The Great Inflation of the 1970s in the United States - Term Paper Example

? of Lecturer] Macro & Micro economics The Great Inflation of the 1970s in the United s Introduction In asummed up brief, the Great Inflation of the 1970s was a period that epitomized the United States’ struggle with double-digit inflation rates beginning early in the 1970s until early 1980s. As asserted by many authors and in many literatures, post World War II economists and politicians toyed with certain ideas proposed by Keynesian economics. According to this type of economics, it is possible to trade off inflation and employment to achieve some economic stability and growth, albeit for a short-term objective (Bulkley, p135). According to this school of thought, small amounts of inflation could be allowed to help lower unemployment rates, thereby, attaining higher overall economic output. The main weakness of the Keynesian economics was that despite the fact that inflation may lead to increased employment; such a strategy only has short-term effects (Hunter, p214). For example, a lot of cash in circulation results in boosted demand for goods and services and a corresponding drop in interest rates. Interestingly, people always mistake this influx in money supply with wealth, thus, increase their spending and demand for goods and services (Bulkley, p135). Unfortunately, it would later require a higher rate of inflation to achieve the same economic effects. In the case of the Great Inflation of the 1970s, the United States was experiencing both high unemployment and inflation, a situation that the Keynesian economists would somehow consider impossible. The Great Inflation and any other inflation for that matter present many problems not only to citizens but also to economists and other policy makers who have to find ways of countering the negative effects of inflation. Although central banks world over have the powers to control and avert inflation through tighter and stronger monetary policies, most policy options available for central banks, the Federal bank included, are not often politically correct since they cause economic downturn at their initial stages. The politically incorrect impacts of some of these central bank policies mostly touch on unemployment and bank interest rates. Therefore, although a central bank may tirelessly try to formulate and implement monetary policies that would curb inflation, the immediate negative economic effects of these policies and political pressures force most central banks relenting and inflation returning (Bulkley, p135). Simply put, inflation refers to a general increase in the prices of goods and services and/or cost of living over a given period. Accompanying this increase in prices is the weakening of a currency, implying that such a currency buys fewer items than before the inflation. In other words, the purchasing power of a currency is reduced day by day, which is measured by the rate of inflation. The rate of inflation is the percentage change in the general price index, calculated as an annual figure. Although a high inflation rate is bad for an economy, a zero or a negative one is equally bad unlike a low inflation rate, which is beneficial to a country. For instance, a high inflation is found to interfere with the behaviors of consumers who may want to buy their requirements in advance, fearing further increases in commodity prices (White, p10). This consumer behavior has an effect of stabilizing the market by way of creating preventable shortages. This paper explores the Great Inflation of 1970s in the United States concerning its background, effects, causes, and the monetary policies in the preceding and succeeding years. The Great Depression Most scholars, economists and historians have described the Great Inflation of the 1970s as one of the biggest economic gaps in the history of not only the United States but also of other countries around the world. Also described as the biggest domestic blunder ever for the United States, the Great Inflation of the 1970s played a rather central role in the transformation that the American society underwent in the years that followed. In fact, this transformation was apparent in almost all the spheres of Americans’ lives including politics, economy, education, and social life. Unfortunately, the story of the Great Inflation of the 1970s is rarely remembered, mentioned, or appreciated by many U.S citizens. However, in the recent times of economic uncertainty, it has become impossible to completely forget the role of the Great Inflation of the 1970s in shaping and influencing not only the economy but also the politics of the United States of America. The Great Inflation remains one of the giant gaps in the history of U.S economy, this is evidenced by the mess, which the stock market was, as marked by the 40% losses it incurred in about 18 months (White, p12). In fact, for close to a decade, most U.S citizens did not want anything to do with the stock market. Worse still, this period was marked by weak economic growth, high unemployment rates that reached double-digits. To blame for the woes that characterized the Great Inflation of the 1970s were the easy-money policies that the U.S central bank practiced. Ironically, the easy-money policies were intended to create more employment opportunities for the U.S population. Later, the Federal Reserve Bank would change these policies and raise interest rates to a rate of 20%, hitherto regarded exorbitant (Samuelson, P. 36). This raising of interests by the new Federal Reserve leadership was however, catastrophic to interest-sensitive industries and sectors such as motor trade and housing due to people pricing out of new cars and homes. The Casualties of the Great Inflation of the 1970 The Great Inflation of the 1970s began in 1972 and would continue until early 1980. As earlier stated, the inflation was largely blamed on the failure of the then macroeconomic policies practiced by the U.S postwar government. Among the macroeconomic factors on which the Great Inflation of the 1970s was blamed, were currency speculators, oil prices, greed on the part of businessmen, and greedy/materialistic trade union leaders. However, the main causes of the inflation, the failed monetary policies applied by the Federal Reserve and other financial institutions, were partly pushed for and supported by the political class of the day. The Great Inflation of the 1970s and the subsequent recession, just like many other inflations, was a monetary phenomenon, which resulted in wrecked businesses and individuals (White, p9). Among the individuals affected and rendered bankrupt by the Great Inflation was John Connolly, the uneducated treasury secretary installed by President Richard Nixon. What intrigued many U.S citizens were the periods of economic boom that preceded the Great Inflation of the 1970s. In fact, it is the relatively low unemployment rates and strong economic growth numbers of the early 1970s that prompted U.S citizens to re-elect President Richard Nixon and the Democratic Congress in 1972 (White, p12). However, President Nixon, the Congress and the Federal Reserve all failed the U.S citizens who had optimistically elected them. The History: How and Why The history of the Great Inflation could be traced back to 1969 after President Nixon inherited economic depression and the Vietnam War from President Lyndon Johnson. President Lyndon had spent quite a lot of resources on the Great Society and the war in Vietnam. Despite protests from a section of American citizens, the U.S Congress and President Nixon continued to finance the Vietnam War (Samuelson, p65). To endear himself to the voters and enhance his re-election chances, the President increased social security funding in 1972. This he did despite the platform of fiscal conservatism on which he rode to presidency. In fact, President Nixon mostly operated in deficit budgets. His other economic change in principle was the policy of imposing wage and price-controls, two strategies that worked quite well for him in the election year of 1972. Unfortunately, these policies would result in double-digit inflation rates with businesses and individuals trying everything possible to make profits when the control policies were lifted. Because of the deficits with which President Nixon was running the government, dollar-holders became anxious, with many foreigners rightly believing the dollar was overvalued. With the last link to gold as currency broken by President Nixon in 1971, the U.S dollar became a fiat or a legally binding currency, consequently, leading to its devaluation. To win the 1972 elections, President Nixon was not concerned with the dollar-holders or budget deficits; he wanted the economy to boom and jobs created so that he would campaign on that basis. To achieve this, he ordered the Federal Reserve Bank to lower interest rates since another recession would diminish his chances of being re-elected. Having replaced William McChesney Martin as the chairperson of the Federal bank, Arthur Burns was soon taught the politics of the Federal Reserve Bank and survival tactics. He, thus, disregarded the monetary policies of the Federal Reserve that were designed to create money, foster economic growth, and lower inflation (Samuelson, p84). He was, therefore, effective in making President Nixon’s dream and goal of short-term economic growth and strength achievable. Although President Nixon pressurized Burns to ensure unemployment remained low even if inflation was high, he was soon to realize that both inflation and unemployment would soar higher than hitherto seen in the United States because the Federal Reserve Bank had to provide cheap money to the public (Samuelson, p312). The short-term growth policies worked well for the President, with him being re-elected while the Democrats held the Congress. After the celebrations of the re-election of President Nixon, the inflations reached double-digits, hitting 12% by 1973. By 1980, the rate of inflation in the U.S had hit 14% with some fearing that the U.S economy would collapse. There was also that section of the public who thought that the Great Inflation of the 1970s was actually a positive thing for the U.S. To recover from the Great Inflation, it required the hiring of another Federal Reserve Bank chairman who would accept a period of an economic decline (Samuelson, p24). This period would be marked by widespread decline in the GDP, employment, and trade lasting between six months and one year. It is only through the implementation of these new policies that the inflation went down to a single digit. However, to achieve these inflation levels, the unemployment rate had to exceed 10%, making many U.S citizens quite angry (Hunter, p312). Effects of High Inflation Rates The Great Inflation of the 1970s, with the characteristically increasing inflation denoted a slowing economy, evidenced by rising food, commodity, and service prices. Besides these increases in prices and the weakening of the U.S currency, other more prominent effects of the Great Inflation could be easily identified. First among these effects of the Great Inflation was increase in costs. For the most part, U.S citizens were to pay more for edible/food products, transport, and energy-consuming commodities among other goods and services. In addition, the price-increase effect was felt even on imported goods such as gas and oil, more so from Arab countries that also happened to be dollar-holders. The second effect of the Great Inflation of the 1970s was the increasing cost of loans as most banks had their lending rates soaring high (Hunter, p48). The implication of this increasing loan cost was that U.S citizens paid more for car and home loans than before. The third effect of the Great Inflation of the 1970s was the apparent decrease in returns on investments. For example, after adjusting for inflation, some fixed deposits in banks and mutual funds returns yielded lower and even negative returns for investors (Hunter, P. 48). Most affected in this regard were short-term investors who sought their returns after a few months. There was also a decline in the value of investment portfolio since the high inflation impacted negatively on stocks, thus, challenging the growth of listed companies. Consequently, most listed companies reported drops in portfolio value. High taxes were the other obvious effects the Great Inflation of 1970s had on U.S citizens. The high taxes resulted from government measures to ensure money kept flowing for supporting the weak economy. There was also a considerable cutting down of working costs by many companies/businesses to ensure their own survival during the hard economic times during which they operated (Dickson & Shenkar, p79). The cost cuts were also intended to ensure that ongoing projects did not stall or collapse all together. By extension, the cost cuts led to reduced allowances, pensions, travels, and parties among U.S citizens. The other effect of the Great Inflation was a slowed infrastructure growth as the government, companies, and individuals deferred or stopped development projects due to high costs of projects. The high inflation during the Great Inflation of the 1970s also redistributed peoples’ incomes with both fixed income earners and those without bargaining powers becoming quite affected as their purchasing powers fell. Furthermore, trade unions demanded wage increment for their members. In cases where employers gave in to these demands by trade unions, wage-price spiral was the outcome, further worsening the inflation problem (Conrad, p162). The uncertainty and fluctuations in inflation during the high inflation times also implied that businesses could not predict future prices and profits, as they could not calculate product prices and returns on investment. Because of these uncertainties and fluctuations, business confidence went down during the Great Inflation of the 1970s. The high inflation also affected U.S’s export and import trade compared to its competitors. The U.S international trade thus experienced low sales during this period, both at the domestic and foreign markets. There was thus a trade deficit as a result of the Great Inflation of the 1970s by extension, therefore, the competitive position of the United States in the international trade arena was greatly reduced (Samuelson, P. 284). The many negative effects of inflation, therefore, make it necessary that nations become aware of its long– and short-term effects. It is thus more rewarding for a country to be prepared for inflation rather than to be sorry after its devastating effects have reached the people. Although most effects of inflation are negative, others may be described as ‘positive, albeit in regard to the sections or groups of people who benefit from inflation (Conrad, p234). First, high inflation may benefit the inflators, such as politicians (Richard Nixon and the Democratic Congress) in the case of the Great Inflation of the 1970s. Second, high inflation could also be of benefit to the first and early users of the inflated money, long before the negative impacts set in. For instance, big business cartels that destroyed small businesses also benefited at the early stages of the Great Inflation (Conrad, p323). The other people that benefitted from the Great Inflation were the borrowers who were lucky to pay the same amount borrowed (including fixed interests). In fact, in situations where inflation was higher than the interest rates, such borrowers would pay less money back. Unfortunately, for borrowers, the banks were aware of the interest problems during the high Great Inflation; they thus increased their interest rates so that borrowers would not pay back less money than the amount of their loan. Policies to Survive the Great Inflation The need to control inflation is one of the core economic responsibilities of central governments and banks. The policies that helped the United States to reverse the Great Inflation were started by the chairman of the Federal Reserve between 1979 and 1987, Mr. Paul Volcker, an appointee of President Jimmy Carter. Instead of focusing on interest rates as his predecessor did, Volcker mainly targeted the monetary bases. In addition, he did not succumb to political pressures to abandon anti-inflation policies, even in bad economic times. Instead, he was resolved to ensure that Federal Reserve Bank policies and measures that promoted inflation were stopped. Although the unemployment rate increased to 10.8% and the prime interest rate exceeded 21% in 1982, the late part of that year marked the beginning of one of the longest periods of consistent economic growth for the United States. Some credit and praise also goes to President Reagan who opted not to meddle in the businesses of the Federal Reserve Bank and its chairman Volcker. Despite the fact that the Federal Reserve Bank has always been considered independent, it has actually been proved susceptible to political pressures and pressures from other business powerhouses. For example, the Great Inflation of the 1970s and the policies that caused it were due to the pressures that Presidents Lyndon and Nixon placed on the Federal Reserve Bank chairmen. President Carter also attempted to put pressure on the chairman of the Federal Reserve Bank with his policy to institute credit control. In fact, Volcker’s anti-inflation policies irked both democrats and President Reagan’s right-wing Keynesian economist supporters. In the years that followed the Great Inflation of 1970s, more so 1982 onwards, keeping control over inflation was among the primary concerns of subsequent U.S governments. Consequently, efficacious policies and strategies have since been formulated and implemented to address the basic causes and effects of inflation as well as those designed to bring inflation under control (Dickson & Shenkar, P. 27). Strong fiscal policies are among those extensively implemented to effectively control inflation. Fiscal policies have been quite effective in increasing leakage rates from circular income flow, as a result reducing additions into particular income flows. Consequently, a reduction in the demand-pull Inflation has been achieved (Dickson & Shenkar, P. 27). The other policy that has helped address inflation in the U.S relates to lowering government expenses, characterized by a drop in the annual borrowings by government departments. To reduce disposable income, subsequent governments have introduced high direct taxes in certain hard economic times. Monetary Policies have also been successfully used in the U.S to control inflation by controlling the rise in demand for money through increased interest rates and decreased money supply. That is, with an escalated interest rate, the collective demand for money goes down considerably. The first way in which this reduced demand has been achieved is by high interest rates that discourage the public (organizations and individuals) from borrowing. On the other hand, people are encouraged to save, as it would earn them higher interests. There is also an accompanying decrease in demand for loans, reducing the growth of broad money. The other inflation-reducing policies used by successive U.S governments to address inflation include escalated exchange rate and direct wage controls/income policies. Conclusion The Great Inflation of the 1970s has been described as the period during which the U.S experienced the worst economic downturn in recorded history. Characterized by high inflation and high unemployment, the Great Inflation of the 1970s was caused by poor monetary and fiscal policies by the Federal Reserve Bank, under political pressure from President Richard Nixon. To win favor in the eye of the electorates, President Nixon had to reduce unemployment even if it meant increasing inflation. Long after the 1972 elections, the long-term effects of the Keynesian economic policies became apparent. High commodity prices, increase in loan cost, changes in consumer behaviors were among the effects of the Great Inflation of the 1970s. Fortunately, change of leadership at the Federal Reserve Bank and the White House led to the formulation and implementation of sound fiscal and monetary policies that reversed the inflation and placed the U.S on the road to economic recovery. Works Cited Bulkley, G. Personal Savings and Anticipated Inflation, 1981. The Economic Journal 91 (361): 135. Print Conrad, B. Profiting From the World's Economic Crisis: Finding Investment Opportunities by Tracking Global Market Trends, First Edition, 2010.Wiley. Print Dickson, C., and Shenkar, O. The Great Deleveraging: Economic Growth and Investing Strategies for the Future, first edition, 2010. FT Press. Print Hunter, L. Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, And Busts, 2011. Axios Press. Print Samuelson, R. J. The Great Inflation and Its Aftermath: The Past and Future of American Affluence, first edition. 2008. Random House. Print White, L. H. The Clash of Economic Ideas: The Great Inflation and Monetarism. 2011. George Mason University. Web. Retrieved on February 16, 2012 from http://mercatus.org/publication/great-inflation-and-monetarism. Read More