• In this post, I review the book The Great Inflation and Its Aftermath, by Robert Samuelson. Samuelson puts forth an explanation for why inflation occurred in the late 1960s and 1970s, and how it was stopped in the 1980s.
• For Samuelson, the rise and fall of inflation in the US during the second half of the 19th century was an integral part of the American economic experience, and constitutes an important historical lesson for future investors and economists. He lays out an interesting story, and some insightful conclusions. After discussing Samuelson’s narrative, I touch on several issues raised by the book.

This week’s post will review The Great Inflation and Its Aftermath, by Robert Samuelson, and highlight some interesting points from the book. Naturally, it will also discuss my thoughts on them. With both the US and many foreign governments printing large amounts of money to stave off a domestic and global depression, the risk of future inflation is serious. I don’t have particular insights into whether it will occur. But I’d like to be ready from an investing perspective to either profit from it or to be protected from it, if it does occur.

The Great Inflation reviews the inflationary period in the United States from the mid 1960s to the early 1980s. It discusses what caused rising inflation; what the period was like; and how it ended. It debunks certain misperceptions about the experience and uses it as a platform to explore different monetary policies. It’s a good read, not to mention quick (especially if you stop reading at page 175, or Chapter 6, since the book devolves into irrelevant rambling after that point).

Samuelson first attacks several misperceptions about inflation during the period – first, that it was caused by high oil prices and energy-related supply-demand shocks; and second, that it was caused by increased spending during the Vietnam War. On oil, he shows that CPI was quite high independent of rising energy costs. For instance, in 1973, before the first oil shock, CPI was at 8.7%. In 1979, CPI’s overall gain was 13.3%, but excluding energy prices, it was still 11.1%. With regard to the Vietnam War, Samuelson agrees that Vietnam exacerbated inflation. But during previous wars, inflation subsided when the wars ended. In the Korean War and World Wars I and II, inflation fell away shortly after the wars. After Vietnam, US inflation shot up.

So what did in fact cause the Great Inflation? The same forces that have caused inflation in all previous inflationary periods, whether in the US or anywhere else. “Too much money chasing too few goods”. Prices and wages didn’t surge nationwide because of the Arab Oil embargo. They rose because of bad monetary and fiscal policies by the government.

According to Samuelson, the story goes like this. After World War II, the US enjoyed a wonderful postwar boom. While there were recessions in 1948-49, 1953-54 and 1957-58, the 15-year period from the mid-1940s to the early 1960s was relatively smooth and prosperous. Unemployment averaged 4.5% in the 1950s and didn’t rise past 7% in any given year. Inflation was low.

When Kennedy came to power in 1960, he appointed various Keynesian economists to his Council of Economic Advisors. These Keynesians believed that governments should actively use fiscal policy to keep the economy at “full-employment”, which they viewed to be around 4%. Taxes should be reduced or spending increased until the government was at full employment. If that resulted in deficit spending, that was ok – Kennedy’s Keynesians didn’t mind deficits as much as economic advisors before them. If they over-stimulated the economy and triggered inflation, they could always raise taxes or reduce spending to slow the economy and bring inflation back down. And really, inflation was 1.5% from 1958-1961 – it wasn’t the Keynesians’ biggest concern. Unemployment, on the other hand, had risen to 6%. A little more inflation was worth a little less unemployment.

An obstacle for these economists was the gold standard. At the time, the United States had pledged to convert dollars to gold at $35 an ounce. But if inflation or deficits eroded the dollar’s value, foreigners would present all their dollars for redemption, and deplete American gold reserves. Then the US would have to slow the economy and strengthen the currency to keep the gold standard viable. So the Keynesians put the dominos in place to end the gold guarantee. Nixon ultimately dropped the gold standard in 1971.

In 1963, Congress passed a large tax cut and by 1965, unemployment had dropped to 4% while inflation remained under 2%. But then prices started to creep up. The chart in the attached materials shows inflation during the 1960s and 1970s. By 1970, inflation was above 5%. Several years after that, it would soar above 10%.

Now, if inflation is about “too much money chasing too few goods”, what does fiscal policy have to do with inflation? Well, higher deficits mean that the government needs to raise money. And those dollars are essentially coming from the Fed printing more money. (To raise cash and finance its deficit spending, the government sells treasuries to banks and dealers. The Fed buys those treasuries from the banks and dealers with newly printed cash).

So why was the Fed complicit in this? Couldn’t it just say, “Sorry Keynesians, we’re not going to print more money to buy your treasuries”. Not really. While the Fed is viewed to be independent, it’s not really. If a President is badgering the Federal Reserve chairman to print more money to stimulate the economy and maintain “full employment”, the Fed chairman usually goes along, as he did in the late 1960s and 1970s. As well, in the 1960s, the Fed was becoming staffed with more Keynesians, who embraced using the money supply to speed up or slow down the economy. So independently from the government’s fiscal policies, the Fed was doing its part from a monetary policy perspective to keep the economy at “full employment” and “potential output”. In the 1950s, money-supply growth was 23%. In the 1960s, it was 44%. In the 1970s, it was 78%. Hence inflation.

The result of this obsession with full-employment and potential output was that whenever the economy began showing signs of deterioration, the government initiated stimulative fiscal policies and the Fed printed more cash. In retrospect, the target for full employment was probably too low and potential output too high. Over time, too much cash was being printed for the amount of goods and services being produced by the US economy. Naturally, there were times when the Fed tightened credit, causing slowdowns in 1960; 1969-1970; and 1973-1975. But the Fed was too quick in re-applying the accelerator to re-stimulate the economy in times of economic weakness. Inflation dropped from 12% in 1974 to 5% in 1976 as a result of the recession. But then it jumped back to 9% in 1978, and then 13% in 1979. And this higher inflation didn’t necessarily mean low unemployment or a strong economy. Unemployment rose above 6% repeatedly during the 1970s, and productivity was lower than in previous decades. Part of the problem was that consumers, employees and companies all became accustomed to rising prices and wages. As soon as the economy would recover from a recession, employees would begin demanding higher wages and companies would begin implementing higher prices, all in an effort to keep ahead of the soon-to-come inflation.

Neither Johnson, Nixon or Carter were willing to tell (or allow) the Fed to tighten credit long enough to keep wages and prices low for a prolonged period of time and therefore break the newly formed cultural habits of asking for wage/price increases, and finally end inflation. The economic consequences would be too harsh to stomach politically. Instead, each administration proposed useless price controls; wage controls; export duties; surgeon general warnings to reduce the demand for eggs when egg prices doubled; etc.

In the end, Paul Volcker and Ronald Reagan took action when they arrived in 1979 and 1980 and triggered the most serious recession since the Great Depression (notwithstanding the current one) for the sole purpose of ending inflation. Between 1979 and 1982, the US economy’s output barely increased, rising in 1979 and 1980 and falling in 1981 and 1982. Interest rates rose above 20% and unemployment above 10%. The subsequent 25 years then enjoyed a tremendously long stretch of low inflation and low interest rates, which in turn triggered smooth economic growth and surging asset prices.

It’s a neat story. It is indeed one man’s description of what happened during that time. Samuelson could be mistaken; perhaps it was indeed energy prices and long-term supply-demand imbalances in various commodity sectors that drove prices higher and pulled wages up with them. But Samuelson’s interpretation is a fairly compelling explanation for high inflation during the late 1960s and 1970s.

There are a couple points I want to highlight and discuss further.

First, how did stocks perform during the inflationary timeframe? Intuitively, one would think that stocks would be a decent protection against inflation, since companies raise prices as inflation accelerates. I’ve included a graph of the S&P 500 from 1960 to 1985 in the attached charts. Stocks didn’t do well during the Great Inflation; rather, they performed awfully. It could be because interest rates were high; high interest rates reduce company valuations by making future cash flows worth less today. So while profits were higher, valuation multiples deserved to be lower. But real interest rates (nominal interest rates less inflation) were actually quite low in the 1970s, materially lower than in the 1980s, when stocks soared. Perhaps investors were mistakenly focusing on nominal interest rates instead of real interest rates. Another explanation is that inflation made future cash flows less predictable. Will a company’s prices increase faster than its wages, or vice versa? Naturally, there are many other factors that may have influenced stock prices aside from inflation. Valuations were too high in the late 1960s and too low in the early 1980s. Perhaps mister market was just acting irrationally. All I can conclude is that when people tell me that stocks are the best protection against inflation, I take their counsel with a grain of salt. The 1970s was the United States’ most inflationary decade in the 1900s, and it was also a terrible time to be in the stock market.

In contrast, land and commodities soared. Wheat jumped from $1.34 to $4.00 from 1972 to 1975. Corn went from $1.08 to $3.02. In Iowa, land prices quintupled from $319 an acre in 1970 to $1,679 in 1982. The 1970s were a great time to own commodities – I recommend Hot Commodities by Jim Rogers for a decent historical perspective. It can be tough however to determine the degree to which an excessive increase in the money supply was causing rising commodity prices, or whether supply-demand imbalances within certain commodity sectors were fueling high inflation.

Second, should the United States have kept the gold standard? With fiat money, central bankers can print money at will, debasing the currency to meet political or short-term objectives, but viciously damaging the economy and country over the long-term. A viable gold standard restricts the amount of money that can be created, preventing governments from running amuck with the printing press. The problem with a gold-backed system, however, is that gold is limited. Growing economies need more money and credit, but gold’s rigid and unpredictable supply limits central bankers’ abilities to increase the money supply. During the Great Depression, Roosevelt viewed gold as a straitjacket on his ability to stimulate the economy. So he devalued the dollar by 70% by adjusting the amount that the US government would exchange gold for. Whether the gold standard should have been kept is a complicated topic and I don’t have an answer.

Third, Samuelson makes an interesting point when he says: “Through its history, the Fed has made many small errors but only two major blunders. The first was permitting the Great Depression; the second was fostering the Great Inflation”. Indeed, while the Fed was too eager to print money in the 1960s and 70s, its excessively tight policies in the 1930s prolonged the Great Depression. In the 1930s, credit and purchasing power dried up, and the Fed could have eased the pain by feeding money and credit into the banking system. It was slow to do so, however, because the prevailing views of the time were wedded to the gold standard, and issuing too much money would subvert the faith in gold.

Fourth, what lessons can we apply to today’s economic environment? A protracted global downturn has quelled worries of inflation, and prices have been fast dropping amongst all products and categories. At the same time, both the US and foreign governments are rapidly increasing the money supply in order to stimulate their economies (attempting to draw lessons from the Great Depression). Will the deflationary forces of the global recession or the inflationary forces of printing money ultimately win out? I don’t have any particular insights, at this point.

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