A review of The Great Inflation and Its Aftermath: The Past and Future of American Affluence, by Robert J. Samuelson

In The Great Inflation and Its Aftermath Robert Samuelson calls the period from the mid-1960s to 1982—when the United States (and much of the world) underwent a long, debilitating era of inflation—"the lost history." Given the sweep of the disaster, he is surprised that this bitter experience has been largely forgotten, and he has undertaken to recover it in his new book, "lest the entire episode vanish from our collective consciousness."

A highly respected economic and political columnist for Newsweek and the Washington Post, Samuelson does more than just admirably chronicle the era. He argues that the Great Inflation's aftermath has profoundly influenced our economy to this day. The origin of last year's housing collapse, for example, "lay in lax lending practices; but the backdrop and inspiration for those lax practices were the expectations of perpetually rising real estate values that were sown in the [post-1982] climate of disinflation and falling interest rates." This post-inflation surge had played itself out by 2007, Samuelson contends. Even without our current troubles, we were due for a period of much slower growth.

The Great Inflation was not one uniform economic crisis, but three increasingly punishing rounds of rising prices followed by ever more severe recessions to try to bring the inflation fever down. The first round began in the late 1960s and was commonly and mistakenly blamed on the Vietnam War. (Previous outbreaks of inflation had always been directly related to major wars and their unwinding.) When Richard Nixon took office in 1969, rising prices were a hot political issue. The Federal Reserve tightened the money supply, Nixon tried to restrain federal spending, and the economy went into reverse. With the unemployment rate almost doubling to 6% in 1970 and price increases slowing only minimally, Nixon in desperation imposed wage and price controls the following year. Stocks, which had slumped almost 35% from their peak in 1966, rallied. Interest rates came down, and economic growth surged. Before the imposition of wage and price controls, 73% of Americans had opposed President Nixon's economic policies; afterwards, 75% gave him a thumbs-up, and in 1972 he won reelection by one of the biggest landslides in American history.

Yet soon after his second inauguration, prices skyrocketed again, wage and price controls returned (after they had been gradually relaxed starting in October 1971), and the president's popularity suffered. The Fed tightened again and unemployment reached 9%—a post-Depression high at the time—before inflation, running 11% annually at its height, went into remission. After a painful recession, the economy expanded and stocks went up, but it wasn't enough to save the Republicans from Nixon's excesses, or Gerald Ford from beltway outsider Jimmy Carter's challenge in 1976. Carter, however, fared little better, presiding over the worst period of inflation yet, with prices rising at a nearly 14% annual rate by the end of his term.

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Inflation is a monetary phenomenon. Why did it take policymakers nearly a decade and a half before they dealt decisively with rampant inflation's cause? Samuelson's argument is that such a confrontation was politically impossible until Americans had suffered through the stagflation of the late 1970s.

Stable prices provide a sense of security. They help define a reliable social and political order. They are like safe streets, clean drinking water and dependable electricity. Their importance is noticed only when they go missing. When they did in the 1970s, Americans were horrified…. [Inflation] was a deeply disturbing and disillusioning experience that eroded Americans' confidence in their future and their leaders.

Articles and books at the time argued that inflation proved democracy was a failure because, in the long run, the system undermines itself: citizens won't govern their own appetites, and politicians, always chasing votes, are unable to restrain or properly direct public appetite through law. Henry Kissinger and others foresaw America's irrevocable decline. President Carter embodied the idea of a permanent malaise overhanging the nation. Apparent weakness abroad—evidenced by, e.g., the Soviet invasion of Afghanistan and spreading Communist power in Africa, the Caribbean, and Central America—deepened the fear that America's best days were behind her.

Yet, this bleak economic and political climate helped Ronald Reagan win the presidency in 1980, and he took office determined to stamp out inflation once and for all. With Reagan's tacit but unshakable support, Federal Reserve Chairman Paul Volcker (appointed by Carter in August 1979) instigated a ferocious credit squeeze. Unemployment soared to almost 11%. In August 1982, Volcker finally eased up: inflation was dead. Samuelson contends that this achievement—not the Reagan tax cuts or Silicon Valley innovations—sparked the subsequent quarter-century boom, an unprecedented era of prosperity both in the U.S. and around the world, punctuated by only two mild recessions.

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Along the way, Samuelson details what the Great Inflation did to our financial system, which had been predicated on low, stable interest rates. The savings and loan industry (S&Ls), the primary source of home mortgages in those days, became insolvent because the interest on short-term deposits was zooming while yields on traditional mortgages were fixed. The resulting squeeze produced rivers of red ink.

Congress reacted to the plight of the S&Ls with disastrous expedients, which led the companies into binges of wild speculation. That, in turn, led to a catastrophic collapse in the early 1990s which almost sank the financial system.

Samuelson notes that the Great Inflation did lead to the deregulation of rail, trucking, and parts of the banking industry, needed steps on the path to greater efficiency and lower prices. But these benefits meant little to a profoundly demoralized public with little faith in the future.

How did this Great Inflation happen? The origins lay in the understandable desire after World War II to make sure the U.S. never had another Great Depression. Building upon the cult of social science that was so central to the Progressive movement, a new generation of economists—armed with new theories and models that they thought told them how economies work—boasted they would banish the business cycle. There would be no more unemployment-generating slumps, no more over-exuberance on the upside. The Fed and other central banks would aggressively supply money when economic conditions got bad and tighten up on the supply when things began to get frothy. In the memorable words of William McChesney Martin, Fed Chairman from 1951 to 1970: "The job of the Federal Reserve is to take away the punch bowl just when the party is getting good."

Restraint by monetary planners and fiscal fine-tuning by the Treasury Department would ensure perpetual prosperity. This hubris reached its apogee when John F. Kennedy took office and the "new economists" came in with him. Big business, now run more by managers than entrepreneurs, went along eagerly. In return for macroeconomic stability, it gave in to union demands for higher wages, better benefits, and job security. The new economists were to usher in a tamed capitalism. Policymakers came to believe that there was an ironclad but easy tradeoff between inflation and unemployment—if we wanted less unemployment, we accepted more inflation (and vice versa).

But the world isn't so neat and tidy. All this intervention, as Samuelson carefully lays out, ended up making the economymore unstable. It was impossible to sustain only a "little bit of inflation." Like a drug, the doses had to be increased over time in order to reach the desired result; the inevitable overdose came in the 1970s. Samuelson maintains that although tough monetary policy could have ended inflation early on, it took the economy's obvious, sustained deterioration to stimulate sufficient political will to apply the cure—in addition to the luck of having a Federal Reserve chairman willing to slam on the breaks, and a president willing to protect him.

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Given the grim situation in the '70s and then the heroic victory over inflation in the early '80s, why is the whole story so little known, much less celebrated today? Samuelson points to

a collective failure of communication and candor by the nations' economists. Inflation was their doing. It resulted from their bad ideas. There has not been much in the way of public apologies or reprimands. There seems to be an unspoken pact of self-restraint to let bygones be bygones, perhaps out of collective embarrassment or a recognition that dwelling excessively on past failures might compromise economists' projects as government advisers and high-level appointees.

Moreover, there is a defect in the historians' craft that persists today. "Historians don't do economics, and economists don't do history," writes Samuelson. In fact, America's professional historians often take a perverse pride in being economically illiterate. What's more, the experts who fancy themselves competent in both economics and history—journalists—too much "concentrate on the here and now." They tend to be reluctant to describe the kind of underlying causes on which Samuelson focuses. The causes and effects of long-term inflation are not the kind of facts with which "objective" journalists are comfortable.

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Although Samuelson's account gets the broad story right, he leaves himself open to a few criticisms. Though he is no fan of the Phillips Curve (named after A.W. Phillips, who expounded the supposed tradeoff between inflation and unemployment), Samuelson doesn't really debunk it. In fact, the author occasionally falls under the curve's influence when he doesn't carefully distinguish between price changes that come about because of normal supply and demand factors, and those that are the result of good old-fashioned currency debasement. For example, if doctors announced that eating five apples a day would prevent cancer, apple prices would soar until enough new orchards were planted to catch up with the new demand. Those high prices for apples would not be inflation; they would simply be a response to increased market demand.

More fundamentally, Samuelson is wrong to dismiss the impact of the Reagan tax cuts on our moribund economy in the 1980s. He notes that tax receipts as a percentage of GDP didn't change much and that therefore the tax burden "remained constant." But he overlooks the enormous effect that lower tax rates have on the incentive to invest, take risks, and work more productively. Taxes are the price one pays for working, for boldly taking risks, for being successful. Lower the price of productive work and you'll get more of it. This is exactly what happened on Reagan's watch: the economy expanded, and so did government revenues. Moreover, the tax simplification of 1986, which both lowered tax rates and eliminated loopholes, further liberated entrepreneurs to follow market—rather than governmental—incentives. Killing inflation was a necessity, but without those cuts in tax rates the Reagan boom would never have happened.

Samuelson also has little to say about the indispensable role gold plays in long-term price stability. The U.S. tied the dollar to gold in 1792, and—except during the Civil War, the two World Wars, and the Great Depression—the link remained until Nixon severed it in 1971. Without gold as a guide—without a link between paper money and a real commodity that is hard to inflate—how can the Federal Reserve, or any other central bank, know if it is creating too much, too little, or just the right amount of money?

Still, the fact that Samuelson gives us so much to chew on proves the ultimate importance and success of his effort. The Great Inflation and Its Aftermath is a timely piece of scholarship that will serve us well in the debates now unfolding on the nature and future of democratic capitalism.