The Perfect Enemy | Inflation Is Only Part of the 1970s Economic Story
August 11, 2022

Inflation Is Only Part of the 1970s Economic Story

Inflation Is Only Part of the 1970s Economic Story  Foreign Policy

Read Time:16 Minute

Some historical analogies are playful. Some require elaborate academic justification. Others are native to our world. The lessons learned from them are so ubiquitous as to be part of our intellectual furniture. They are built into our very institutions. The European Union, for instance, repeatedly invokes the need to avoid anything that resembles the violent European politics of the first half of the 20th century. NATO abides as an organization dedicated to, in the words of its first secretary-general, keeping “the Russians out, the Americans in, and the Germans down”—all three imperatives learned from the experience of the early 20th century.

For economic policy, there are two such formative moments. One is the Great Depression of the 1930s, from which we learned the lesson not to allow aggregate demand, the money supply, or global trade to implode. Those lessons informed economic policy in response to the crises of 2008 and 2020. 

The other formative moment for economic policy is the 1970s. It is barely an exaggeration to say that today’s repertoire of day-to-day economic policy is a distillation of the traumatic experience of that decade. Between 1971 and the early 1980s, the postwar monetary order anchored on Bretton Woods fell apart, currencies gyrated, inflation surged, and so too did unemployment. The disorder was brought to an end after 1979 by the application of an unprecedentedly severe dose of high interest rates, which precipitated a major recession both in the United States and much of Europe. 

In the subsequent decades, avoiding a return to the 1970s was the idée fixe of economic policy. And it seemed to have succeeded, so much so that in the aftermath of the unprecedented economic shock of the COVID-19 pandemic in early 2021 we seemed finally to be escaping the grip of this historical analogy. But history is moving fast. Since last summer, inflation has been back with a vengeance. And once again references to the 1970s are everywhere. Policymakers and pundits fret that having left it too late central banks may now have to hike interest rates so high that we will tumble into a recession. 

At a superficial level, the analogy is striking. As in the 1970s, commodity markets are disrupted by a war. In early 2022, prices in the United States were rising by more than 8 percent per year. As in the 1970s, fiscal policy and monetary policy seemed stuck for too long in expansionary mode. But these similarities hide huge differences below the surface. To view the 1970s as a data set from which to draw technical lessons is to mistake for a laboratory experiment what was, in fact, a historic power struggle. That power struggle ended with the conclusive victory of the forces of disinflation. It could perhaps have gone another way. But, for better and for worse, there is no way back. 

The experience of the 1970s informs today’s mainstream view that it is important to act preemptively to forestall the buildup of inflationary expectations. This is crucial because it is the expectation of future inflation among workers and industries that drives wage and price increases, which in turn generate further inflation. To ensure that the central bank acts promptly to stop an acceleration of the inflationary cycle, it is important that control over monetary policy be handed to an independent central bank staffed by technocrats of a broadly conservative disposition and not beholden to voters, as they may prefer to avoid the pain of disinflation. 

Of course, the history from which we learn lessons is itself a matter of interpretation and argument. And this raises the question, were the 1970s really that bad? 

As far as the U.S. economy and world economies are concerned, the main damage was confined to 1973-75. Otherwise, growth was somewhat better than in subsequent decades. In many countries, the 1970s were a period of social advance. Welfare states and welfare rights expanded. Even inflation created winners: Anyone who owned a home financed with a mortgage did well, as did taxpayers, who by the 1980s were shouldering a much lower real value of public debt. It was in the 1970s that the debts accumulated during World War II by Britain and the United States were finally burned off. 

The decade was also a last high of trade union power. It was the last moment in which capitalist democracy was still checked on both sides of the Atlantic by a truly powerful countervailing force in the form of organized labor. That power sometimes expressed itself with disruptive strikes, but labor’s fight was a losing battle. Particularly in the United States, real wages fell over the decade, driven down by automation and digital technology, competitive pressures from globalization, and price increases. Nevertheless, the trade unions exercised a voice in economic policy to a degree barely imaginable today. 

The 1970s also saw a rebalancing of the world economy, which had long favored the former imperial powers over recently decolonized raw material exporters. The OPEC oil boycott was no doubt a shock but could be read as an overdue correction of those fundamental imbalances. 

When we say that economic policymakers learned lessons from the 1970s, what we typically mean is that they are focused on a conservative interpretation of their own ostensible failures during that decade. The ’70s were a time when many of the West’s economic and political elites sensed they were losing their grasp on control after having failed to sufficiently discipline oppositional forces both at home and in the world at large. 

According to this version of events, complacent policy by central bankers and politicians in the late 1960s and early 1970s in the form of low interest rates and undisciplined spending compounded the problems created by economic shocks such as the OPEC price hike of 1973. This is said to have set in motion runaway inflation. Politicians were cornered by powerful interest groups—forces such as the British National Union of Mineworkers, which effectively challenged and toppled a Conservative government in 1974. The Trilateral Commission, formed in 1973 as a discussion group for leaders from Japan, Western Europe, and North America, warned in ominous tones that democracy was becoming ungovernable. Expectations of welfare and consumption were set too high for the economy and politics to satisfy. What was at risk was nothing less than the viability of capitalist democracy.

It was against this dark backdrop that the independent central bankers appeared in the role of saviors. In Europe, the Bundesbank, Germany’s central bank, anchored a conservative commitment to low inflation throughout the decade. In October 1979, the U.S. Federal Reserve under Paul Volcker, nominated as chair by President Jimmy Carter, pivoted to a tougher stance. Hiking the federal funds rate to 19 percent, he squeezed inflation out of the system by making credit scarce. 

As Rudiger Dornbusch and other master thinkers of contemporary economic policy liked to proclaim, the aim of the game was not simply to stop inflation but to roll back political influence, to put an end to what Dornbusch dubbed “democratic money.” In inflicting the savage shock of 1979-80, the Fed, according to the likes of Dornbusch, demonstrated that it stood above interest groups and would not be swayed by public opinion. That description is self-serving. It would be more accurate to say that central banks delivered for the constituency of savers, business owners, and investors—none of whom liked inflation—as well as a swath of conservative political opinion that wanted stability restored. Independent central banks were not truly above politics; they were the extension of conservative politics by technocratic and nondemocratic means. 

The economic results of this counterrevolution were far from unambiguous. Growth in the early 1980s slumped. Entire industrial sectors were rendered uncompetitive by soaring interest rates and surging exchange rates. Unemployment hit postwar records. It was painful, but on the conservative reading there was, as British Prime Minister Margaret Thatcher liked to say, no alternative. If the struggles of the 1970s had continued, she suggested, the result would have been a slide toward ever more rapid inflation and threats to the institutional status quo. Ultimately, the Cold War order was in peril, and if avoiding that fate required turning monetary policy into a more blunt-force form of political struggle, then so be it. In fighting the mineworkers into submission in 1984-85, she was waging war on enemies within, as she waged war on the Soviet enemy without. The prize was nothing less than a permanent shift in the balance of social and economic power and the exclusion of alternatives to the rule of private property and markets. 

The alternative that Thatcher wished to rule out was exemplified in France by the Socialist government of President François Mitterrand, elected in 1981 with the backing of the French Communist Party, which embarked on a social and economic experiment that included the nationalization of industry and finance. Through a state-directed program, the French Socialists hoped to restore growth and tame inflation in cooperation with the trade unions. It would have been a gamble under any circumstances. The high interest rate policy being driven by the Fed and the Bundesbank, and the appeal to global investors of the market revolution, further lengthened the odds. In 1983, under huge pressure from bond markets, Mitterrand abandoned the fight. Thatcher’s slogan “There Is No Alternative” was not so much a statement of fact as a performative act—a claim designed to sideline alternatives and to encourage the bond vigilantes who killed them dead. 

In both Europe and the United States, the labor movement never recovered from the deflationary shock of 1979. Globalization, which gathered pace in the 1970s, put downward pressure on wages and prices. Japan’s long boom came to a sudden stop in 1991 with the bursting of the real estate bubble. The following year in Europe, the agreement to create the eurozone anchored disinflation across the EU, making low inflation secured by the European Central Bank (ECB) into a quasi-constitutional requirement. By the early 2000s, Ben Bernanke, soon to take over at the Fed himself, could quip that the Great Inflation of the 1970s had given way to a new era of the Great Moderation—a characterization more apt for those earning median or low wages than it was for those at the top of the income distribution, whose wealth and incomes soared. In 2006, billionaire investor Warren Buffett succinctly summarized the history of economic policy since the 1970s: “There’s class warfare, all right, but it’s my class, the rich class, that’s making war, and we’re winning.”

The comprehensive victory of the disinflationary forces was undeniable. But rather than loosening up, the conservative vision of the 1970s was now endlessly repeated as a mantra. Implicitly, the suggestion was that unless central bankers remained on guard, there would be a constant risk of sliding back to the future. Central bank economists habitually produced exaggerated forecasts of inflation, helping to impart a restrictive bias to policy. In 2008, even as the banking systems of Europe and the United States were collapsing, central bankers called for rate rises to counter the rising price of commodities and energy. In 2011, in the midst of the eurozone crisis, the ECB convinced itself to raise interest rates for fear of runaway inflation. 

It was only in the aftermath of the global financial crisis, 30 years on from the 1970s, that the paradigm seemed finally to be shifting. The recovery from the 2008 crisis was painfully slow, especially in Europe. Despite huge expansion in central bank balance sheets, inflation remained well below the central bank upper limit of 2 percent. In Europe, inflationary expectations threatened to slide into negative territory, signaling Japan-style long-term stagnation. In 2013, economist Larry Summers in a highly influential address to the International Monetary Fund recast the new era as one not of repressed inflation but of secular stagnation. The risk was not that prices and wages would surge but that investment would be insufficient to sustain economic growth. Without artificial stimulus from the central bank, in the form of ultra-low interest rates and monetary stimulus, the economy would slide into a slump. The better alternative, according to Summers at the time, was government-financed investment, a line with which many on the left since the 1970s could have agreed.

This was a radical reworking of the post-1970s script. And it seemed to be borne out by the data. Between 2013 and the 2020 COVID-19 shock, central banks talked repeatedly about the “normalization” of monetary policy, trying to remove the stimulus they had created, but every time they did so, they risked upsetting financial markets and tipping the economy into recession. Meanwhile, rather than launching irresponsible spending plans, as they were accused of doing in the standard 1970s scenario, politicians, at least in Europe, systematically opted for tight fiscal policy. Wage and price pressure was muted at best. 

In 2021, in the wake of the COVID-19 shock, which threatened not inflation but a gigantic global recession, both the ECB and the Fed adopted new and more permissive inflation targets. The ECB proposed to target 2 percent inflation—no more but also no less. The Fed adopted average inflation targeting, which allowed it to tolerate periods of higher inflation if that was necessary to offset periods of undershoot. Finally bidding adieu to the 1970s, Fed Chair Jerome Powell told journalists that on his watch he did not expect to see the kind of inflation that had characterized his younger years. 

That was in January 2021. And it was, it seemed, a historic turning point. But more than a year later, the picture has entirely changed. Inflation has accelerated to levels not seen in 40 years, and the 1970s analogy once again screams from countless op-ed pages. 

The trigger to our current inflation, it is commonly agreed, was the unprecedented dislocation created by the COVID-19 shutdown. Supply chains were disrupted and demand and supply thrown out of balance. Nevertheless, some similarities to the 1970s are undeniable. Then as now, energy prices are driving the surge in the inflation indices. Then as now, a war is disrupting supply. In 2021, fiscal and monetary policy helped stoke demand, as fiscal and monetary policy did in the early 1970s. 

The critical questions are the extent to which the first round of rising energy and commodity prices will spread to broader categories of goods and whether the increase in prices will become self-sustaining. All eyes are on inflation expectations, the anchor that broke loose in the 1970s. So far this year, medium-term expectations over the five-year time horizon have hardly budged, but short-term expectations are rising. This sets alarm bells ringing at the Fed and ECB headquarters in Washington and Frankfurt. 

But if inflationary pressures are now spreading, the reasons for this upward drift are telling. In 2021 and 2022, on both sides of the Atlantic, two factors have counted. One is the cost of inputs—raw materials and energy. The other is profit margins. Firms are taking advantage of the surge in demand to reap whatever advantage they can. What is missing is any sustained wage pressure. Wages in the United States have risen. But they have not kept up with prices. Real wages in early 2022 were below the upward trend they appeared to have been on before COVID-19 struck. In Europe, trade unions are beginning to make more significant claims. But there, too, wage growth has lagged behind prices.

What the facile 1970s analogy ignores is the basic shift in the balance of social forces. Whereas in the 1970s the response to inflation was strikes and loud demands for welfare state expansion, today the cost of living crisis is a matter of media reporting, Twitter campaigns, and philanthropic concern, not social protest or a workers’ struggle. In 2022, the radical energy of the early Biden administration has largely dissipated. In Europe, to address the hardship of the worst-off faced with the energy price hike, politicians promise remedies in the form of price-fixing for energy or increased welfare payments. But when it comes to changes that might permanently alter the balance of wage negotiations, such as wage indexation or measures to strengthen the bargaining position of trade unions, the “lessons of the 1970s” are readily at hand. Such mechanisms, central bank economists warn, risk unleashing a spiral of higher prices and higher wages, so-called second-round effects. 

It is important, sage central bankers remind us, to recognize that the shift in the balance between supply and demand in energy markets means that consumers must learn to live with less purchasing power. The less fuss they make, the easier the eventual stabilization will be. After all, no one would want to have to repeat the bitter medicine dispensed by Volcker in 1979. Some central bankers, such as Andrew Bailey of the Bank of England, come straight out and demand that employees should refrain from asking for any wage increase, implicitly advocating a real wage cut at a time that profits are surging.

Tellingly, neither the ECB nor the Fed has so far indulged in talk that smacks so openly of Buffett’s class war. The 1970s analogies have remained mainly in the realm of punditry. Sensibly, what the two leading central banks are betting on is that the disruption is transient, that the basic economic conditions of recent decades still hold, and that they will be able to pull off a soft landing with only mild monetary intervention. After all, in the last half-century, the Volcker shock is the only instance of inflation that was suppressed by the force of a savage interest rate hike. As the Fed and the ECB edge interest rates upward, they are hoping simply that markets will do their job, prices will ease, and wage growth will cool. This would allow them to achieve stabilization without either ongoing losses in real income for workers due to inflation or, on the other side, a surge in unemployment provoked by a slide into recession. They are not vying for a counterrevolution of the 1980s variety because they are hoping the original one is still in effect.

As central banks tread this narrow path, inflation hawks continue to urge that the greater risk lies in accelerating inflation. The evidence for that is frankly slim. Practically all serious forecasts predict a calming of inflation in 2023. And if this proves correct, if the central banks stick to their guns and succeed in bringing inflation under control, perhaps we can finally acknowledge that for better and for worse history has moved on and that the old balanced constitution of democratic capitalism that is thought of as falling into crisis in the 1970s is gone for good. In the new constitutional economic order, the countervailing power of labor has been permanently diminished, and the freedom for technocratic action has been enhanced. 

That would mark a loss for democracy and should provoke calls for both a rebalancing of economic power and a democratization of economic policy. But in the current moment, the crucial priority is to ensure that those in charge of policy do not slam on the breaks too hard. And to do that, it would be good if we can rid ourselves of the ghosts of the past. If in the face of inflation rising toward 10 percent the central bankers hold their nerve and manage to engineer a soft landing, perhaps then we can finally bury the 1970s analogy and its mistaken portrayal of history.