That 1970s Inflation

Patrick Horan directed me to these tweets:

Luther is right. There are actually three issues that need to be disentangled here:

1.The cost of high trend inflation

2.The cost of high inflation volatility

3.Supply vs. demand-side inflation

High trend inflation increases the real tax rate on saving and investment, which hurts capital formation. This reduces economic growth, lowering living standards. The negative effects are not offset by gains to borrowers, as the Fisher effect implies that nominal interest rates rise to reflect higher inflation expectations.

As Appelbaum suggests, an unexpected surge in inflation can indeed help borrowers. However, in the long run there will be just as many years where inflation is less than expected as there are years where it is higher than expected. The gains to borrowers in the 1970s were offsets by losses in the 1980s when inflation fell more rapidly than expected. Hence lots of loan defaults and a big S&L crisis during the 1980s, followed by an expensive taxpayer bailout. The 1970s were the party; the 1980s were the hangover. There’s no long-run gain to borrowers from a policy of higher inflation. (Not to mention that there’s no plausible reason why we’d want public policy to favor borrowers.)

A high level of inflation volatility (as we saw during 1966-81) tends to create business cycles. (Actually, it is NGDP growth volatility that matters, but that was also very high during the 1970s.)Because of the highly unstable monetary policy, the US experienced four recessions between 1970 and 1981, and two were quite severe. The high inflation did not help workers.

Nonetheless, there is a reasonable case to be made for the argument that 1970s inflation was not as bad as it seemed. The US was hit by two supply shocks (1973-74 and 1979-80), which resulted in real wages falling during those two spikes in inflation. In both cases, the fall in real wages wasn’t actually caused by the inflation; it was caused by a real shock to the economy, less energy to drive our economy. Those two shocks would have hurt living standards even if the Fed had kept inflation at low levels.

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