1958, slumps which hit bottom early in October contributed to substantial Republican losses in the House and Senate,” as Nixon himself wrote in 1962.

So come December 1968, when Herbert Stein first met with Nixon as head of his Council of Economic Advisers — and Nixon asked Stein to name the biggest problem they faced — “I started with inflation,” said the economist.

“[Nixon] agreed, but immediately warned me that we must not raise unemployment,” Stein was to recall nearly 15 years later. “I didn’t at the time realize how deep this feeling was or how serious its implications would be…”

Fast-forward to the brink of Easter ‘08, and the “serious implication” of the Great Depression once again is the cost of not acting to prevent it. Or so everyone says.

And I mean everyone…

“[The liquidationists] turned the 1930 recession into a slump,” says Ambrose Evans-Pritchard for The Daily Telegraph here in London:

“They insisted with Puritan zeal — or malice — that speculators should be driven to the wall amid a cathartic purge of the Roaring ‘20s.

“Among them were top bureaucrats at the U.S. Federal Reserve and some of Europe’s central banks.

“The consequence was the Bruning deflation in Germany, ushering in the Nazis. Democracies snapped across half of Europe. If it had not been for the towering figure of Franklin Roosevelt, America might have splintered into a bedlam of prairie populists, Coughlin fascists and Huey Long extremism.”

Better anything — even a bailout of Wall Street’s hated bankers today — than jackboots and Benzedrine addicts with Chaplin moustaches, right? And where better to start in getting the voters onside than with Ben Bernanke’s complete collection of The Waltons, seasons 1-9, on DVD…?

“During the major contraction phase of the Depression, between 1929-1933,” as Bernanke said in a speech in 2004, “real output in the United States fell nearly 30 percent.

“During the same period, according to retrospective studies, the unemployment rate rose from about 3 percent to nearly 25 percent, and many of those lucky enough to have a job were able to work only part time.”

By comparison, the 1973-75 recession — “perhaps the most severe U.S. recession of the World War II era,” according to Ben “John-Boy” Bernanke — real output fell 3.4 percent and the unemployment rate merely doubled, from four percent to nine percent.

So never mind about the double-digit inflation. Never mind that by the end of the ‘70s, “every business decision [had become] a speculation on monetary policy,” as J. Bradford DeLong put it in a 1996 essay. Never mind that business can’t function if money becomes a flickering variable, making the trade-off between inflation and jobs…bailouts and growth…a loser both ways.

“Other features of the 1929-33 decline included a sharp deflation,” Bernanke went on in his speech, soup ladle in hand and a Baker Boy flat cap on his head, “prices fell at a rate of nearly 10 percent per year during the early 1930s — as well as a plummeting stock market, widespread bank failures, and a rash of defaults and bankruptcies by businesses and households.”

So no matter the cost, deflation must be defeated long before it arrives. Indeed, the higher the cost, the better!

“In 1938, Congress enacted the Fair Labor Standards Act,” writes David Hackett Fischer in The Great Wave — his sweeping review of history’s longest inflations — “which set the first national minimum wage. It also briefly considered a maximum wage, but that idea was quickly forgotten.”

Over the next 30 years, this upward bias in wages — all floor and no ceiling — was “built into the American economy,” Hackett Fisher goes on. “Floors under wages, pensions, and compensation for the unemployed; floors beneath farm prices, steel prices, liquor prices, and milk prices; floors for airline fares, trucking charges, doctors’ bills, and lawyers’ fees…”

Come Nixon’s first term, the high cost of living was mandated by government, corporations, unions, and householders alike. Falling prices could not be allowed (“You remember the ‘30s, don’t you?”) and — as yet — rising prices were no more than a puzzler at the grocery store every Saturday morning.

Convinced by economists of a trade-off between rising prices and jobs, governments everywhere watered and tended inflation, thinking they could always prune it if the foliage got out of control. And feeding its roots, deep below ground, was the rich, manure mulch of the Great Depression.

“At the surface level,” DeLong explains, the destruction of money during the ‘70s happened because no one in power “placed a high enough priority on stopping inflation.” Worse than that, Nixon and his successors — Gerald Ford and then Jimmy Carter — inherited “painful dilemmas with no attractive choices.” The ‘60s battle to grow jobs at the expense of sound money had already locked in that problem.

Look deeper again, and “no one had a mandate to do what was necessary,” our Berkeley professor goes on. “It took the entire decade for the Federal Reserve as an institution to gain the power and freedom of action necessary to control inflation.”

But at the very deepest level, “the truest cause of the 1970s inflation was the shadow cast by the Great Depression,” DeLong concludes. “It took the 1970s to persuade economists and policymakers that ‘frictional’ and ‘structural’ unemployment were far more than 1-2 percent of the labor force. It took the 1970s to convince [them] that the political costs of even high single-digit inflation were very high.”

In short, the developed world balked at the chance to “liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate” — as U.S. Treasury Secretary Andrew Mellon had urged in the ‘30s — when the liquidation wouldn’t have washed so deep or so hard at the start of the ‘70s.

Scared by the ghost of a Greater Depression instead, the West pushed ahead with big budget deficits, negative real interest rates, and a destruction of money that almost bankrupted Treasury bond holders. The runaway inflation that failed to back off when Richard Nixon nudged the Fed about defending jobs before the dollar (for what else is “inflation” if not a loss of purchasing power?) proved a hard-won lesson all told.

Reaching double digits across the developed world and causing a flight into commodities that in turn led to a huge bubble of malinvestments in the early 1980s, the “sustained spurt” of ‘70s inflation equaled the worst wartime price increases by the time double-digit interest rates could be used — with broad voter approval — to kill it off.

It all ended — guess what! — with a forced liquidation at the start of the ‘80s. And today?

“Ben Bernanke is smarter than I am and thinks about this 24/7, which I do not,” says Bradford DeLong on his blog this week. “He leads a superb committee. He is backed by the best monetary policy technical economic staff in the world. If I disagree with Ben’s FOMC on an issue of monetary policy, I am probably wrong.”

Either that, or Bernanke’s still stuck on Walton’s Mountain nostalgia…just as TV audiences were back in the ‘70s.

Adrian Ash
March 21, 2008