Economics / History

The Turn to Disinflation Part 2—What Richard Nixon Didn’t Know

This is Going to Hurt…

I left off my last post with Nixon helplessly grasping at straws as the economy plunged:

{Sorry, I’m not technically adept enough to know how to paste FRED graphs into this blog.  If someone is so inclined, click on the link below see a Federal Reserve depiction of the economy falling into recession in late-1973}

FRED Graph – St. Louis Fed

Inflation soared…

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 %

…and unemployment was about to skyrocket.

So, what should Nixon have done?  It’s a real pickle, because war severely distorts economic output.

Life in the Command Economy: Years of Distorted Energy Now…

I mentioned in the post that precedes this one that Nixon, an employee of the Office of Price Administration (OPA) during World War II, tried to replicate the success the OPA had it stemming wartime inflation…

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 %

…but failed to consider that the War Production Board (WPB) was dictating all economic output.  Controlling supply and demand at best could be described as a command economy (others characterize it as a fascist economy).

Nixon, scarred by the wartime decision of the Curtiss Candy Company to shrink the size of its Baby Ruth bars to skirt OPA restrictions, was a trifling concern to the supply-controlling production board.  The WPB concerned itself with what I call the BBBs: bullets, bombs, and battleships (land, air, and naval military production).  The Curtiss actions may have assisted the war effort—its Baby Ruth shenanigans probably freed up sugar, peanuts and chemicals that could be used to make C-rations and explosives.

Perhaps the most startling effect on the American economy during the Second World War was the unbelievably low unemployment rate of 1.2% in early 1944:

The standard measure of the unemployment rate (persons officially unemployed as a percent of civilian labor force) fell between 1940 and 1944 from 14.6 percent to 1.2 percent.4 Michael Darby’s measure, which does not count those in “emergency government employment” as unemployed, fell from 9.5 percent to 1.2 percent.5 Either measure signals a virtual disappearance of unemployment during the war, but in the circumstances neither measure means what it is commonly taken to mean.

How can it not mean ‘happy days are here again?’  Well, there’s this…

Between 1940 and 1944 unemployment fell by either 7.45 million (official measure) or by 4.62 million (Darby measure), while the armed forces increased by 10.87 million. Even if one views eliminating civilian unemployment as tantamount to producing prosperity, one must recognize that placing either 146 or 235 persons (depending on the unemployment concept used) in the armed forces to gain a reduction of 100 persons in civilian unemployment was a grotesque way to achieve prosperity, even if a job were a job.

…and the bullets don’t help…

But military “jobs” differed categorically. Often they entailed substantial risks of death, dismemberment, and other physical and psychological injuries. Military service yielded little pay under harsh conditions and, like it or not, lasted for the duration of the war. Sustained involvement in combat drove many men insane.9 Physical casualties included 405,399 dead and 670,846 wounded.10 To treat military jobs as commensurable with civilian jobs, as economists do in computing the tradeoffs between them, betrays a monumental obtuseness to their realities.

…which is an important point when considering the absurdly low unemployment rates the U.S. also “enjoyed” during the Korean and Vietnam War years.  I’ll let Robert Higgs take it from here:

Table 1. EMPLOYMENT AND UNEMPLOYMENT, FISCAL YEARS 1940-1949
(as percent of total [civilian plus military] labor force)

Fiscal
Year

Nondefense
Employment

Defense
Employment

Civilian
Unemployment
(BLS concept)

Labor Force
Residuum

1940

82.4

1.8

15.7

17.6

1941

79.4

8.5

12.0

20.6

1942

67.3

25.7

7.0

32.7

1943

57.6

39.4

3.0

42.4

1944

58.4

40.3

1.3

41.6

1945

59.5

39.2

1.3

40.5

1946

88.5

8.9

2.6

11.5

1947

90.9

5.3

3.8

9.1

1948

90.9

5.3

3.9

9.1

1949

88.4

5.2

6.4

11.6

Notes: Defense employment includes military personnel, civilian employees of the military, and employees of defense-related industries. The labor force residuum is 100 minus nondefense employment. Source: Computed from data in U.S. Dept. of Defense, National Defense Budget Estimates, p. 126.

To see more clearly what happened to the labor force, one can examine the percentage of the total (civilian plus military) labor force occupied in what I call the labor force “residuum.” This includes unemployed civilians, members of the armed forces, civilian employees of the armed forces, and employees in the military supply industries. (See Table 1.) This measure rose from 17.6 percent, almost all of it being unemployment, in fiscal year 1940 to more than 40 percent, almost all of it being war-related employment, during the fiscal years from 1943 to 1945, then dropped abruptly to about 10 percent during the fiscal years from 1946 to 1949. The extraordinarily high level of the labor force residuum during the war indicates that the “prosperous” condition of the labor force was spurious: official unemployment was virtually nonexistent, but four-tenths of the total labor force was not being used to produce consumer goods or capital capable of yielding consumer goods in the future. The sharp drop of the labor force residuum between fiscal years 1945 and 1946 marks the return of genuine prosperity.

…and Full Crash Later

The severe wartime imbalances came to head immediately after V-J Day, the demobilization triggering a recession.  Maybe:

Simon Kuznets, a pioneer in national income accounting, expressed many concerns. In National Product in Wartime Kuznets noted that national income accountants must make definite assumptions about “the purpose, value, and scope of economic activity.” He observed that “a major war magnifies these conceptual difficulties, raising questions concerning the ends economic activity is made to pursue; and “the distinction between intermediate and final products.” Moreover, “war and peace type products . . . cannot be added into a national product total until the differences in the valuation due to differences in the institutional mechanisms that determine their respective market prices are corrected for.” During the war Kuznets constructed several alternative series, one of which appears in Table 2, column 4. Its values for 1942 and 1943 are substantially lower than those in columns 1, 2, and 3, in part because Kuznets used preliminary nominal data as well as different deflators for expenditure on munitions.11

After the war Kuznets refined his estimates, producing a series (Table 2, column 5) that differs substantially from the standard series “partly because of the allowance for overpricing of certain types of war production, partly because of the exclusion of nondurable war output (essentially pay and subsistence of armed forces).” Contrasting his estimate and that of the Commerce Department, he found the latter “difficult to accept” because it made too little correction for actual inflation during the war years and did not deal satisfactorily with the decline in the relative prices of munitions during the war.12 Kuznets’s refined estimates follow a completely different profile for the 1940s. Most notable is that whereas the Commerce Department’s latest estimate of real GNP drops precipitously in 1946 and remains at that low level for the rest of the decade, Kuznets’s estimate increases in 1946 by about 8 percent, then rises slightly higher during the next three years.

Table 2. REAL GROSS NATIONAL PRODUCT, 1939-1949
(index numbers, 1939 = 100)

 

Commerce

 

Kuznets

 

Year

Estimate of
1975

Estimate of
1990

Kendrick

Wartime

Revised

Variant III

GNP*

1939

100.0

100.0

100.0

100.0

100.0

100.0

100.0

1940

108.5

107.9

109.7

109.3

109.0

109.0

108.7

1941

125.9

126.9

128.7

125.9

121.8

121.7

119.4

1942

142.2

150.8

145.5

131.9

126.5

118.2

108.4

1943

161.0

178.1

160.6

148.6

132.5

117.6

102.2

1944

172.5

192.7

172.4

 

135.8

122.1

105.4

1945

169.6

189.1

171.3

 

139.4

125.6

114.3

1946

149.3

153.1

156.7

 

151.0

146.5

144.8

1947

148.0

148.9

153.4

 

154.5

148.0

147.3

1948

154.6

154.7

160.0

 

155.5

153.1

152.3

1949

154.8

154.8

156.9

 

152.6

148.5

147.5

Sources: Column 1 was computed from data in U.S. Bureau of the Census, Historical Statistics, p. 224 (series F-3); column 2 from data in U. S. Council of Economic Advisers, Annual Report, p. 296; column 3 from data in Kendrick, Productivity Trends, pp. 291-92 (national security variant); column 4 from data in Kuznets, National Product in Wartime, p. 89 (Variant a); column 5 from data in Kuznets, “Long-Term Changes,” p. 40; and column 6 from data in Kuznets, Capital, p. 487. GNP* is equal to Kuznets’s variant III minus gross war construction and durable munitions and was computed form data in Kendrick, Productivity Trends, pp. 291-92.

Either way, another recession followed in 1949, due in part to the utter failure of price controls starting in 1946:

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1950 -2.08 % -1.26 % -0.84 % -1.26 % -0.42 % -0.42 % 1.69 % 2.10 % 2.09 % 3.80 % 3.78 % 5.93 % 1.09 %
1949 1.27 % 1.28 % 1.71 % 0.42 % -0.42 % -0.83 % -2.87 % -2.86 % -2.45 % -2.87 % -1.65 % -2.07 % -0.95 %
1948 10.23 % 9.30 % 6.85 % 8.68 % 9.13 % 9.55 % 9.91 % 8.89 % 6.52 % 6.09 % 4.76 % 2.99 % 7.74 %
1947 18.13 % 18.78 % 19.67 % 19.02 % 18.38 % 17.65 % 12.12 % 11.39 % 12.75 % 10.58 % 8.45 % 8.84 % 14.65 %
1946 2.25 % 1.69 % 2.81 % 3.37 % 3.35 % 3.31 % 9.39 % 11.60 % 12.71 % 14.92 % 17.68 % 18.13 % 8.43 %

Combined with Truman ushering in an epic demobilization and reverting to a severe balanced-budget fanatic, the results weren’t pretty:

Unemployment soared.  Then yet another war broke out on June 25, 1950…

Milton Friedman is Still Wrong

Notice I made no mention of monetary policy until now.  That’s because in a wartime command economy, it is largely meaningless:

Finally, one can make an even more unorthodox—which is not to say incorrect—argument for rejecting the conventional wisdom. One can simply argue that outside a more or less competitive equilibrium framework, the use of prices as weights in an aggregation of physical quantities loses its essential theoretical justification. All presumption that price equals marginal cost vanishes, and therefore no meaningful estimate of real national product is possible.22

In fact, price was “never a factor” in the allocation of resources for war purposes. The authorities did not permit “the price-cost relationship . . . to determine either the level of output or the distribution of the final product to individual uses.”23 Clearly, all presumption of equalities between prevailing prices, consumers’ marginal rates of substitution, and producers’ marginal rates of technical substitution vanished. Absent those equalities, at least as approximations, national income accounting loses its moorings; it necessarily becomes more or less arbitrary.

Or at the very least the important signal to send during total war is “build, build, build.”  This indicates to me that the monetary base should have risen precipitously during the war…

{Sorry, got to click to see}

FRED Graph – St. Louis Fed

…and indeed it did (though for some reason the Fed reduced the monetary base just before Pearl Harbor).

This has extremely important ramifications, because the five years in the immediate aftermath of World War II produced stagflation.  It’s also important to note widespread monthly economic data only began to be collected by various federal agencies in 1947 and 1948, at which point inflation had already exceeded 18%.  Though the Fed gave its best effort to contain the damage:

{Sorry, same problem]

FRED Graph – St. Louis Fed

Given how distorting the wartime economy was, is it any wonder the Federal Reserve had trouble containing the inflationary pressures after the command economy was dissolved?  Nor are these wartime inflationary effects an anomaly limited to the 1940s:

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1923 -0.59 % -0.59 % 0.60 % 1.20 % 1.20 % 1.80 % 2.38 % 3.01 % 3.61 % 3.59 % 2.98 % 2.37 % 1.80 %
1922 -11.05 % -8.15 % -8.74 % -7.73 % -5.65 % -5.11 % -5.08 % -6.21 % -5.14 % -4.57 % -3.45 % -2.31 % -6.10 %
1921 -1.55 % -5.64 % -7.11 % -10.84 % -14.08 % -15.79 % -14.90 % -12.81 % -12.50 % -12.06 % -12.12 % -10.82 % -10.85 %
1920 16.97 % 20.37 % 20.12 % 21.56 % 21.89 % 23.67 % 19.54 % 14.69 % 12.36 % 9.94 % 7.03 % 2.65 % 15.90 %
1919 17.86 % 14.89 % 17.14 % 17.61 % 16.55 % 14.97 % 15.23 % 14.94 % 13.38 % 13.13 % 13.50 % 14.55 % 15.31 %
1918 19.66 % 17.50 % 16.67 % 12.70 % 13.28 % 13.08 % 17.97 % 18.46 % 18.05 % 18.52 % 20.74 % 20.44 % 17.26 %
1917 12.50 % 15.38 % 14.29 % 18.87 % 19.63 % 20.37 % 18.52 % 19.27 % 19.82 % 19.47 % 17.39 % 18.10 % 17.80 %
1916 2.97 % 4.00 % 6.06 % 6.00 % 5.94 % 6.93 % 6.93 % 7.92 % 9.90 % 10.78 % 11.65 % 12.62 % 7.64 %
1915 1.00 % 1.01 % 0.00 % 2.04 % 2.02 % 2.02 % 1.00 % -0.98 % -0.98 % 0.99 % 0.98 % 1.98 % 0.92 %
1914 2.04 % 1.02 % 1.02 % 0.00 % 2.06 % 1.02 % 1.01 % 3.03 % 2.00 % 1.00 % 0.99 % 1.00 % 1.35 %

The United States did not get the inflationary effects of the First World War under control at all–the country instead suffered a severe contraction (worse than 1937-38) when the nation went back on the gold standard.  The ‘Roaring Twenties’ did not really begin until the U.S. exited deflation in 1923–ironic considering the Weimar Republic inflation rate at the time…

So, there was a 1918-1920 stagflation, a 1940s stagflation, and a 1970s stagflation.  It’s apparent now (to me at least) that coming off wartime’s economic distortions and imbalances has a history of severely shocking the American economy.  Though this is decidedly not accepted economic dogma:

The United States has experienced three major price inflations since 1914, and each has been preceded and accompanied by a corresponding increase in the rate of growth of the money supply: 1914–1920, 1939–1948, and 1967–1980. An acceleration of money growth in excess of real output growth has invariably produced inflation—in these episodes and in many earlier examples in the United States and elsewhere in the world.

Getting back to Richard Nixon, what advice should we give him?  Probably along the lines “the war’s over, the distortion is ending, get ready for hell.”  Both inflation and unemployment are likely to rise—the first from a transition back to capitalism, the second from the readjustment and demobilized returning veterans.

Instead, he announced Phase IV.

 Notes to the Future

It is 2013, not 1973 of course.  But the lessons are still relevant, still as stark as ever.  How much does the distortive command economy vestiges exert on the United States with a 60 year history of elevated military budgets?  How should economic models be modified to account for these distortions?

The Cold War (and the Second World War that preceded it) affected the United States’ economy and economic policy profoundly.  The effects of the 1940s stagflation were never widely recognized, if at all.  The 1970s stagflation is widely seen to have discredited John Maynard Keynes, though I’m certain he didn’t factor in these war effects before he died in 1946.  But neither have the monetarists—this event was the one big prediction that coincidentally came true for Friedman, and he took advantage.  The hubris of his acolytes is stunning given that in reality Friedman missed by a mile.

Keen observers might note that postwar inflation explosions have been negated since Vietnam.  This is due to what I theorize has been a decades-long turn to disinflation, which has had far greater consequences than the wartime-to-peacetime effect that predominated before.  This entire series attempts to identify that turn and its consequences, so I will return frequently in later posts to shed light on this topic.

Though something is nagging at me—the end of the Korean War:

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
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 %
1959 1.40 % 1.05 % 0.35 % 0.35 % 0.35 % 0.69 % 0.69 % 1.04 % 1.38 % 1.73 % 1.38 % 1.73 % 1.01 %
1958 3.62 % 3.25 % 3.60 % 3.58 % 3.21 % 2.85 % 2.47 % 2.12 % 2.12 % 2.12 % 2.11 % 1.76 % 2.73 %
1957 2.99 % 3.36 % 3.73 % 3.72 % 3.70 % 3.31 % 3.28 % 3.66 % 3.28 % 2.91 % 3.27 % 2.90 % 3.34 %
1956 0.37 % 0.37 % 0.37 % 0.75 % 1.12 % 1.87 % 2.24 % 1.87 % 1.86 % 2.23 % 2.23 % 2.99 % 1.52 %
1955 -0.74 % -0.74 % -0.74 % -0.37 % -0.74 % -0.74 % -0.37 % -0.37 % 0.37 % 0.37 % 0.37 % 0.37 % -0.28 %
1954 1.13 % 1.51 % 1.13 % 0.75 % 0.75 % 0.37 % 0.37 % 0.00 % -0.37 % -0.74 % -0.37 % -0.74 % 0.32 %
1953 0.38 % 0.76 % 1.14 % 0.76 % 1.14 % 1.13 % 0.37 % 0.75 % 0.75 % 1.12 % 0.75 % 0.75 % 0.82 %
1952 4.33 % 2.33 % 1.94 % 2.33 % 1.93 % 2.32 % 3.09 % 3.09 % 2.30 % 1.91 % 1.14 % 0.75 % 2.29 %

Inflation did not spike after the 1953 armistice, although unemployment certainly did:

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
1953 2.9 2.6 2.6 2.7 2.5 2.5 2.6 2.7 2.9 3.1 3.5 4.5
1954 4.9 5.2 5.7 5.9 5.9 5.6 5.8 6.0 6.1 5.7 5.3 5.0
1955 4.9 4.7 4.6 4.7 4.3 4.2 4.0 4.2 4.1 4.3 4.2 4.2

Perhaps the Fed learned its lesson from the late ‘40s, and tightened as soon as the war concluded.  But I don’t think that’s the full story.  I haven’t covered every major act Nixon took on August 15, 1971.  What effects did ending Bretton Woods that same day really have?

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5 thoughts on “The Turn to Disinflation Part 2—What Richard Nixon Didn’t Know

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

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

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

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

  5. Pingback: Aggregate Demand Dominance: The Enigma of 1945 | In The Corner, Mumbling and Drooling

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