Soon after the Great Inflation got underway, policymakers began looking for solutions. Ever since 1934, the $35/oz. gold price peg had provided a sort of anchor for prices. Yes, it was a weak anchor, as the gold standard was gradually being dismantled, but it still had some ability to hold down inflation expectations. Once that price peg was lifted in March 1968, LBJ looked for alternative solutions. His first choice was MMT. Then Nixon tried statism (or socialism, if you want to troll the Sanders/AOC supporters). Then Carter tried Keynesianism. They all failed. Then Reagan tried monetarism. He succeeded. This is their story.
In 1968, LBJ raised taxes sharply as a way to slow inflation, the MMT solution. In one sense this policy was a smashing success, as the budget swung into surplus during the 1968-69 fiscal year (which went from July to July in those days). That was a mind-boggling accomplishment at the time. When does a country balance its budget in the midst of a major war, and when it is also rapidly scaling up the “Great Society”? (Everything from expanded welfare, to Medicare, Medicaid, housing programs, moon landing, etc.) That’s crazy!
Unfortunately, it was a complete failure at holding down inflation, which continued to accelerate. That’s because it was based on the false model that fiscal policy determines inflation, whereas in fact it is monetary policy that determines inflation.
In August 1971, Nixon adopted wage/price controls. These did briefly slow measured inflation, but by 1973, inflation was soaring to new highs even as shortages were developing. Nixon ended the controls during 1974. (And no, the 1972-81 inflation was not about oil, as NGDP grew at 11%/year and RGDP grew by a bit over 3%/year. It was money.)
During 1979-81, Carter’s Fed adopted a high interest rate policy to control inflation. Almost everyone in the world, both left and right, gets this wrong. They draw a sharp break between the period before August 1979, when G. William Miller led the Fed, and the next 8 years, when Volcker led the Fed. Actually, the 1979-81 policy that led to America’s highest inflation rates since WWII was produced by both Miller and Volcker; the actual policy break toward tight money occurred in mid-1981.
Keynesians have a bad habit of reasoning from a price change, assuming that inflation comes from an overheating economy (it comes from easy money), and they also have a bad habit of assuming that high interest rates represent tight money (sometimes, not always). They wrongly see high interest rates as a way to control inflation. That’s like saying “High oil prices are a good way to reduce oil consumption.” Not if the high oil prices are caused by public policies that boost oil demand. People need to stop reasoning from a price change.
During 1979-80, the high interest rates were caused by an easy money policy, which boosted interest rates via the income and Fisher effects (mostly the latter.) That’s why this Keynesian policy failed. For you econ nerds, the Fed shifted the IS curve to the right (via bad signaling), boosting interest rates, while it wrongly believed that it was shifting the LM curve to the left, an alternative way to create high interest rates.
The Volcker policy failed so spectacularly that NGDP growth reached an annual rate of 19.2% during 1980Q4 and 1981Q1. Those are Latin American rates. You might argue that it was just a question of giving the policy enough time to work. After all, inflation did eventually come down. But that argument won’t fly, as even the financial markets were freaking out about high inflation. Thirty-year bond yields reached nearly 15% in mid-1981, as people lost all faith in the future value of the US dollar. Policy may affect inflation with a lag, but it affects market expectations immediately.
Then in mid-1981, Volcker switched to a tight money policy. Monetarists had told Volcker to forget about interest rates and control the M1 money supply. That’s still not a good policy, but it’s far less bad than targeting interest rates during high inflation periods. By late 1981, the monthly inflation numbers had fallen to about 5%, and by late 1982 we had reached the 4% range maintained throughout the remainder of the 1980s. The Great Inflation was over. Monetarism ended the Great Inflation.
When there is high inflation, the world will always (eventually) turn to monetarism for an answer. In the early 1920s, hyperinflation roared through several European countries. Wicksell and Keynes suddenly stopped talking about monetary policy in terms of interest rates and starting talking about the money supply as the key variable. Keynes’s Tract on Monetary Reform of 1923 is a monetarist book.
[I mention Wicksell and Keynes, as they are the two most important advocates of the interest rate approach to monetary policy in all of world history.]
So there are lessons here. If you want to control high inflation, do not rely on tax increases (MMT), price controls (statism) or high interest rates (Keynesianism). Rather, adopt a tight money policy. That always works, and it’s the only policy that works. Tight money might raise interest rates, or it might lower rates (as in Switzerland during January 2015), but it will always lower inflation.
PS. There is some debate over the actual “concrete steps” used by Volcker to control inflation, an issue people obsess over far too much. The monetarists recommended money supply targeting at a steady growth rate, but Volcker did not in fact adopt that policy. M1 money growth did slow during the period from April 1981 to mid-1982, however, which is when inflation came down. What’s important is that Volcker’s Fed adopted a tight money policy in mid-1981, and that this is what brought inflation down. Interest rates, M1, exchange rates and all the rest will adjust as needed, as long as you adopt a tight enough policy to control inflation.
PPS. If you insist on concrete steps, here’s one option. Do enough open market sales of bonds until market expectations of inflation fall to your target range. (Obviously I’d prefer NGDP targeting over inflation targeting.) Let interest rates go wherever they want to go.
By Scott Summer
