As these policies took effect, the prosperous American economy skidded into a brief “mini-recession” in 1967. But inflation did not end. Consumer prices continued to climb, and by 1968 the buoyant American economy began to boom again. As inflationary pressures mounted, public officials in the Johnson administration and the Federal Reserve Board once again adopted policies of economic restraint. They tightened credit, applied various fiscal restrictions, drove interest rates higher, increased taxes by a 10 percent surcharge on incomes, and curbed monetary growth in early 1969.
These measures were deliberately intended to create what was called a “policy recession.” They succeeded all too well. In 1969, anti-inflationary measures began to have an effect, but not precisely the one that was intended. After the long boom of the 1960s, the American economy went into steep decline, dragging other nations with it. The recession of 1968–71, writes economist Robert Gordon, combined “the worst of three worlds.” One might say that it combined the worst of five worlds. National product diminished. Unemployment rose sharply. The dollar fell against other currencies, and yet the American balance of payments rapidly deteriorated. Through it all, inflation stubbornly persisted in a new combination with economic stagnation, which American economist Paul Samuelson may have been the first to call “stagflation.”8
Neoclassical economists were baffled by stagflation. Some believed it to be an unprecedented anomaly. In fact, stagflation had happened in the later stages of every price-revolution from the thirteenth century to our own time.
Figure 4.14 shows the relationship between inflation and the use of manufacturing capacity in the United States from 1960 to 1993. When capacity-utilization rose above 8 percent, rates of inflation generally increased. When capacity-utilization fell below 8 percent, inflation tended to fall. Sources: Historical Statistics of the United States (1976), E135; Statistical Abstract of the United States (1993) table 757; capacity utilization, ibid., (1976) table 1250; (1988) table 1250; (1993) table 1261.
When President Richard Nixon came to office, he was forced to deal with an economy in deep disarray. In response to stagflation, this highly conservative president amazed his friends and gratified his enemies by suddenly becoming a convert to the interventionist economics of John Maynard Keynes. “Now I am a Keynesian,” Nixon told an astonished television journalist, Howard K. Smith. The president’s “new economic policy” combined a strong dose of Keynesian fiscal stimuli with an unprecedented system of peacetime price and wage controls.
These measures proved immensely popular with most Americans. National polls consistently showed strong public support for price controls. The economy began to revive, and inflation rapidly diminished from 5 percent in 1970 to 3 percent in 1972.9
But despite their general popularity, price and wage controls had powerful enemies in the United States. They were strongly opposed on theoretical grounds by neoclassical economists. At the same time they were strenuously resisted by leaders of big labor and big business, and also by their many friends and protectors in both political parties. These small but vocal elites mounted effective campaigns—insisting over and over again that “price controls don’t work,” that “regulation is unfair,” and that restraints would be destructive of economic growth.
Figure 4.15 shows that the rate of inflation generally increased when unemployment fell below 6 percent. The rate of inflation commonly declined when unemployment rose above that level. The sources include: for inflation, Historical Statistics of the United States (1976) E135; Statistical Abstract of the United States (1993) table 757; for unemployment, ibid., (1976) table 558; (1988) table 605; (1993) table 652.
All of those arguments were false. Short-term price and wage controls had worked well in recent applications. They were less unfair than unrestrained inflation, and did far less damage to economic growth than anti-inflationary tools such as interest-rate manipulation and policy recessions. But the anti-regulatory arguments were often repeated and widely believed. Powerful interests lobbied incessantly for an end to price and wage controls, until both Congress and the Nixon administration gave way. Controls were relaxed prematurely, while inflationary pressures remained strong.
Once more prices began to advance rapidly. This time, leaders of the administration tried to restrain them by a policy of moral suasion called “jawboning” in the jargon of the day. The only discernible effect of jawboning was an inflation of rhetoric that kept pace with rising prices. The cost of living kept on climbing.
Later in his beleaguered presidency, Nixon wanted to freeze prices again. His neoclassical economic advisers firmly resisted that idea. Herbert Stein remembers: “I warned him, citing Heraclitus, that you can’t step in the same river twice.” Nixon replied, “you can if it’s frozen.” But controls had become politically untenable, whatever their economic merits may have been.10
Price Volatility: Oil Shocks and Commodity Surges, 1973–80
Then came an entirely unexpected event, of the sort that happens frequently in price history and yet can never be predicted. In October 1973, the state of Israel was attacked without warning by its Arab neighbors on the Jewish holiday called Yom Kippur. At the same time, Arab nations placed an embargo on oil as part of their war effort. A hitherto ineffective cartel called the Organization of Petroleum Exporting Countries (OPEC), agreed to raise the benchmark price of Saudi “marker crude” oil from $3 to $5.11 a barrel. This measure was meant to be a strategic weapon against Israel and her western allies. It proved to be highly successful—so much so that in January 1974 OPEC raised prices again, to the dizzy height of $11.65 a barrel. The Arab cartel also tried to stop the flow of oil altogether to the United States and the Netherlands as a special punishment for their support of Israel.
These acts were not unprecedented. Twice before the Arab states had tried to use oil as a strategic weapon. Twice the United States had stabilized prices by drawing on its vast petroleum reserves. By 1973, however, the American reserves were nearly gone, and the United States had become a heavy importer of foreign oil. It was powerless to stop OPEC by anything short of military action, which for a time was seriously considered by the Nixon administration. Within a few months, oil prices quadrupled.
The American reaction, writes oil expert John M. Blair, “approached pure panic.” Governments, corporations, and individuals were entirely unprepared for this turn of events. Many American families and institutions found their budgets strained beyond the breaking point. In Europe, energy-poor industries collapsed. Unemployment soared. The worst suffering occurred in the third world, where fragile economies were cruelly shattered by the actions of the OPEC cartel.11
Figure 4.16 compares the cost of fuel oil with consumer prices in the United States (1960=100). The source is the Statistical Abstract of the United States (1993), table 756.
The success of OPEC was made possible by fundamental economic forces. By 1973, the world had become highly vulnerable to commodity cartels. Twenty years of postwar prosperity and accelerating population growth had created heavy demand for raw materials. Oil was not unique in that respect. During the decade of the 1970s, the prices of many commodities rose even more rapidly than petroleum. Some surged to their highest levels in modern history. In 1980, as the price of oil climbed to $40 a barrel, tin reached $8 a pound, silver peaked at $54 an ounce and gold rose to $875 an ounce. Other raw materials such as hides, rubber, cotton, and grain also rose to high levels.
The velocity of these trends accelerated after 1973. In the United States, the Consumer Price Index registered an increase of 11 percent in 1974. Producer prices rose even more rapidly, to 18.9 percent in the same year. This “double-digit inflation” as it came to be called, was at that time the highest peacetime price-surge in American history.12
In 1975, President Gerald Ford convened an urgent “summit meeting” of leading economists to discuss the problem of inflation. John Kenneth Galbraith was present. “There was full professional agreement on only one remedy,” Galbraith re
membered, “that government regulations should be reviewed to remove any obvious impediments to market competition. For practical effect, this was no better than the President’s own prescription, which was the wearing of buttons inscribed with the insignia WIN, for Whip Inflation Now.”13
Inflation moderated in 1976–77, largely because of the disruption of the world economy and the decline of demand, but annual price increases continued in the range of 6 percent—an exceptionally high level by historic standards. The stubborn persistence of inflation, and the recent failure of so many policies created a painful dilemma for national leaders.
In the United States, the new Carter administration acted on the advice of neo-classical economists and promoted a new idea called “deregulation,” partly in the hope of removing regulatory “floors” under price and wages. The effect of “deregulation” did not as a rule remove the floors themselves. It merely removed control of them from the public to the private sector. Inflation continued, now in company with growing inequalities of income. During the late 1970s, consumer prices in the United States accelerated sharply yet again, in another surge of increasing volatility. Once more the OPEC cartel played a leading role. In 1978–79, it ruthlessly raised the price of oil to such a height that the United States was paying nearly $100 billions a year to oil-producing nations. The annual rate of inflation in consumer prices reached 13.5 percent in 1980, a new peacetime record in American history.
American inflation, high as it was by historical standards, remained below the global average. A survey by the International Monetary Fund in 1979–80 found that consumer prices were rising in every nation for which data was available. The smallest rates of inflation that year were in Switzerland, Burma, and Saudi Arabia. The highest rates were in Israel, Turkey and Latin America. The United States experienced price increases of 12.8 percent, very high by the measure of its own experience, but below the International Monetary Fund’s estimated “world inflation rate” of 15.6 percent that year. The price-revolution of the twentieth century was a global movement, with local variations.14
Figure 4.17. Source: International Financial Statistics 34 (1981) 45.
The tightly controlled Communist economies of eastern Europe were also caught up in the great wave, but in a different way. Prices and wages were held ruthlessly in check by the instruments of a totalitarian state, but state planners were not able to restrain the pressures of aggregate demand. The result was the development of rationing, the Communist alternative to inflation. In the western world, rising prices were themselves a system of market-rationing which allocated scarce resources to those who were willing and able to pay higher prices. The Communist system substituted state-rationing for market-rationing. Throughout eastern Europe the same scenes were enacted. Long queues, empty shops, and meatless meals became the Marxist surrogate for price-inflation. State-rationing, continued year after year, engendered problems of deep corruption in Communist nations. Corrupt regimes that ruled in the name of the people rapidly lost their moral legitimacy.
Free-market nations tried to protect themselves against inflation by adopting autarchic policies, with consequences that caused major economic problems throughout the world. The leading example was Japan, which was highly vulnerable to commodity cartels. To pay its soaring oil bills, the Japanese flooded the world market with exports. In America alone, the total value of Japanese goods rose from five billion dollars in 1970 to thirty billions only a decade later. At the same time, the Japanese actively discouraged imports to their own economy. The result was the growth of large imbalances in international trade, and the collapse of many American industries. Unemployment surged in the United States, while inflation continued at high levels.
In 1979–80, the liberal Democratic administration of Jimmy Carter declared inflation to be the nation’s “number one problem.” On the advice of economists, and in alliance with Chairman Paul Volcker, a deeply conservative banker who headed the Federal Reserve Board, a southern Populist president adopted highly repressive economic policies. Interest rates were raised to record heights. The money supply was restrained. Taxes were allowed to reach the highest peacetime levels in American history, mainly as a consequence of inflationary “bracket creep,” which carried most Americans into higher tax brackets. A major effort was made to reduce American dependence on foreign oil. In the last months of the Carter administration these policies began to take effect. The American economy faltered and turned sharply downward. Inflation began to subside. But new problems began to appear.
Major instabilities developed in commodity markets. The United States and other nations had responded to rising the cost of energy by increasing domestic production of oil, by shifting to other fuels, and by reducing demand for energy. These measures succeeded beyond expectations. Their effect was to solve one problem by creating another—the energy glut of the 1980s. Suddenly, the world found itself awash in oil. Energy prices fell sharply, and petroleum-producing regions such as Texas and Alberta fell into deep depressions.
The oil glut of the 1980s caught governments and corporations by surprise. A symbol of massive miscalculations by high executives in the major oil corporations and shipping companies was long rows of idle supertankers, rusting at their moorings in Norwegian fjords during the early 1980s. These ships had been ordered during the OPEC oil famine. They had been completed just in time for the glut that followed. Many were among the largest ships ever constructed. Some were destined never to sail except to the breakers’ yards. The shipbuilding industry had expanded to meet the demand for these new ships. Now it found itself with excess capacity, and collapsed with a resounding crash throughout the world.15
Similar reversals also occurred in other sectors of the world economy, notably in agriculture. During the early 1970s, high food prices had sent production soaring. American farmers borrowed heavily to increase production. Then, in the 1980s, the world found itself producing more food than it could consume. American farmers were faced with saturated markets, heavy debts, and excess capacity. They began to go bankrupt in numbers unprecedented even in the Great Depression. Meanwhile, politically powerful European farmers, encouraged by price supports, kept producing a vast surplus which was purchased by the European Economic Community and stored in “butter mountains” and “wine lakes.” India and other developing nations, with the aid of new farming methods in the “green revolution,” also began to produce more food than they consumed, and agricultural markets were glutted round the world.
Market-instability was intensified by the acts of private speculators. The effect of increasing wealth concentration was to increase the supply of surplus capital, which shifted rapidly from one investment opportunity to another throughout the world in search of profit. The increasing liquidity and volatility of markets created opportunities that were aggressively pursued, sometimes less for profit than for sport. Some of these speculations succeeded; others failed; all of them together contributed to the growing instability of the world economy.
An example was the silver bubble of the 1970s. In 1973, the Hunt family of Texas, at that time possibly the richest family in America, decided to buy precious metals as a hedge against inflation. Gold could not be held by private citizens in the United States at that time, and so the Hunts began to buy silver in enormous quantity, perhaps even hoping to corner the world silver market—a wild speculation reminiscent of Colebrook’s alum scheme in the price-revolution of the eighteenth century. Silver prices surged from $1.94 an ounce in 1973 to $50.35 in 1980. The corner failed, and the Hunt family fell deep in debt. By 1987, their liabilities had grown to nearly $2.5 billion, against assets of $1.5 billion. America’s richest family slipped to the edge of bankruptcy, and the shock waves spread through the economy.16
After 1981, the Reagan administration created new opportunities for speculators and corporate raiders by relaxing antitrust rules and promoting business deregulation. “Hostile takeovers” and “leveraged buyouts” multiplied at a rapid rate, often w
ith catastrophic consequences for corporations, jobs, communities, and individuals. In the economically depressed state of Maine, for example, what remained of the shoe industry was dealt a heavy blow by takeovers. In the fragile economy of the American Middle West, small industrial corporations were destroyed by the same process. Healthy corporations with strong balance sheets, cash reserves, and an active sense of civic responsibility were specially at risk. Some of the best and most responsible American companies such as Dayton-Hudson and Phillips Petroleum, outstanding corporate citizens with strong balance sheets, were compelled assume crushing debt in an effort to fight off hostile takeovers. The result of this activity was growing instability in the economic life of the nation.
In the mid-1980s, the new electronic technology of securities markets increased speculative instabilities of another kind. Chicago’s Mercantile Exchange invented futures-trading in stocks, with lower margin requirements than the stock exchanges themselves. This created opportunities for traders to shift their money back and forth from stocks to stock futures, and to extract large profits from small disparities. The work was done by “programmed trading,” in which computers sent automatic signals to buy and sell when stocks and stock-futures reached predetermined levels. Programmed trading increased the volatility of securities markets. Buffers that had been invented after the Great Depression were unable to restrain this new technology. Stock values soared in 1987, and Wall Street became a great casino. Millions of small investors were caught up in the speculative mania.
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