Economics / History

The Turn to Disinflation Part 1—Correcting the False History

Milton Friedman Was Wrong All Along

It really is too bad that I, the author, am the only reader of this blog; for once I think I might have stumbled onto something extremely important.  I believe economics would be well served with the argument that Milton Friedman was wrong all along.

Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output—Milton Friedman, 1970.

Many economic histories attribute Friedman writing the above statement in The Counter-Revolution in Monetary Theory as the turning point where monetarism reentered the vogue.  The 1970s proved that high inflation and high unemployment was possible, to the chagrin of saltwater economists.  Economists that subscribe to an underlying framework that acknowledge the work of John Maynard Keynes had to chalk it up to Friedman’s hypothesis—after all, stagflation did arise.

A question always nagged at me about this—why?  What caused this dramatic change?  How could the ten years with the best track record for economic growth, 4.4% on average between 1963 and 1973, turn so dramatically into the stagflation that did not really end until the aftermath of the 1982 Federal Reserve-induced recession?  How had monetary policy caused this massive switchover?

There was an inflection point*—a dramatic change that occurred on a specific date that completely upended the paradigm.  A point after which inflation took off, spiraling out of control in the United States.  It had absolutely nothing to do with monetary policy, and everything to do with Richard Nixon’s experience with the Baby Ruth candy bar.

Weaponized Keynesianism Run Amok

Rather than trying to set this statement up, I’ll let William Walker’s work speak for itself:

As a young lawyer during World War II, Nixon had worked for the Office of Price Administration and he harbored a deep and abiding distaste for the bureaucratic intrusiveness of that earlier controls program. In consultations with consumer leaders in 1971, Nixon recalled from his OPA experiences an incident in which the Curtiss Candy Company shrank the size of its Baby Ruth candy bar, while charging the same price. Nixon vowed that he would never allow those kinds of shenanigans to take place under his leadership. But the cost of preventing shenanigans was an inevitable increase in the complexity of the regulatory structure. The Price Commission did what bureaucracies tend to do: it grew.

Notice that the passage concerns Nixon’s wartime experiences working for the OPA.  The reader must keep this in mind—the United States has never implemented price controls during peacetime—only during WARTIME.  What does Walker mean when he refers to 1970s consumer leaders?  This:

Late in the day on Sunday, August 15, 1971, The White House announced that President Nixon would address the nation at 9:00 P.M., on the state of the American economy. No fanfare accompanied the announcement and weary vacationers streaming back into the city that evening had little reason to suppose that the President was about to announce the most sweeping changes in U.S. economic policies in four decades. But that is precisely what he proceeded to do. With the Congress away on recess and the rest of the Government trying to escape the August heat, Nixon had secretly convened a weekend meeting of his top advisers at Camp David to plan an abrupt change of direction which he would proclaim that night.

First, the President said, he was imposing a 90-day freeze on all wages and prices — the first peacetime controls program in U.S. history. Second, he closed the gold window, ordering a suspension in the convertibility of the dollar into gold or other reserve assets. Third, he declared a state of national emergency and imposed a 10% surcharge on all goods imported into the United States. The impact of the announcements was stunning.

Wrong.  The 1971 price controls were not implemented during peacetime.  This mistaken statement is repeated endlessly, but the August 15, 1971 controls were put in place during wartime, because of the effects of BATTLE and BOMBING.  The war was still raging in Vietnam during 1971, and in the next two years the war will enter its most expensive phase due to the concentration of the Arc Lights.

The Arc Lights are the U.S. Air Force codename for B-52 carpetbombing strikes.  Suffice to say, the B-52s dropped the largest bombloads of any combatant aircraft, ever.  The USAF had modified the Strategic Air Command’s originally nuclear-only heavy bombers with “big belly” upgrades in the early 1960s to enable the nearly 250-ton max gross takeoff aircraft to drop 60,000 pounds of conventional ordnance.  Per bomber.  USAF, U.S. Navy and Marine Corps tactical aircraft would join Strategic Air Command in pounding Southeast Asia with more than 7,500,000 tons of high explosives over a nine year period, nearly quadruple the weaponry used during the Second World War:

The United States Air Force dropped in Indochina, from 1964 to August 15, 1973, a total of 6,162,000 tons of bombs and other ordnance. U.S. Navy and Marine Corps aircraft expended another 1,500,000 tons in Southeast Asia. This tonnage far exceeded that expended in World War II and in the Korean War. The U.S. Air Force consumed 2,150,000 tons of munitions in World War II – 1,613,000 tons in the European Theater and 537,000 tons in the Pacific Theater – and 454,000 tons in the Korean War.”

Needless to say, the largest air raids in history don’t come cheap, and the material costs of the Vietnam War were pushing up inflation in the early 1970s.  I will use Walker’s research extensively, but with a caveat: his conclusions are often way off.  As a limited-government type, Walker is horrified by bureaucratic creep and believes this 1971 episode vindicates supply-side economics.  Paul Krugman would know better—this is in reality shows how weaponized Keynesianism requires careful planning and understanding of combat objectives.  Richard Nixon and his advisors were not a group predisposed to accomplishing any of this, and the effort ran off the rails.

Lawyers in the Warzones

It’s odd that Walker fully recognizes the cause of rising inflation rates

From the end of World War II until the early 1970’s, the U.S. economy had been largely immune to outside influence. Secure in a mammoth continental market and sustained by a stable dollar which had become the world’s reserve currency, the U.S. could ignore international economic events. Foreign trade was only a marginal 4% of GNP and the only problem with oil prices was cheap imports which had to be kept to a minimum so as to protect domestic oil producers. But things began to change in the late sixties. The rate of inflation, which had been running at 1% to 1.7% between 1960 and 1965, started to rise in 1966 with the Vietnam buildup and the U.S. balance of payments dropped sharply in 1968 and 1969 and fell into deficit for the first time since World War II in 1971.

…but is so disingenuous that he has the gall to claim this:

Nixon had come to office in 1969 determined to stern the inflation of the Johnson years. He introduced a policy called “the game plan” aimed at slowing demand, instituting a small budget surplus and reducing monetary expansion. But things had not worked out. By mid-1971, while inflation had slowed, unemployment had nearly doubled to 6.2% and economic growth was sluggish.

Inflation statistics tell a different story:

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1974 9.39 % 10.02 % 10.39 % 10.09 % 10.71 % 10.86 % 11.51 % 10.86 % 11.95 % 12.06 % 12.20 % 12.34 % 11.03 %
1973 3.65 % 3.87 % 4.59 % 5.06 % 5.53 % 6.00 % 5.73 % 7.38 % 7.36 % 7.80 % 8.25 % 8.71 % 6.16 %
1972 3.27 % 3.51 % 3.50 % 3.49 % 3.23 % 2.71 % 2.95 % 2.94 % 3.19 % 3.42 % 3.67 % 3.41 % 3.27 %
1971 5.29 % 5.00 % 4.71 % 4.16 % 4.40 % 4.64 % 4.36 % 4.62 % 4.08 % 3.81 % 3.28 % 3.27 % 4.30 %
1970 6.18 % 6.15 % 5.82 % 6.06 % 6.04 % 6.01 % 5.98 % 5.41 % 5.66 % 5.63 % 5.60 % 5.57 % 5.84 %
1969 4.40 % 4.68 % 5.25 % 5.52 % 5.51 % 5.48 % 5.44 % 5.71 % 5.70 % 5.67 % 5.93 % 6.20 % 5.46 %
1968 3.65 % 3.95 % 3.94 % 3.93 % 3.92 % 4.20 % 4.49 % 4.48 % 4.46 % 4.75 % 4.73 % 4.72 % 4.27 %
1967 3.46 % 2.81 % 2.80 % 2.48 % 2.79 % 2.78 % 2.77 % 2.45 % 2.75 % 2.43 % 2.74 % 3.04 % 2.78 %
1966 1.92 % 2.56 % 2.56 % 2.87 % 2.87 % 2.53 % 2.85 % 3.48 % 3.48 % 3.79 % 3.79 % 3.46 % 3.01 %
1965 0.97 % 0.97 % 1.29 % 1.62 % 1.62 % 1.94 % 1.61 % 1.94 % 1.61 % 1.93 % 1.60 % 1.92 % 1.59 %
1964 1.64 % 1.64 % 1.31 % 1.31 % 1.31 % 1.31 % 1.30 % 0.98 % 1.30 % 0.97 % 1.30 % 0.97 % 1.28 %
1963 1.33 % 1.00 % 1.33 % 0.99 % 0.99 % 1.32 % 1.32 % 1.32 % 0.99 % 1.32 % 1.32 % 1.64 % 1.24 %
1962 0.67 % 1.01 % 1.01 % 1.34 % 1.34 % 1.34 % 1.00 % 1.34 % 1.33 % 1.33 % 1.33 % 1.33 % 1.20 %
1961 1.71 % 1.36 % 1.36 % 1.02 % 1.02 % 0.68 % 1.35 % 1.01 % 1.35 % 0.67 % 0.67 % 0.67 % 1.07 %
1960 1.03 % 1.73 % 1.73 % 1.72 % 1.72 % 1.72 % 1.37 % 1.37 % 1.02 % 1.36 % 1.36 % 1.36 % 1.46 %

Nixon took office on January 20, 1969 amidst an inflation rate that had abated from a decade high of 4.75% to 4.40%.  Initiating a widening of the war in Southeast Asia (Cambodia and Laos in addition to Vietnam), inflation rose above 5% in March 1969 and remained above the level Nixon inherited until 1971.  Nixon and his administration had managed to drop the rate of inflation to below his inaugural baseline of 4.40% twice—4.16% in April and 4.36% in July 1971—and all it required was sacrificing 79% increase in unemployment.  (I might as well include unemployment data—sorry it’s chronological instead of reverse chronological):

Year

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

 

1960

5.2 4.8 5.4 5.2 5.1 5.4 5.5 5.6 5.5 6.1 6.1 6.6  

1961

6.6 6.9 6.9 7.0 7.1 6.9 7.0 6.6 6.7 6.5 6.1 6.0  

1962

5.8 5.5 5.6 5.6 5.5 5.5 5.4 5.7 5.6 5.4 5.7 5.5  

1963

5.7 5.9 5.7 5.7 5.9 5.6 5.6 5.4 5.5 5.5 5.7 5.5  

1964

5.6 5.4 5.4 5.3 5.1 5.2 4.9 5.0 5.1 5.1 4.8 5.0  

1965

4.9 5.1 4.7 4.8 4.6 4.6 4.4 4.4 4.3 4.2 4.1 4.0  

1966

4.0 3.8 3.8 3.8 3.9 3.8 3.8 3.8 3.7 3.7 3.6 3.8  

1967

3.9 3.8 3.8 3.8 3.8 3.9 3.8 3.8 3.8 4.0 3.9 3.8  

1968

3.7 3.8 3.7 3.5 3.5 3.7 3.7 3.5 3.4 3.4 3.4 3.4  

1969

3.4 3.4 3.4 3.4 3.4 3.5 3.5 3.5 3.7 3.7 3.5 3.5  

1970

3.9 4.2 4.4 4.6 4.8 4.9 5.0 5.1 5.4 5.5 5.9 6.1  

1971

5.9 5.9 6.0 5.9 5.9 5.9 6.0 6.1 6.0 5.8 6.0 6.0  

1972

5.8 5.7 5.8 5.7 5.7 5.7 5.6 5.6 5.5 5.6 5.3 5.2  

1973

4.9 5.0 4.9 5.0 4.9 4.9 4.8 4.8 4.8 4.6 4.8 4.9  

1974

5.1 5.2 5.1 5.1 5.1 5.4 5.5 5.5 5.9 6.0 6.6 7.2  

But back to William Walker.  Naturally as the United States is suffering from increased inflation as a result of conducting the largest military air campaign in history and in the process has set a small region in the world known as Southeast Asia on fire (sorry, I haven’t found exact napalm figures yet), the fault in the minds of Republicans must lie with unreasonable labor unions:

Wage settlements were the principal culprit as organized labor sought to restore income lost to inflation by heavily front-loading new labor contracts. In the jargon of the times, there was intense pressure on the Nixon Administration to invoke an “incomes policy” to overcome this inflationary “wage-price spiral.”

As this is the story of massive economic mismanagement, it figures a conservative former governor of Texas would be in the center, right in the thick of it:

The ring-master for the freeze was the charismatic Treasury Secretary John B. Connally. As Governor of Texas, Connally had been wounded in the fateful Dallas motorcade in 1963 when President John F. Kennedy was assassinated. Finding little room in the national Democratic Party for his conservative outlook, Connally had switched his party affiliation to Republican and had been Nixon’s surprise choice for Treasury Secretary earlier in 1971. Connally privately urged Nixon to take the bold step of imposing controls and, once the decision was made, he stepped forward to take charge. In that summer of 1971, Connally was a consummate political pro playing at the top of his game.

Walker is right about one thing—Nixon acted like (might even have believed) his price controls were being applied to a nation in peacetime.  His actions certainly did not mimic the Second World War price controls from thirty years prior:

On Monday morning August 16, 1971, following the President’s address, bedlam reigned in Washington. Companies and workers wondered what to do under the freeze. Lawyers and lobbyists tried to find out, but nobody had any answers. Documents were unavailable, executive orders had not been published; the rules hadn’t even been written. John Connally strode onto center stage that morning, presiding over a turbulent, first-ever televised press conference in the main Treasury building. He parried reporters’ frantic questions, conveying the clear message that a wage and price freeze meant exactly what it said: neither prices nor wages could increase —-period. Virtually the only exception was raw agricultural products. As Connally explained to Virginia Knauer, the President’s Consumer Adviser, “Remember, Virginia, when it’s a cucumber you can raise the price, but when it becomes a pickle, it’s frozen.”

The President established a Cost of Living Council composed of Cabinet members and other senior government officials to run the new program. Connally was the chairman and convened the Council’s first meeting at 4 o’clock that same Monday afternoon in The White House. At the appointed hour, the new and somewhat bewildered members gathered around the polished table in the West Wing’s historic Roosevelt Room. Connally proceeded to explain what a wage and price freeze meant in much the same way he had in the morning press conference: a freeze meant that neither prices nor wages could rise, “except for cucumbers.” (The Council was to meet on a virtually daily basis thereafter for roughly 60 days. Like obedient schoolchildren, the members continued to occupy the very same seat around the table which they had chosen the day of the first meeting).

The Roosevelt Administration, unbeknownst to Nixon and his advisors apparently, had also created the War Production Board (WPB) in conjunction with Nixon’s wartime employer, the OPA.  Increasing output to fuel the coming war effort was the chief aim, the so-called “guns and butter” metaphor.  Inflation wasn’t a major concern until late-1941:

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1945 2.30 % 2.30 % 2.30 % 1.71 % 2.29 % 2.84 % 2.26 % 2.26 % 2.26 % 2.26 % 2.26 % 2.25 % 2.27 %
1944 2.96 % 2.96 % 1.16 % 0.57 % 0.00 % 0.57 % 1.72 % 2.31 % 1.72 % 1.72 % 1.72 % 2.30 % 1.64 %
1943 7.64 % 6.96 % 7.50 % 8.07 % 7.36 % 7.36 % 6.10 % 4.85 % 5.45 % 4.19 % 3.57 % 2.96 % 6.00 %
1942 11.35 % 12.06 % 12.68 % 12.59 % 13.19 % 10.88 % 11.56 % 10.74 % 9.27 % 9.15 % 9.09 % 9.03 % 10.97 %
1941 1.44 % 0.71 % 1.43 % 2.14 % 2.86 % 4.26 % 5.00 % 6.43 % 7.86 % 9.29 % 10.00 % 9.93 % 5.11 %
1940 -0.71 % 0.72 % 0.72 % 1.45 % 1.45 % 2.17 % 1.45 % 1.45 % -0.71 % 0.00 % 0.00 % 0.71 % 0.73 %
1939 -1.41 % -1.42 % -1.42 % -2.82 % -2.13 % -2.13 % -2.13 % -2.13 % 0.00 % 0.00 % 0.00 % 0.00 % -1.30 %

Price controls had not implemented haphazardly—the focus was modulating the rate of inflation to maximize military production output.  That was decidedly not on the Nixon Administration’s radar:

Connally dominated the process and made sure everyone knew who was in charge. Three days into the program, as the regular afternoon meeting convened, an aide handed him a wire service story quoting a Defense Department source who declared that the freeze would not delay a long-awaited military pay increase which had been enacted by the Congress months before and was scheduled to take effect at the end of August.

Connally read the story, walked over to a telephone and asked the White House operator to put him through to Defense Secretary Melvin Laird. The room fell silent and all eyes were on Connally as he waited for the call to be placed. Secretary Laird, the operator reported, was out of the country and could not be reached.

“Get me Dave Packard,” snapped Connally. Packard was the Deputy Secretary of Defense.

Another wait, with Cabinet officers and staffers alike watching Connally in action. Packard finally got on the phone.

“Dave, It seems there’s been a misunderstanding over in your Department,” said Connally. “The President’s freeze order applies to the military pay increase and whoever over there is saying it doesn’t is dead wrong. So, to make things clear, we need a statement from the Department stating that the current levels of pay are frozen by the President’sorder.” Short pause. “You’ll get that statement out within the hour, Dave? Good.”

It was a bravura performance — the message was loud and clear; the freeze applied to everyone.

A bravura performance—to what end?  The United States had boots on the ground, in combat, on August 16, 1971.  So, the first order of business was to anger and demoralize the troops in a warzone by freezing their pay?  Should we be surprised that the Executive Branch’s impoundment power which permitted Nixon to defy Congress to impose the pay freeze in the first place, with the enactment 23 months later of the Congressional Budget and Impoundment Control Act of 1974, would be removed?  Let me reiterate this: every time price controls have gone into effect in the United States the nation was waging war.  Richard Nixon’s price controls have a different distinction—this was the first instance during which price controls were imposed for political rather than military reasons.

But damned if Nixon’s pay freezes didn’t work at containing inflation at first:

Early in the Council’s deliberations it was decided that the freeze could not simply be lifted after 90 days without some follow-up program and the Council approved a plan to usher in a period of more flexible wage and price controls called Phase II. (Phases of the controls program, like World Wars and Super Bowls, were denominated in Roman numerals.) The Council didn’t want the administrative burden or political responsibility for actually running Phase II, so it established a Price Commission to impose price controls and a Pay Board to limit wage increases. But the Council remained in overall charge.

Phase II rules essentially allowed companies to pass through increased labor and component costs but, by establishing pre-notification requirements and profit margin limitations, they limited company eligibility for price increases. The real action was on the wage side.

The wage freeze and the follow-on Phase II wage standard, limiting wage increases to no more than 5.5%, reduced the inflationary pressure on prices. The labor leaders on the Pay Board were willing to support wage restraint in order to lower the rate of inflation so long as there was discipline on the price side.

Phase II, like the freeze, was a political ten-strike for Richard Nixon and for the U.S. economy. Inflation slowed, economic activity recovered and organized labor grudgingly agreed to moderate wage demands. The principal union chieftains had been named to the Pay Board and their cooperation was effectively marshaled by George Shultz, who was at that time Director of OMB, and by John T. Dunlop, a little-known Harvard professor who was an expert in labor-management issues and was destined to play a central role in the drama which unfolded.

John T. Dunlop was a former chairman of the Harvard University economics department and dean of the faculty of arts and sciences. He wore a bow tie, but he was no meek academic. He was robust and barrel-chested with a prickly temperament and an earthy vocabulary. No one knew labor management relations better than Dunlop. He was personally close to both labor and business leaders and, for many years, had served as an intermediary who was trusted by both sides. Since 1971, he had been head of the Construction Industry Stabilization Committee and had used his knowledge of the equilibrium among different unions in different regions to lower the pace of wage settlements sharply in the construction industry. Most nights he could be found in the bar of the Harrington Hotel in downtown Washington settling labor disputes in his own unorthodox but highly-effective manner.

A side note: the long march of steadily increasing postwar wages is almost universally acknowledged to have ended in 1973.  I’m no expert, but I believe there is reason to believe John Dunlop brought the 1943-73 era of prosperity to a close.

The success of Phase II was not without its critics:

As the problems became more complicated, the Phase II Regulations got thicker and more impenetrable. Companies began to chafe under the increasing bureaucracy and the growing complexity of the system.

Amongst them were the president himself:

Nixon had serious philosophic misgivings about the controls program. His decision to launch it was aimed at deflecting Democratic criticism of his economic performance as the countdown began to the1972 elections. Congressional Democrats had championed the Economic Stabilization Act, enacted in 1970 over Nixon’s opposition, which authorized the President to impose controls. Congress assumed a conservative President like Nixon would never invoke the authority and they intended to use it to embarrass him. By preempting the Democrats’ idea, Nixon had very neatly turned the political tables.

The voters, however, loved it and Nixon was not about to jettison what had become a political asset before the 1972 election. But once he was safely returned to office, he ordered a complete review of the controls program with the aim of ending it. The controls program had been a useful political device for Nixon and it had actually helped to bring inflation under control.

Richard Nixon naturally had leveraged the initial price control success into major political advantage before it exploded in his face:

But it was inefficient, bureaucratic and philosophically repugnant; he wanted it done away with as soon as possible. That proved to be much easier said than done, however. Nixon didn’t know it, but he was about to enter the tar baby phase of his New Economic Policy: it was to stick to him until it became transformed from a popular success into an economic and political rout.

Ah, nothing like old-fashioned racism to describe a coming disaster, eh?

What We Knew About Stagflation Is Completely Wrong

Considering this recount of Richard Nixon’s imposition of price controls has gone through the relatively smooth sailing of Phase I (the first 90 day freeze after August 15, 1971) and Phase II (November 13, 1971 to January 11, 1973), it’s time for the hurricane.  Walker of course has to mention Milton Friedman’s villain:

Part of the reason for the sudden [economic] change was the Federal Reserve Board’s expansive money supply policy in 1972. Suddenly there was too much money chasing scarce goods and pushing prices higher. Phase II controls also contributed by blocking price increases, thereby masking the sea changes which the economy was about to undergo. Finally, there were unforeseen supply shortages, particularly in the commodity sector of the economy. But if the causes of the price increases were not well understood, the increases themselves became all too visible as prices rose sharply after Phase III was ushered in.

That statement has absolutely no foundation in reality.  We can argue whether Federal Reserve Chairman Arthur F. Burns was keeping the monetary supply loose to help reelect the president that nominated him to the position in 1970, but let’s look again at the key facts in 1972:

Inflation…

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1972 3.27 % 3.51 % 3.50 % 3.49 % 3.23 % 2.71 % 2.95 % 2.94 % 3.19 % 3.42 % 3.67 % 3.41 % 3.27 %

…and unemployment.

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec  
1969 3.4 3.4 3.4 3.4 3.4 3.5 3.5 3.5 3.7 3.7 3.5 3.5  
1970 3.9 4.2 4.4 4.6 4.8 4.9 5.0 5.1 5.4 5.5 5.9 6.1  
1971 5.9 5.9 6.0 5.9 5.9 5.9 6.0 6.1 6.0 5.8 6.0 6.0  
1972 5.8 5.7 5.8 5.7 5.7 5.7 5.6 5.6 5.5 5.6 5.3 5.2  

Where is the high inflation rate in 1972 that necessitates tight monetary policy?  Remember, unemployment was 3.4% and inflation was 4.40% in January 1969.  Until August 1971, inflation had a floor of 4.16% during Nixon’s tenure.  So, throughout 1972 inflation averaged 24% lower than 1971, 40% lower than 1969 and 46% lower than 1970 while unemployment was a full 2.4 percentage points higher than on the date of Nixon’s inauguration three years earlier. What economist or economic textbook—classical, neoclassical, Keynesian or otherwise dictates that interest rates should rise under such a scenario?

Besides the fact that standard economic theory lays waste to the Arthur F. Burns assumption, there is another pressing reason the Fed did not tighten in 1972—we were still at war!  To those that would argue otherwise, I give you the Christmas Bombing:

It was about 10 o’clock on the night of December 26 [1972] when the North Vietnamese early warning radars detected the massing of escort forces that meant B-52s were on the way. The radar controllers watched a large B-52 raid moving up through Laos, but then another force of B-52s appeared coming in from the Gulf of Tonkin. The two B-52 raids bracketed the city and began to spread out around both Hanoi and Haiphong. Then, at almost the same time, over 110 B-52s turned inbound to their targets, attacking from all directions on the compass.

There were details to be worked out, and the raids on Hanoi continued. The night that the North Vietnamese agreed to return to Paris, 60 B-52s went back to the capital and two B-52s were lost, and on the nights of December 28 and 29, the B-52s raided without loss. Then, on December 30, because enough progress had been made, President Nixon ordered a final bombing halt, and by the end of January, the Paris Peace Agreement ended the U.S. involvement in the Vietnam War.

Thereafter both sides agreed that Linebacker II had been the critical battle, the battle that had ended the war, but that is where agreement stopped.

Combat in Vietnam did not end with a whimper, it concluded with a definite bang.  The Christmas Bombing was the culmination of the Linebacker air campaign that dragged on for most of 1972.  Linebacker II was the largest strategic bombing operation since the end of the Second World War—and it and its predecessor were extremely expensive.

Of course, Milton Friedman’s acolytes might argue that loose monetary policy had a delayed effect into 1973.  Those same monetarists have been arguing for almost five years that the current Federal Reserve’s monetary policy must trigger hyperinflation.  Umm…

Year

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Annual

2013 1.59 %                        
2012 2.93 % 2.87 % 2.65 % 2.30 % 1.70 % 1.66 % 1.41 % 1.69 % 1.99 % 2.16 % 1.76 % 1.74 % 2.07 %
2011 1.63 % 2.11 % 2.68 % 3.16 % 3.57 % 3.56 % 3.63 % 3.77 % 3.87 % 3.53 % 3.39 % 2.96 % 3.16 %
2010 2.63 % 2.14 % 2.31 % 2.24 % 2.02 % 1.05 % 1.24 % 1.15 % 1.14 % 1.17 % 1.14 % 1.50 % 1.64 %
2009 0.03 % 0.24 % -0.38 % -0.74 % -1.28 % -1.43 % -2.10 % -1.48 % -1.29 % -0.18 % 1.84 % 2.72 % -0.34 %
2008 4.28 % 4.03 % 3.98 % 3.94 % 4.18 % 5.02 % 5.60 % 5.37 % 4.94 % 3.66 % 1.07 % 0.09 % 3.85 %
2007 2.08 % 2.42 % 2.78 % 2.57 % 2.69 % 2.69 % 2.36 % 1.97 % 2.76 % 3.54 % 4.31 % 4.08 % 2.85 %

…I don’t see it.  Does anyone else?  As for the cause of elevated inflation in 1973-74, this seems to be a boondoggle in the making:

A key objective of Phase III (as the next step in the controls program was inevitably called) was to eliminate the bureaucratic red tape imposed on companies by the price control regulations. As Herbert Stein, the Chairman of the President’s Council of Economic Advisers, put it, Phase III was to be “a gentle blanket of restraint” on wage and price decisions. Both the Price Commission and the Pay Board were to be scrapped and the new program was to be self-administered — a concept that proved to be exceedingly elusive in practice. A new general price standard was aimed at holding inflation to no more than 2.5% in 1973. Companies would be told that they must moderate their pricing behavior so as to be consistent with this goal. This meant they could “self-administer” the regulations as guidelines to measure company pricing against the inflation goal, but they could also apply exceptions to themselves, “as necessary for efficient allocation of resources or to maintain adequate levels of supply.”

Did Wall Street write these regulations?  How on Earth was this supposed to work?  It didn’t help that the person selected to run Phase III hated the very concept of price controls:

George Shultz by this time had succeeded John Connally as Treasury Secretary and assumed the role of Chairman of the Cost of Living Council. Shultz’s aversion to the wage and price control program was well-known. As a highly-regarded economist from the University of Chicago and an exponent of free markets, Shultz had let it be known that he was opposed to wage and price controls as a matter of principle. Shultz scheduled a press conference at 11:00 A.M. on January 11, 1973 in The White House briefing room to introduce Phase III.

This can’t go well:

It was a disaster. Instead of announcing the “self-administered” controls program envisioned by the Phase III planners, he characterized Phase III as “voluntary”. While he said that the Administration retained the authority to re-impose mandatory controls in sectors where inflation threatened to get out of hand, his clear message, which the journalists duly communicated to the American people, was that controls were lifted and prices were free to rise. “Mandatory Wage-Price Controls Ended; Nixon Calls For Voluntary Compliance”, headlined the New York Times the next morning. The stock market plunged (it would not recover for nine long years) and the political reaction was strongly negative. That same day, Nixon announced that John Dunlop would become the new Director of the Cost of Living Council to administer Phase III.

Oh, the Hero of Phase II.  How could this go wrong?

In January 1972, the Cost of Living Council staff threw a lively farewell party for Donald Rumsfeld who had been the Council’s Director during Phase II and was departing to become U.S. Ambassador to NATO. A highlight of the party was a song written by one of the staffers which wondered, “will they perform for the John as they did for the Don?” Dunlop was not amused. He delivered a short, stern lecture about the importance he attached to Phase III. A policy of the kind pursued by the controls program was a legitimate tool of economic management by governments, he said. The problem had always been knowing when and how to get out of these programs once started. He felt that Phase III was an important opportunity to put into practice some of the lessons that had been learned from earlier failed attempts. It was to prove a bitter irony that, in less than six months, Phase III would collapse, showing again just how hard the task was which Dunlop embarked upon that night.

Ouch.  I have to correct Walker here—Rumsfeld became Ambassador to NATO on February 2, 1973, so this party almost certainly occurred in January 1973.  Beyond date quibbles, I could write thousands of pages about how differently unions and company management approach negotiations in general; but suffice to say managers tend to play ‘fast and loose.’  Typical flipped psychology: ham-handed tactics with the relatively docile unions in Phase II, a light touch with aggressive, craven business executives in Phase III.  Most of my own conclusions are diametrically opposed to Walker’s, but I admire his candor with this statement:

What no one understood at the time was that economic conditions had undergone a profound and dramatic change. The cycle of wage-driven price hikes had been broken during Phase II. But government and private forecasters uniformly failed to recognize that demand had begun putting such severe pressure on supplies that within a matter of months, prices of virtually all commodities — food-stuffs, minerals and petroleum — would explode, reaching historic highs. The rate of inflation shot up to 11% by the summer of 1973, leaving Phase III in shambles.

He’s off by one year again—inflation hit 11% in the summer of 1974, not 1973:

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1976 6.72 % 6.29 % 6.07 % 6.05 % 6.20 % 5.97 % 5.35 % 5.71 % 5.49 % 5.46 % 4.88 % 4.86 % 5.75 %
1975 11.80 % 11.23 % 10.25 % 10.21 % 9.47 % 9.39 % 9.72 % 8.60 % 7.91 % 7.44 % 7.38 % 6.94 % 9.20 %
1974 9.39 % 10.02 % 10.39 % 10.09 % 10.71 % 10.86 % 11.51 % 10.86 % 11.95 % 12.06 % 12.20 % 12.34 % 11.03 %
1973 3.65 % 3.87 % 4.59 % 5.06 % 5.53 % 6.00 % 5.73 % 7.38 % 7.36 % 7.80 % 8.25 % 8.71 % 6.16 %
1972 3.27 % 3.51 % 3.50 % 3.49 % 3.23 % 2.71 % 2.95 % 2.94 % 3.19 % 3.42 % 3.67 % 3.41 % 3.27 %
1971 5.29 % 5.00 % 4.71 % 4.16 % 4.40 % 4.64 % 4.36 % 4.62 % 4.08 % 3.81 % 3.28 % 3.27 % 4.30 %

Anyway, Phase III definitely hits the skids—inflation rises relentlessly throughout 1973 and 1974.  So what does the Nixon Administration plan to do about it?

George Shultz delivered a speech to the U.S. Chamber of Commerce recalling that while he had said the Phase III rules were voluntary, they were about as voluntary as paying taxes. He stressed the government’s authority to reassert mandatory controls, saying that the government had a “club in the closet” and that if any company got out of line, he would see to it personally that they got “clobbered.”

Okay, ham-handed tactics.  Worked with the unions, why not businesses?

The first target of Administration jawboning was the oil industry which had announced increases in home heating oil prices within a matter of days after Phase III began.

Jawboning?  Are you kidding me?  Won’t the thin-skinned oil company executives just go crying to their congressman or senator?  Oh, for crying out loud:

This action provoked a strong reaction in Congress and Senator Thomas J. McIntyre (D-NH), Chairman of the Senate Banking Committee, sent a stinging letter to Dunlop demanding that the increases be rolled back, pointedly reminding him that his confirmation hearings were scheduled to begin only a few days hence. The Council warned the major US oil companies that they were forbidden to increase prices in the absence of cost justification and ordered an immediate investigation by IRS agents. The Council then convened a well-publicized hearing in which the oil companies were urged to restrain price hikes. Secretary Schultz announced that “the club was out of the closet and laid on the table”. But it was to no avail. Oil prices continued to rise, even after the Administration acted on its threat and reasserted mandatory controls.

Not willing to swing that club, are we Secretary Schultz?  Why the hesitation (other than philosophy)?

By this time, heating oil shortages were also beginning to appear and there were predictions of wide-spread shortages of gasoline during the summer driving months. In testimony before the Senate Banking Committee in May, Dunlop frankly admitted the dilemma which the Council faced: on one hand, restraining price increases to contain inflation; on the other hand, foregoing supply increments which higher prices might encourage. This dilemma was to become even more acute as time went along because of a development understood at the time by only a handful of experts: the world oil surplus, dating back to the Texas oil discoveries of the l930s had come to an end. Crude oil prices would never again return to the levels that prevailed during Phase II.

To risk sounding like a broken record, that’s why a supply-controlling entity like the War Production Board (WPB) is necessary when imposing price controls.  If you are going to control wages and thus manipulate consumer demand, you also must control supply to set production targets (number of bombs, bullets, battleships, etc.)  But this was mid-1973, and the air campaign concluded with Linebacker II in December 1972, the Paris Accords ending American combat involvement altogether the following month.  This is only going to get worse now that it is truly peacetime in America, right?

Food prices also defeated the Administration’s policy. 1973 ushered in a period of very tight supplies in wheat and feed grains worldwide. In 1972, the U.S. had sold over 20 million metric tons of grain to the Soviet Union and dollar devaluations in December 1971 and again in February 1973 sharply stimulated export sales of other agricultural commodities. The Administration had anticipated some pressure on food prices during the first half of 1973 and had retained mandatory, though looser, controls over the food industry during Phase III. The results, however, were worse than even the most pessimistic predictions. During the first quarter of 1973, consumer food prices shot up at an annual rate of 29.8% while the wholesale price index for farm products rose at an annual rate of 51.9%. Red meat prices alone surged at an annual rate of 90% during the quarter.

The Council explained that the price increases reflected fundamental market forces: a combination of very strong consumer demand, unprecedented decline in supplies carried over from the previous year and expanded exports due to currency shifts and crop failures abroad. On March 29, 1973, in an abortive attempt to slow the onslaught, the Council slapped a freeze on red meat prices, but this step backfired as ranchers retaliated by withholding supplies and creating meat shortages. Meanwhile, other food prices continued their seemingly inexorable rise.

By early June 1973, Phase III was thoroughly discredited. Public criticism was mounting and there were pressures in Congress and from business leaders for the Administration to take stronger direct action. Most of the Administration, however, had lost its stomach for another round of mandatory controls. Nixon’s economic advisers were unanimous in advising against a stringent controls program, but Nixon ignored them. On June 13, 1973, he decreed a second price freeze and directed the Cost of Living Council to develop a new controls program to be called (what else?) Phase IV.

This can’t be good…

Whatever his reasoning may have been, Nixon went before the Nation and for the second time in less than two years imposed a freeze on prices. Wages were not to be frozen since wage settlements had not caused the inflationary price hikes of Phase III. Twice during his speech, Nixon cautioned against the seductiveness of controls, warning that “rigid, permanent controls always look better on paper than they do in practice”. He stressed the importance to returning to a free economy stating, “We must not let controls become a narcotic — we must not become addicted.”

Fascinating—not only has Walker depicted Nixon as having flipped his lid, but states “wage settlements had not caused the inflationary price hikes.”  That would be the day when freshwater economics comes to the same realization…

Operation Nickel Grass

The ignoble sunset for Nixon’s price control gambit was a lot like Phase III, only more horrible.  Walker describes Phase IV as “mov[ing] ‘from the freeze to the squeeze.”  Yep, that’s right—austerity didn’t work in 1973 either.  Nowhere was that more true than in the industry that first fought back against Schultz:

Petroleum price increases were a particular source of concern to the Phase IV planners. Supplies were suddenly tight and prices were rising. If Phase IV was to retain any shred of credibility, strict controls had to be applied because of the pervasive effect of petroleum prices on the economy. Shortly after announcing the second freeze, Nixon persuaded John Love, Governor of Colorado, to resign and become the energy czar to preside over Administration efforts to fashion a new energy policy. Love accepted the offer and arrived in Washington only to discover that czars don’t have much power by the Potomac. In his first meeting with Dunlop, Love insisted that oil prices be decontrolled. Dunlop bluntly refused, stating that such a step would destroy Phase IV. Dunlop told Love that only the President could order him to decontrol oil prices and that if Nixon did so, he would resign. That ended that, and several months later Governor Love returned to Colorado and disappeared from view.

Dunlop was doubtless right about the controls program. But in terms of overall economic policy, there is no doubt that decontrolling oil prices would have been the right move, even though painful. To avoid the pain, the Council made the biggest mistake of the entire controls program and one which would cause major dislocations for years to come.

Crude oil price postings had been virtually flat for many years as a result of chronic over-supply in world markets. In the twenty years 1949-1969, crude oil prices in the U.S. ranged between $2.54 and $2.94 per barrel and American consumers had come to assume that low prices for gasoline and other oil products were an inalienable birthright. But price stability ended as U.S. production declined and world demand surged. Phase IV regulations placed a ceiling on the price of domestic crude oil at $4.25 per barrel. It was the Council’s intent to increase this ceiling by about 25 cents every quarter so that by April 30, 1974, when the controls program was scheduled to expire, crude oil prices would be in the $5.00-$5.25 range, comparable to expected world price levels. Events were to prove these assumptions fatally wrong

But what is most fascinating about the 1973 oil shock is the military connection:

October 20, 1973 became known as the Saturday Night Massacre when Nixon fired Attorney General Elliot Richardson and Deputy Attorney General William Ruckelshaus for refusing to dismiss Archibald Cox as Watergate Special Prosecutor. It was a night of high drama and political intrigue in Washington. Only a handful of people paid attention to an item moving over the news ticker that same evening reporting that OPEC nations had doubled the price of their crude oil exports.

Kind of harsh, right?  It spelled doom for Phase IV:

This action raised world crude oil prices to almost $7.00 per barrel, creating a huge spread above the U.S. ceiling price, fixed at $4.25, and causing major problems for the Phase IV rules. In early December, the Council raised the U.S. ceiling price $1.00 to $5.25 per barrel. The public was furious, Ralph Nader filed suit to set aside the increase, Congressional hearings were immediately called and the Council’s decision was attacked on all sides. The conventional wisdom at the time was that OPEC was weak and ineffectual. The public was therefore indignant that U.S. oil prices were being raised ‘just to pay off some desert sheiks.’

Nixon wasn’t paying off desert sheiks.  OPEC acted because of a USAF airlift, Operation Nickel Grass:

One of the most critical but least celebrated airlifts in history unfolded over a desperate 32 days in the fall of 1973. An armada of Military Airlift Command aircraft carried thousands of tons of materiel over vast distances into the midst of the most ferocious fighting the Middle East had ever witnessed-the 1973 Arab­-Israeli War. MAC airlifters-T-tailed C-141s and C-5As-went in harm’s way, vulnerable to attack from fighters, as they carved a demanding track across the Mediterranean, and to missiles and sabotage, as they were off-loading in Israel.

The fleet consisted of 268 C-141s and 77 C-5As, and Carlton knew that he could sustain a steady flow of three C-141s every two hours and four C-5s every four hours-indefinitely. He also knew that MAC could orchestrate the operation, establishing a rational flow of aircraft matching the cargo to be carried with off-loading equipment at the destination. In his plan, MAC would essentially become a conduit through which materiel would flow in a well-adjusted stream.

Nixon’s actions led directly to the deaths of thousands of Egyptian and Syria soldiers:

Because it eliminated the need to husband ammunition and other consumable items, the continuous flood of US war materiel enabled Israeli forces to go on the offensive in the latter stages of the war. In the north, Israel’s ground forces recovered all territory that had been lost and began to march on Damascus. In the Sinai, tank forces led by Maj. Gen. Ariel Sharon smashed back across the Suez, encircled the Egyptian Third Army on the western side of the canal, and threatened Ismailia, Suez City, and even Cairo itself.

The airlift had been a key to the victory. It had not only brought about the timely resupply of the flagging Israeli force but also provided a series of deadly new weapons put to good use in the latter part of the war. These included Maverick and TOW anti-tank weapons and extensive new electronic countermeasures equipment that warded off successful attacks on Israeli fighters. Reflecting on the operation’s vital contribution to the war effort, Reader’s Digest would call it “The Airlift That Saved Israel.”

There was a snag, however:

The threat of an oil embargo frightened US allies. With a single exception, they all denied landing and overflight rights to the emergency MAC flights. The exception was Portugal, which, after hard bargaining, essentially agreed to look the other way as traffic mushroomed at Lajes Field [(in the Azores)]. Daily departure flights grew from one to 40 over a few days. This was a crucial agreement for MAC, which could not have conducted the airlift the way it did without staging through Lajes.

It wasn’t an idle threat:

Oct 17, 1973:

OPEC enacts oil embargo

The Arab-dominated Organization of Petroleum Exporting Countries (OPEC) announces a decision to cut oil exports to the United States and other nations that provided military aid to Israel in the Yom Kippur War of October 1973. According to OPEC, exports were to be reduced by 5 percent every month until Israel evacuated the territories occupied in the Arab-Israeli war of 1967. In December, a full oil embargo was imposed against the United States and several other countries, prompting a serious energy crisis in the United States and other nations dependent on foreign oil.

In March 1974, the embargo against the United States was lifted after U.S. Secretary of State Henry Kissinger succeeded in negotiating a military disengagement agreement between Syria and Israel. Oil prices, however, remained considerably higher than their mid-1973 level. OPEC cut production several more times in the 1970s, and by 1980 the price of crude oil was 10 times what it had been in 1973.

Walker describes this in much more detail:

The public soon discovered just how badly they had miscalculated OPEC’s resolve and its leverage. In the wake of the Yom Kippur Arab-Israeli conflict, OPEC declared an embargo upon shipments of oil to the U.S. and other Western nations and, by the first quarter of 1974, in the greatest supply disruption the nation had ever experienced, American motorists were forced to endure long lines at the gas pump. To make matters worse, on the last day of December 1973, OPEC again doubled oil prices, to levels above $12.00 per barrel. The spread between the U.S. crude oil price ceiling and rising world prices increased. This created the need for a new “entitlements program” to ration low-cost, price-controlled U.S. crude oil among American refiners by forcing the domestic producers to transfer hundreds of millions of dollars to the refiners purchasing much higher priced foreign oil. This program lasted for several years until the crude oil price ceilings were finally scrapped and prices were allowed to find their equilibrium.

I should really put together another post about oil refineries.  This topic takes me back.  Though I also have to admit—this drama reminds me of VPK (which coincidently or not was gearing up at the same time).

Well…What Else?

Is the military connection applicable to more than this one episode?  I believe so—and I intend to write more about this in connection with the OPA and WPB.  Oh, and the OPS from Korea…

Another question—what kind of beast is inflation exactly?  Why can hyperinflation skyrocket into incredibly high factors but deflation of 4% have worse effects?

I might have a thought about answering the above questions.  Stickiness…is that really…economic inertia?

Oddly enough, I managed to write over 6,000 words about August 15, 1971 and didn’t touch on the gold window.  Bravo for me!

May 2013 Addendum– * Research I conducted later indicates the inflection point was March 19, 1973:

There was hope that the Smithsonian currency alignment in December 1971 would work for some time.  The U.S. dollar gained strength in the second half of 1972.  Unfortunately, after a heavy speculative attack on the dollar it was suddenly devalued on 12 February 1973 for the second time after World War Two.  This time, it was devalued by 10 percent, as the official price of gold was increased from US$38 per oz fine to US$42.22.  Soon after the second devaluation, there was another heavy speculative attack on the dollar so much so that foreign exchange markets all over the world had to be closed from 2 March for seventeen days.  When the exchange markets were reopened, the major currencies of the world including the US dollar,  Deutsch Mark, Japanese Yen, Pound Sterling, French Franc, Dutch Guilder etc. were all floating.  The world was now in a floating exchange rate system  as a revolt against the IMF fixed exchange rate system.

I write more about this episode at length, but suffice to say the market-triggered collapse of the fixed rate exchange system played havoc during Phase III (and throughout all subsequent economic history).

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8 thoughts on “The Turn to Disinflation Part 1—Correcting the False History

  1. Pingback: The Turn to Disinflation Part 2—What Richard Nixon Didn’t Know | In The Corner, Mumbling and Drooling

  2. Pingback: The Turn to Disinflation Part 3—More Distorting Than Wartime Price Controls | In The Corner, Mumbling and Drooling

  3. Pingback: The Failure To Understand History (Stagflation Edition) | In The Corner, Mumbling and Drooling

  4. Pingback: Revisiting the Wage-Price Spiral (Part of the Turn to Disinflation Series) | In The Corner, Mumbling and Drooling

  5. Pingback: The Week of Reckoning | In The Corner, Mumbling and Drooling

  6. Pingback: Aggregate Demand Dominance: The Lost History of the Early 1970s | In The Corner, Mumbling and Drooling

  7. Pingback: Aggregate Demand Dominance: the Unknown History of Price Controls | In The Corner, Mumbling and Drooling

  8. Pingback: Aggregate Demand Dominance: Price Controls’ Nemesis—Oil Embargoes and the Onset of Stagflation | In The Corner, Mumbling and Drooling

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