Economics / History

The Failure To Understand History (Stagflation Edition)

For the past two months, I’ve been reading extensively instead of writing my essays.  Long story short, I have convinced myself that the common story of stagflation during the 1970s throwing a monkey wrench into standard economic theory (Keynesian at least) is based upon a total misreading of history.  However, the scope of my writing has included far more than just that one fateful decade, and I realized I needed to understand the historical subject better before making more pronouncements (not that anyone other than myself is reading this, so why bother?)  But upon reading this Matthew O’Brien entry on The Atlantic website, I feel compelled to return to writing.

War is Inflationary

O’Brien begins with this:

Stagflation wasn’t supposed to happen, but it did. Economists had thought there was a stable relationship between higher unemployment and lower inflation — the Phillips Curve — that broke down in the 1970s: prices rose, but so did joblessness. It broke down because people started to expect more inflation the more inflation there was. This cycle of ever-rising prices got going with too loose monetary policy, and continued with the oil shocks. The former started when Richard Nixon pressured Fed Chair Arthur Burns into lowering rates in the runup to the 1972 election, and the latter turned commodity inflation into wage inflation due to widespread cost-of-living-adjustment contracts.

O’Brien’s piece, which wisely recognizes that there are too many economists (60-year old men like Michael Kinsey according to O’Brien) that are obsessed with fighting nonexistent inflation instead of encroaching deflation.  But to risk beating a dead horse, O’Brien’s description of the 1970-74 economy is just flat-out wrong.

Wage inflation preceded the explosion of commodity prices—the textbook “wage-price spiral.”*   Front-loaded collective bargaining agreements were decried as the incipient cause of rising inflation, leading to the August 15, 1971 imposition of price controls and John Dunlop’s successful negotiation with unions to pare back workers’ demands during Stage II of IV of Nixon’s pricing gambit.  Wage inflation dropped so significantly in 1972 that when Treasury Secretary George Shultz announced Stage III on January 11, 1973, wage controls were no longer included in the package.

O’Brien’s timeline is also dead wrong.  Inflation had risen much earlier than 1972 (inflation in fact was running a full percentage point below the 1971 average).  Monetary policy did not spark the stagflation.  The Vietnam War itself did:

U.S. inflation

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 %
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 %
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 %
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 %
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 %
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 %
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 %
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 %
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%
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 %
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 %

Inflation rose as Operation Rolling Thunder got underway, reaching double its prewar level during the Tet Offensive and triple during the 1970 recession.  Burton Abrams (whose paper Matthew O’Brien links to) has some handy tables:

Table 1

Key Interest Rates and the Civilian Unemployment Rate

Date Federal Funds Rate 10-Year Treasury Discount Rate Unemployment Rate
1-1-70 8.71% 7.88% 6.0% 3.9%
7-1-70 7.23% 7.64% 6.0% 5.0%
1-1-71 4.82% 6.50% 5.5% 5.9%
7-1-71 5.07% 6.69% 4.75% 6.0%
1-1-72 4.05% 5.94% 4.5% 5.8%
7-1-72 4.49% 6.15% 4.5% 5.6%
11-1-72 5.06% 6.30% 4.5% 5.3%

Table 2

Growth Rates for M1, M2, and Real GDP

Year M1 Growth M2 Growth Real GDP Growth Rate
1970 4.51% 7.36% 2.8%
1971 6.77% 13.38% 3.5%
1972 7.56% 11.65% 7.7%

The common refrain about 1972 is that the Federal Reserve lowering interest rates and putting the monetary pedal to the metal blew up the American economy.  But the data is clear–inflation was falling in 1972.

Referring to the monthly inflation table, it should be clear that Stage I & II price controls were very effective, driving inflation during the first half of 1972 down to levels not seen since 1967.  The slight rise after June coincided with Operation Linebacker I, Nixon’s gambit to bomb North Vietnam back into the Stone Age, hitting full swing.  Astonishingly, inflation did not rise precipitously at the tail-end of a nine-year strategic bombing campaign that had set Southeast Asia ablaze with 7,500,000 tons of ordnance, just shy of four times the tonnage the USAAF dropped during the Second World War.  Considering Linebacker I was succeeded by the far more intensive Operation Linebacker II (sometimes known as the Christmas Bombing), I might even argue Stage II was shockingly effective.

I raised this point in a previous post, but I do not buy the argument that Arthur Burns was playing with fire.  The Federal Reserve has a dual mandate—full employment while controlling inflation.  Inflation was 3.42% the month prior to the 1972 national election (and averaged 3.27% over the course of that year)—almost a full percentage point below the 1968 and 1971 averages and more than two entire percentage points below the 1969 and 1970 averages.  As for unemployment:















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


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


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


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


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

5.6% of the workforce was out of a job the month prior to the 1972 election, two full percentage points above where unemployment stood the day Nixon was inaugurated.  So, the argument is that Burns should have been tightening instead?  Isn’t this the argument that champions of austerity make today, this very second?

Stating that war causes inflation to rise shouldn’t be an earth-shattering revelation.  But wartime effects on unemployment (the stagnation side of the coin) are also well-established, just not often recognized for what they are.

Stagnation in the Demobilization

I’ve written about military-induced stagflation in detail once before, but in light of the times my research bears repeating.  Stagflation was not new in the 1970s.  Inflation remained very high after the Treaty of Versailles, and the same phenomenon manifested itself in 1946.  Taming inflation in 1920 with the gold standard induced a deflationary shock so severe it triggered the second-worst recession in American history; the 1948-49 recession induced to shut down inflation which peaked at 19.67% in March 1947 might have been much worse if the Korean War had not ended Truman’s balanced-budget fanaticism.  Claiming monetary policy triggered the postwar imbalances of both World Wars and Vietnam really stretches credulousness in my opinion—it seems obvious to me demobilization has a tendency to trigger a rise in inflation and unemployment simultaneously.

The enigma to me up until recently was simple: why?  I never could narrow down a full explanation—drop in aggregate demand for wartime production, reversion from wartime command economy to market economy, displacement of women mobilized into factories while soldiers served overseas?  Recessions almost certainly follow the conclusion of a major war if government military purchases drop significantly, as was the case in World Wars I and II, Korea and Vietnam, but would those effects really trail on for more than a year?  No description seemed plausible to cause long-lasting inflation.  That is, until one considers the generations themselves.

Between the 1860s and 1973, a significant percentage of those in uniform during wartime were drafted.  These were not professional soldiers—thus a huge percentage of the wartime forces were released from duty immediately after the conclusion of a war.  Those recently released draftees go home—and create a demographic explosion nine months later.  In the case of Vietnam, the entire draft system is shut down at the end of the war.  Considering how expensive it is to raise children, I began to theorize that a sudden demobilization will trigger a brief drop in aggregate demand before a massive, sustained blast takes over a year later.  Simultaneously, recently released draftees will need work unless they volunteer back into the service.  Sustained aggregate demand only coming into play a year after an enormous increase in the supply of labor—sadly, this seems like a clear recipe for stagnation, especially the short-run.  Especially when the postwar recession starts during the war.

Recessions can and do occur during wartime.  The last twelve years have been a prime example.  But the same was true of Vietnam—the stagflation first hit in 1970.  Or the 1945 recession during World War II.  Wait, what?

The American economy ran into a wall in 1945, GDP crashing by 11%.  Every account I have read about the 1945 recession blames postwar demobilization—the loss of aggregate demand from the abrupt ending of wartime production levels and/or returning soldiers displacing working women are the two factors most often cited to explain the downturn.  There’s a major issue with these assumption.  The “demobilization” recession officially started in February 1945 and lasted until October.  Am I the only one who sees a problem here?

The postwar recession started before V-E day (and ended a mere month after V-J day).  Growth in the United States peaked in December 1944, during the Battle of the Bulge.  The battles for Iwo Jima and Okinawa (the amphibious assault on the latter island was larger than Operation Overlord on June 6, 1944) had not yet occurred.  So, how did this constitute demobilization?  Short answer—it didn’t.  Oddly enough, Hollywood might have the answer.  A quotation from the fictional Flags of our Fathers character Bud Gerber even sounds plausible at first:

You know what they’re calling this bond drive?  The Mighty Seventh. They might’ve called it the “We’re Flat Fucking Broke And Can’t Even Afford Bullets So We’re Begging For Your Pennies” bond drive, but it didn’t have quite the ring.  They could’ve called it that, though, because the last four bond drives came up so short we just printed money instead.  Ask any smart boy on Wall Street, he’ll tell you our dollar is next to worthless, we’ve borrowed so much.  And nobody is lending any more.  Ships aren’t being built, tanks aren’t being built, machine guns, bazookas, hand grenades, zip.  You think this is a farce?  You want to go back to your buddies?  Well stuff some rocks in your pockets before you get on the plane, because that’s all we got left to throw at the Japanese.  And don’t be surprised if your plane doesn’t make it off the runway, because the fuel dumps are empty.  And our good friends, the Arabs, are only taking bullion.  If we don’t raise $14 billion, and that’s million with a “B,” this war is over by the end of the month.  We make a deal with the Japanese, we give whatever they want and we come home, because you’ve seen them fight, and they sure as shit ain’t giving up.  $14 billion!  The last three drives didn’t make that much all together.

Or not.  For those not already incredulous at Clint Eastwood’s pronouncements, the historical basis for his depiction of a Treasury Department official telling two marines and a navy corpsman that the American war effort was about to grind to a screeching halt is pure bullshit.  American oil production was surging throughout 1945:


U.S. Field Production of Crude Oil (Thousand Barrels per Day)



































































































Why did I include five years of data?  Maybe because I am aware American oil fields accounted for 63% of the world’s oil production in 1940?  I don’t take a swipe at Eastwood just to show his anti-debt philosophy is inappropriate during wartime.  I mention it to postulate that preparing for a single, massive amphibious assault may have thrown the United States of America into a severe recession.

Operation Downfall, the planned invasion of the Japanese Home Islands in late 1945, would have been the most violent American military operation in history.  As a study by Secretary of War Henry Stimson’s staff calculated a loss of 1.7-4,000,000 American casualties including 400,000-800,000 KIA (killed in action–for perspective 521,915 American servicemen lost their lives in both World Wars) in the invasion of Japan, the military ordered the manufacture of 500,000 Purple Hearts.  The nearly 70 year-old stockpile of medals still numbered in excess of 100,000 in 2003 and is currently being distributed to casualties in Afghanistan today.  Until Hirohito’s surrender message, Downfall still loomed menacingly.   Could the “guns and butter” economic calculation run so far toward the guns side that economic output actually began to drop?

Price Control Fail

So, is there any other plausible explanation for the enigma that is the 1945 recession?  I have a theory—Bretton Woods.  The conference occurred in 1944, reestablishing part of the fixed-exchange system that had collapsed when the full gold standard was abandoned during the 1930s.  When the gold standard had been reintroduced in 1920 it merely triggered the second worst recession in American history; what’s the worst that could happen?

Sadly, not even John Maynard Keynes himself was as far seeing to recognize the folly of fixed-exchange systems.  Britain’s representative at Bretton Woods, he proposed bancor:

One of the reasons for financial crises is the imbalance of trade between nations. Countries accumulate debt partly as a result of sustaining a trade deficit. They can easily become trapped in a vicious spiral: the bigger their debt, the harder it is to generate a trade surplus. International debt wrecks people’s development, trashes the environment and threatens the global system with periodic crises.

As Keynes recognised, there is not much the debtor nations can do. Only the countries that maintain a trade surplus have real agency, so it is they who must be obliged to change their policies. His solution was an ingenious system for persuading the creditor nations to spend their surplus money back into the economies of the debtor nations.

He proposed a global bank, which he called the International Clearing Union. The bank would issue its own currency – the bancor – which was exchangeable with national currencies at fixed rates of exchange. The bancor would become the unit of account between nations, which means it would be used to measure a country’s trade deficit or trade surplus.

Keynes idea was discarded when American representatives insisted the U.S. dollar be designated the international reserve currency, itself convertible to gold and vice-versa at $35 to an ounce, the rate set eleven years prior in 1933.  Before any Second World War inflation could be factored in.

The essential error with fixed exchange seems to be supply and demand cannot enter equilibrium for the controlling reserve unit (commodity and/or currency).  Local supply and demand shocks take on an international and eventually global scope because prices cannot float up or down much to alleviate the shocks.  A massive increase in gold demand in the London gold market would indicate that gold’s price should have risen, should it not?  Well, the fixed exchange monetary system required gold to be sold in a band from $34.82 to $35.18.  Anything outside the band would lead to large-scale raiding of various nation’s gold stocks (namely the U.S.’s).  In the 1960s, this range was maintained by a group of nations known as the London gold pool purchasing and selling gold to prevent the price from skyrocketing.  These transactions, otherwise known as manipulating aggregate demand, were in effect until March 1968 and managed to more or less lock the price of gold at $35.08 for approximately seven years.  How could this not end badly?

I wrote extensively about the gold standard’s dubious utility before, but I feel the need to revisit after reading this part of Paul Krugman’s piece lambasting austerity:

David Stockman’s The Great Deformation should be seen in this light. It’s an immensely long rant against excesses of various kinds, all of which, in Stockman’s vision, have culminated in our present crisis. History, to Stockman’s eyes, is a series of “sprees”: a “spree of unsustainable borrowing,” a “spree of interest rate repression,” a “spree of destructive financial engineering,” and, again and again, a “money-printing spree.” For in Stockman’s world, all economic evil stems from the original sin of leaving the gold standard. Any prosperity we may have thought we had since 1971, when Nixon abandoned the last link to gold, or maybe even since 1933, when FDR took us off gold for the first time, was an illusion doomed to end in tears. And of course, any policies aimed at alleviating the current slump will just make things worse.

Krugman rightly dismisses The Great Deformation as “standard goldbug bombast,” but the fact that the Princeton economist doesn’t realize that the gold peg remained in force until 1973 is somewhat disturbing to me.  The “Nixon Shock” was anything but.

Gold Standard defenders don’t appear to have a good grip on what Bretton Woods was or its history—otherwise they wouldn’t be crying about August 15, 1971 as the end of the world.  The globe did not transition to a floating exchange system that year.  The $35 to an ounce of gold peg did not end with the closing of the gold window.  It was revised to $38 an ounce on December 18, 1971 under the Smithsonian Agreement.  Britain floated its currency in the face of speculative attack on June 23, 1972, while inflation remained comfortably below 4% in the United States (the slight rise in the American inflation rate, as previously mentioned, almost certainly was due to Operation Linebacker I and II).  It wasn’t until February 1973 that speculation forced a second devaluation of the U.S. dollar, to $42.22, on February 12.  That only worked until March 2, when foreign exchange markets all over the world seized up and had to be closed for 17 days under “heavy speculative attack.”  When the markets reopened on March 19, 1973, all the major currencies of the world were floating.  Coincidentally, monthly inflation tables show that March 1973 was the month that American inflation began to skyrocket.

The reasons for the collapse of Bretton Woods over a 19 month period following the end of gold convertibility are quite long and involved, but I believe I have covered most of the basis here.  As a personal aside, I am still surprised how vexing it was to nail down the actual date the U.S. dollar began to float.  I had to track down a Singaporean financial history to find March 19, 1973.  But it was on that date, not in August 1971, that the last link to gold was severed and Bretton Woods finally collapsed.

A Note on Keynesianism

In studying material for my continued series on disinflation, I realized that not even Keynes and acolytes that at least acknowledge that the demand side of the equation exists seem to fully comprehend how wide-ranging and prolonged are the effects of aggregate demand change.  I know this is a bold statement, but my conviction grew more strongly after reading this postscript in Kevin Drum’s critique of Paul Krugman’s NYRB piece:

And what about liberal elites? Beats me, but if I had to guess I’d say that too many of them were burned by the 70s and have remained in a fetal crouch ever since. For them, every recession is a rerun of the 70s and needs the same kind of medicine if we want to recover. It’s kind of sad, really.

I remember reading Krugman’s offhanded criticism of Arthur Burns for winning Nixon’s reelection on his blog and feeling disappointment that someone as thorough as the Nobel Prize winner does not appear to have done a data analysis of 1972 to support that claim.  My cursory analysis indicates to me that monetary policy had little or nothing to do with rising inflation after Nixon’s second inaugural.  But I think Drum’s angle is right—the 1970s, specifically 1970 to 1974 so burned Keynesians said economists have not carefully studied the episode in detail, simply assuming Milton Friedman was right.  Saltwater economics has done the world a disservice in this regard (I might even argue massively derelict in its duty to reality), because Milton Friedman’s 1970 statement “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” is highly self-serving and, at best, merely incorrect.

Addendum: * I reconsider the wage-price spiral in this post.


5 thoughts on “The Failure To Understand History (Stagflation Edition)

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

  2. Pingback: Revisiting the Wage-Price Spiral (Part of the Turn to Disinflation Series) | 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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