Home > Uncategorized > Weekend read: What caused the stagflation of the 1970s? Answer: Monetarism

Weekend read: What caused the stagflation of the 1970s? Answer: Monetarism

from Philip George

 If any one event can be said to have knocked Keynesian economics off the high perch it occupied during the 1950s and 1960s it was the stagflation of the 1970s.

Keynes held that when aggregate demand fell due to a fall in business investment the government could stimulate the economy by increasing its own spending and lowering interest rates. Inflation would kick in only when the economy approached full employment. Monetarists questioned the ability of the government to control the business cycle through fiscal spending or loose monetary policy. They held that loose monetary policy could affect output only in the short run, and that in the long run it would only result in inflation. When the US economy simultaneously experienced both high unemployment and high inflation in the1970s, monetarism seemed to have triumphed.

If Keynesians had no policy or theoretical response to monetarists it was because they thought of money in the same way as monetarists did, as exemplified in the image below.

George 1

The economy is like a boat floating in a tank into which money is being poured. Monetarists argued that the top of the tank rose each year by an amount proportional to the growth rate of GDP. Only when the money being poured into the tank exceeded that level would the inflation meter start ticking. Keynesians held that money could be poured into the tank as long as the level was below “full employment”. Only after that level would the inflation meter start ticking. Allowing for differences of emphasis between monetarists and

Keynesians the model was substantially the same, which was why Keynesians had no answer to the monetarist claim that when unemployment fell below a certain level, inflation would accelerate.

But while the model seems to work for closed economies it fails for open economies where inflation comes in, for example, through external oil price increases. In such cases, we have to analyse the economy from a completely different viewpoint, by regarding money as a medium of exchange, whereas both Keynesians and monetarists regard money as an asset.

The figure below plots year on year changes of West Texas Intermediate crude price against consumer price inflation. From 1974 onwards it can be seen that inflation is always triggered by changes in oil prices. I have used West Texas Intermediate as a proxy for international oil prices.

George 2

The problem is to estimate the effect of oil price increases on inflation. For that, consider the economy as a firm which has an input A accounting for 5% of total input costs. If the price of this input goes up by 20% while the prices of all other inputs remain unchanged then the firm has to raise the price of its own output by 1% to keep its profit at the old level.

The graph above shows that in 1974 the price of crude went up by an average of 170%, year on year. At that time energy costs accounted for 10% of the US economy. A rough-and-ready calculation shows that a crude oil price increase of 170% would translate into inflation of 17%. The higher cost of imports and, by transmission, the higher prices of goods and services would call for a greater amount of money to effect exchanges. If the central bank allowed money supply to grow by 17% then we would have inflation of 17% (assuming a one-to-one relationship between money supply growth and inflation) but no reduction in growth. If the Fed instead curtailed money growth to less than 17%, then we would have both inflation and a contraction of GDP (and hence higher unemployment). This is what happened after global oil prices began to shoot up. In 1974 the average rate of growth rate of M1 was cut to an average of 5% during the year from 9.1% at the start of 1973. The average inflation in 1974 was 11%, less than our calculated 17%, but the cost was a severe recession.

Inflation in 1974 was caused by higher prices of oil imports. The contraction in growth occurred because the Fed, under the mistaken view that inflation was caused by too large increases in money supply, curtailed money supply growth instead of allowing it to expand by the amount required by imported inflation. The rise in unemployment was caused not by too much money but by too little money.

In the first six months of 1980, oil prices rose by an average of 127%, year on year. By then energy accounted for 13.5% of the economy, so inflation should have been 17%. If money supply had been allowed to grow to this extent, there would have been inflation of 17% and no effect on growth. The actual money supply growth (M1) was 6%, roughly the same as in the previous year. Inflation was on average 14% but the reduction in inflation from the calculated 17% was paid for in the form of a recession, which lasted from January to July1980.

From July 1980 the price of oil began to fall steadily. Between July 1981 and November

1982, the price of oil fell 6.5% on average each month, year on year. Oil accounted for about 13% of the economy, so inflation should have fallen to about 1% over time, without any intervention. Instead, the Fed squeezed M1, whose growth during this period was about 6.3%, a fall from 11.5% in April 1981. Inflation fell sharply from 10.8% to 3.8%, but the cost was a severe recession. Again, stagflation was caused not because of too much money but because of monetarist ideas.

If an oil-importing refiner was importing 1 million barrels of crude a day at $15 and the price rises to $30 then it needs to pay twice the amount of money to import the same amount of crude that it did earlier. Also, those to whom it sells the refined gasoline will need more money than they spent earlier to buy the same amount of gasoline. Money supply needs to be expanded to permit this. Else, less crude will be imported and less gasoline sold down the line, resulting in a fall in GDP and a rise in unemployment. Instead, central banks typically reduce the growth rate of money, which explains the stagflations of 1973-75, 1980 and 1981- 82.

The 1969-70 inflation was not caused by either high oil prices or too much money but by increased expenditure on the Vietnam war. The figure below shows expenditure on defence as a percentage of GDP. In 1968 spending on war rose to 8.6%. To understand the effect of this on inflation, it is again necessary to view money in a way different from how Keynesians and monetarists have customarily viewed it.

George 3

Consider an economy working at full employment. It produces $90 worth of consumption goods. An equal amount is therefore paid out in income flows: wages, rent, and profit. If the saving rate is 10%, $9 of these income flows is saved and $81 is spent on consumption goods. That leaves $9 worth of consumption goods unsold. But the economy also spends $10 on investment, which means an equal amount is paid out as income. Since the saving rate is 10%, $9 of this income is spent on consumption goods and $1 is saved. The $10 of total saving is channelised into investment by financial institutions.

Now assume that this economy goes to war. $5 now has to be spent on defence goods and services. Since the economy was operating at full-employment, real resources newly spent on defence have to be diverted from the production of consumption goods. But an equal amount of income, $100, is paid out as before. Assuming the same saving rate as before, $90 is now available to be spent on consumption goods but only $85 worth of consumption goods is now being produced. The result is inflation, which is caused not by too much money (the central bank has not expanded money supply) but by a shortage of consumption goods.

The central bank, however, believing that the inflation was caused by too much money curtailed the growth of money supply from March 1969. This caused a reduction in output, which exacerbated inflation instead of reducing it, and increased unemployment. The result: inflation and high unemployment or, in other words, stagflation.

Thus, the episodes of simultaneous higher inflation and higher unemployment in 1969-70 as well as the subsequent three recessions were caused by the central bank’s mistaken belief that inflation was caused by an unwarranted increase in money supply. Stagflation was caused not by too much money but by the central bank’s belief in monetarism.

When money is viewed as a medium of exchange, as above, we can also question the concept of NAIRU. When unemployment falls the money being put into the economy in the form of wages goes up. But since the newly employed are also producing goods and services on which wages can be spent, inflation will not accelerate.

What is a bit difficult to explain at first glance is the situation in 1953, when defence spending was 11.3% of GDP but inflation was less than 1%? A publication of the Federal Reserve Bank of Minneapolis, Monthly Review, dated January 31, 1952, offers clues to an explanation. “Perceiving the worsening international situation at the close of 1950 and studying the defense programme, most consumers in the early weeks of 1951 rushed into the market places to buy goods which they feared might soon be in short supply. They then observed that the shelves were quickly refilled with merchandise,” it noted.

“Their awareness of this made people less eager to spend and more willing to save.” Personal net saving rose sharply. “… many families had become rather well stocked with consumers’ durable goods in the period June 30, 1950 to February or March of 1951, and were in a strong position to postpone further purchases.” Tightening of credit controls too may have helped. This explanation seems to have carried on into 1953 as well and explains the low inflation of that year.

What is interesting is that in 1952, six years after the death of Keynes and 12 years since the publication of his How to Pay for the War, central bankers, in seeking to explain inflation or the absence of it, took into account defence expenditure, consumer spending and saving in addition to money supply and credit controls. By 1970 all explanations of inflation centred on a single point: money supply. And Keynesians had no answer to the monetarist claim because by then, the transformation of the “economics of Keynes” into “Keynesian economics” was complete.

We may add in, passing, that expectations cannot explain inflation. One expression of the expectations thesis is that if a central bank signals its intent to run an expansionary monetary policy, then agents will raise prices if they trust the central bank’s pronouncements, whether the central bank expands money supply or not. But this cannot be correct. If one set of agents raises prices of goods and services, then in order for those prices to become effective, another set of agents must have a larger quantity of money (as medium of exchange) to purchase those goods and services at the higher price. And since that money must be real and not merely exist in someone’s expectations, the purchases cannot be carried out unless the central bank increases money supply.

  1. August 14, 2021 at 3:36 pm

    For “Keynesians” in this, read “pseudo-Keynesians”. The real Keynes solving a problem of unemployment by advocating printing money is not the same as advocating keeping on printing it after adequately full employment has been reached. The real Keynes was in fact an advocate of Gesell’s system of stamped money (i.e. negative interest rates), believing “the future will learn more from the spirit of Gesell than from that of Marx” (General Theory p.355); and in conclusion (p.379), “Thus I agree with Gesell that the result of filling in the gaps in the classical theory is not to dispose of the “Manchester System” [control by pricing money] but to indicate the nature of the environment which the free play of economic forces requires if it is to realise the full potentialities of production”. But in 1936 even Keynes was still thinking in terms of forces, this being twelve years before Shannon’s general theory of information enabled one to say that that is all prices and indeed money are: information. The pseudo-Keynesians missed their chance and continued to suffer from the diabolical disease said to have afflicted the Southwold Railway: “hypertropic accountantitis”.

  2. August 15, 2021 at 6:51 am

    From Naked Capitalism:

    “Warren Mosler has a persuasive analysis that shows that inflation started to fall in 1979 just after oil prices peaked; his charts make the case that the Fed driving interest rates to the moon and the resulting steep recession were unnecessary save to further weaken labor bargaining power. As we wrote in 2019:

    Some experts, such as Warren Mosler, point out that the underlying inflationary trends were dissipating even before Volcker launched his money jihad, as shown by oil prices peaking in 1979. Recall that Volcker became Fed chairman in 1979 and started implementing the “Volcker shock” of constraining money supply in March 1980. Thus there is a case to be made that inflation would have abated, particularly since the key practice that had helped reinforce it, widespread formal and informal cost of living adjustments, had been abandoned or weakened.”

  3. Ikonoclast
    August 16, 2021 at 1:02 am

    How is the analysis affected by the fact that the US did not import ALL its oil, even in the 1970s? What proportion of its oil needs did the US import at that time? If, for example, it was half, then the above theory would have it NOT that:

    (A) A rough-and-ready calculation shows that a crude oil price increase of 170% would translate into inflation of 17%; BUT

    (B) A rough-and-ready calculation shows that a crude oil price increase of 170%, for imported oil, would translate into inflation of 8.5%.

    Except then we have to take into account the effect of import prices and domestic prices. Does domestic pricing become opportunistic and follow import prices? Then we have to have a more complex theory to account for foreign and domestic power / exigencies in moving prices. I don’t know the answers to my questions. I simply ask them.

    In addition, I recall reading, but I don’t recall where, that at that time the USA placed restrictions on exporting grain. These restrictions pushed up world grain prices which then fed into world inflation and even into US domestic inflation, though I don’t recall the supposed mechanisms for this. Is this part of the history?

    As well as being a medium of exchange, money is (according to Capital as Power theory or CasP) NOT a measure of value but an instantiation and thus a measure of power (finance power). This implies (I think) that we have to abandon any theory that money prices move according to their reflecting supposedly real, objective values made commensurable in the market place. Rather it suggests that the political economy rules constructing money and markets simply (or complexly) set the relative values (prices) of all commodities, goods and services.

    This is a deeper critique of money under capitalist political economy rules than MMT or (original) Keynesian critiques, again in my opinion and if I am characterizing CasP theory correctly. (I strongly lean to the CasP theory.) This means there is no objective way to set money operations under capitalist political economy. There are only prescriptive ways. And capitalism prescribes that which is advantageous to dominant capital, except when workers exert their powers from strikes to revolution.

    Even MMT and Keynesianism, or most of their supporters, accept capitalism as given and as in some way acceptable.Thus according to these views (in the main) the capitalist paradigm must be accepted, accommodated and ameliorated (somehow, usually by welfarism) in it effects on the environment, workers and indigent. So remediation and re-distribution must follow environmental damage and distributional. Without a radical and complete rejection of capitalism we are going get nowhere. Surely, history since 1970 has taught us that. The human world stands on the brink of catastrophic collapse from climate change and capitalism continues to do absolutely nothing about it. Capitalism is systemically incapable of doing anything about it. Capitalism is predicated on exploitation, environmental destruction and endless growth. It is completely unsustainable and will collapse in short order now. Unless we are ready with entirely new theories and practices, we don’t stand a chance.

    • Roger Chittum
      August 19, 2021 at 12:01 am

      Ikonoclast, you are onto something here. In the 1970s, I worked for a company that ran refineries and was at the mercy of crude oil prices. What I remember about oil prices in that era is that the Carter Administration waged a multi-front war to become “energy independent.” One of those initiatives was controlling oil and gas prices. Domestic production was divided between “old oil” and “new oil.” The prices of “old oil” were controlled because price increases were regarded as mere windfalls, but the prices of “new oil” were allowed to rise to encourage investment in increasing domestic oil production. (At one point the wellhead prices of natural gas–which had been controlled by a federal agency for decades–were decontrolled to unleash production and drive down NG prices.) Whether a refiner was allowed to purchase oil at “old oil” prices was determined by a federal agency that awarded “entitlements.” Naturally, there was extreme effort–and a lot of dishonesty–for each refiner to portray its sources as producing “old oil,” and for each producer to portray its production as “new oil.”

      So, while I am quite persuaded by Philip George’s analysis (many of us in the oil industry thought at the time oil prices were the No. 1 driver of inflation), he might like to use a different data set for domestic crude oil prices. Using spot prices for WTI I suspect tracks only the price of “new oil” and tells us nothing about the price of “old oil” or the relative volumes of each. I would not be surprised if the Energy Information Agency has not done and published that work.

      Another thing I recall from that era is that it was impossible to get firm bids for capital projects because of runaway inflation. I seem to remember that refinery project bids were to be adjusted to spot steel prices. There was an acute shortage of steel (and long lead times) in those days, as exemplified by the story (true, I think) that Parsons Engineers ordered the steel for its new offices in Pasadena before it designed those octagonal buildings. Another commenter says contracts like that had run their course by 1980, but I recall they lasted a year or two more–until a lot of construction projects had been cancelled.

      • Ken Zimmerman
        August 23, 2021 at 9:46 am

        Roger, I was a regulator during this period. The issue at the center of all you describe was fear. Fear that the rules were not clear and those in power liked it that way. There was also paranoia among many fossil fuel companies and their lobbyists that politics was turning against them. These came up in just about every ‘off the record” conversation with these folks.

      • Roger Chittum
        August 23, 2021 at 5:16 pm

        Ken, Today is the 50th anniversary of the Powell Memo. https://www.nakedcapitalism.com/2021/08/50th-anniversary-of-powell-memorandum-neoliberalism-has-wrecked-its-hosts.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+nakedcapitalism+%28naked+capitalism%29 I was not aware of it in 1971, but certainly by the end of the 1970s our company was being invited to participate in funding conservative think tanks and other ideas proposed by Powell–organizing for a long-term fight to take back control from labor, socialists, and environmentalists. There was fear. Oil companies were taking their signs off their refineries, and executives who had never worried about security were traveling with armed security guards.

      • Ken Zimmerman
        September 2, 2021 at 7:54 am

        Roger. There are so many defects in Powell’s memo that it cannot be taken seriously as a policy stance.  Here are just a few.

        The statement that, “No thoughtful person can question that the American economic system is under broad attack” shows a lack of knowledge of American history. As does the entire document. This is as close as Powell comes to giving a definition to that system. “Variously called: the ‘free enterprise system,’ ‘capitalism,’ and the ‘profit system.’ The American political system of democracy under the rule of law is also under attack, often by the same individuals and organizations who seek to undermine the enterprise system.” But this has never been the American economic arrangement. Right after the Revolution craft persons and farmers were most common.  Along with shipping, mining, and transport. There were also wealthy patricians in the north and plantation oligarchs in the south. To the extent theory entered into the situation there were ‘free traders’ and ‘protectionists.’ In the South free traders dominated since exporting cotton kept the oligarchs rich. In the North protectionists dominated since the manufacturers and craft persons wanted protection from larger and more aggressive nations (e.g., UK, France). It would be a massive stretch of the American imagination to conclude that current economic theory or transactions is the legitimate heir of these ideas or ways of life.
        Second, socialism has always been a strong force in the US.  From city governments with fire protection, police, hospitals, etc., to rural and urban populism, to cooperatives rural and urban, large and small. After warfare between labor and firms subsided in the early 20th century, socialism became quite admired with hundreds of local and state officials elected just before and after WWI. And before and after WWII local school boards, county and city boards, college boards, etc. often included socialists and communists.

         Third, the kind of big industrial capitalism Powell defends has often been unpopular in the US.  Both officially in the laws and court decisions (antitrust, interlocking directorates) and among the public (fear of too much control and subversion of democracy). So, attackers of these would more likely be viewed as good citizens rather than a danger to the American ‘free’ society.

        Finally, there is real and substantial evidence that the attacks Powell decries from such as college campuses, the pulpit, the media, the intellectual and literary journals, the arts and sciences, and from politicians are not only accurate but justified. As are those Powell objects to from Kunstler, Nader, Reich, etc.

        Powell’s main evidence to support his claims seems to be this from Milton Freidman,

        “It (is) crystal clear that the foundations of our free society are under wide-ranging and powerful attack — not by Communist or any other conspiracy but by misguided individuals parroting one another and unwittingly serving ends they would never intentionally promote.” It is not free society that is under attack but the power of large American corporations.  And it is this power Powell is attempting to protect. Power that was significant, sometimes overwhelming in 1970. But has all but evaporated in 2021. Now new players play a different game and hold a level of power that dwarfs that of 1970 corporations. But still Powell played a large part in allowing these new American oligarchs to take control and with their generally accidental political accomplices now near the destruction of American democracy.

  4. August 16, 2021 at 3:54 am

    The price I used was of domestic oil, West Texas Intermediate crude. The price of higher imports was transmitted to all crude.

  5. Ken Zimmerman
    August 17, 2021 at 11:17 am

    The popular view of inflation and some argue of stagflation as well (wherein it is the result of money growth) depends critically on assumptions that do not hold in the ‘real’ world. That term real is popular on this blog. So, I wanted to use it in context here. Money comes into existence when it’s added to a savings account, invested, a loan is made, etc. Here either new cash reserves are created or new cash is put to into the ‘real’ economy. Neither of these scenarios allows the central bank to increase the supply of money beyond demand, the story told by those in the money growth equals inflation camp. Instead, inflation happens first. Agents need more cash for their enterprises, leading them to borrow more or sell government securities to the Fed. Thus, the money growth accompanies inflation, but inflation is not the result of money growth.

    Inflation is simply a rise in the average price of goods and services experienced by participants of every sort in a region. Levels of inflation can and often do vary among different regions and among different goods and services. Which particular regions, and goods and services depend on the measure we are examining. Consumer price inflation is the one usually in the news. It takes a weighted average of various items purchased by the typical household (the list being determined by survey and then updated periodically). The average can rise while some prices have actually fallen, and how much it reflects your personal situation is a function of how closely the basket of goods and services in the index matches your buying patterns. But basically, we say that inflation has occurred when the average price of those goods and services increases.
    This does not happen by magic. It takes someone, somewhere making a conscious choice to charge more for the good or service they sell and having the power to make that decision stick. Actually, many someones in many places, with both often international. Particularly since World War II. The initial increase does not have to be in something that is being directly measured by the consumer price index. No household in any American neighborhood, for example, buys barrels of oil; and yet when they become more expensive that sends a ripple throughout all related products. In the end, consumer prices jump as well. The price of all fossil fuels has been directly linked to inflation for consumers, industry, and governments since the 19th century. Direct links to inflation for most other industrial inputs, for food, and for housing inputs have existed during all of the 20th century.

    There are four factors in particular at the root of inflation. First is market power. This means that one or a group of firms control a service or resource to the extent that any decision they make to increase price cannot be stopped or reversed. Neoclassical economists claim fear of competitors has this power. Governments hypothetically have such power through antitrust and similar laws. During the 1970s neither was available to turn back OPEC price increases. And when OPEC raised oil prices all other oil producers in the world followed suit. As did producers of other fossil fuels.

    Second, inflation can take place when there is a rise in demand relative to supply. Say there is an increase in the demand for housing during an economic expansion. Even if those who provide building resources and services do not hold market power, delays in construction, in financing, or in move in schedules may lead to inflation in housing costs.

    Third and very relevant today, inflation can overflow from the asset market. The connection between the prices of goods and services and those of financial assets has been weak in most situations. Sometimes there is practically none at all. Witness the 1990s, with a massive increase in stock prices but very little movement in the consumer price index. However, relationships can exist, particularly though commodities futures trading.
    Since the late 1990s this relationship has become a strong factor in the prices of many important commodities. The gist of this change is not difficult to describe. When speculative money bids up the price of a commodity future, this creates an incentive for those actually selling the commodity to withhold supply today in favor of the future (when prices will presumably be higher). The rising spot price then convinces the speculator that their bet had been correct, and they increase their position. This may drive futures prices even higher, and so on. Thus, a goods and services price is driven up by the price of a financial asset. This was of course a major factor in the 2008 US collapse. Another problem here is that once the real commodity price is high it’s difficult to convince commodity sellers to lower prices even when the financial asset price drops.

    Finally, there is supply shock. If a storm rages through the Gulf of Mexico, or a war through Saudi Arabia, or environmental regulations reduce oil production closing derricks and refineries along the way this may well raise the price of oil and gas. As it should, according to capitalism dogma for this creates incentives to build more derricks and refineries and for consumers and governments to find alternate energy sources. In essence, then inflation is part of the fabric of capitalism. A fabric often frayed and ill fitting and suffocating to ordinary people.

  6. Gerald Holtham
    September 2, 2021 at 11:54 am

    Inflation is not what knocked Keynes off his perch. It was not news to either Keynesians or the public that excess demand can cause inflation. Inflation in the United States was raised by war expenditure coming on top of Great Society spending without any tax increase. But inflation at full employment presented no surprise. The shock was stagflation, high inflation combined with recession and high unemployment. It was the combination that undermined faith in the prevailing orthodoxy.
    Stagflation was caused by the quadrupling of oil prices. That rise reduced real incomes in oil importing countries – their cost of living went up considerably. Lower incomes implied lower spending and hence recession. The incomes of the oil exporters went up but they were often sparsely populated autocracies like Saudi Arabia that couldn’t and didn’t spend the extra income. Result a global fall in demand and recession. But the higher oil prices raised the price indicators and set off a scramble to get someone else to take the hit, i.e. a wage price spiral as workers and shareholders tried to protect their real incomes. Competition over income shares was a feature of post-war capitalism that resulted in creeping inflation but it was the terms of trade shock that pushed the conflict to a new level. If 10 per cent of a country’s imports by value are oil and its price rises fourfold that’s a big hit to GDP, perhaps 3 or 4 percentage points off. Somebody has to pay – but who?
    Of course the surge in inflation began to decline from the peak but it remained at historically high levels and when the second oil shock arrived in 1979-80, Volcker ramped up interest rates. He took the decision that a prolonged deep recession was necessary to drive unemployment up enough to put the workers in their place and break the wage price spiral. They had to take the terms-of-trade hit to protect profits and investment. However, he couldn’t put it like that. That would be impolitic. So he pretended to believe in monetarism, that excess money was causing inflation and that he had to raise interest rates to reduce credit and money creation. According to one school of monetarists, once everyone knew he was serious they would reduce their expectations and inflation would subside without harm to the economy. That was pure nonsense. Raising interest rates to the levels the Fed did would crush inflation at the cost of a long period of high unemployment – and Volcker knew it. He regarded it as the lesser evil. Electorates took the same view, returning the Reagan and Thatcher administrations to office.
    Monetarism was not the cause of inflation or stagflation but it was the excuse for repressive policies to get rid of inflation by reducing the bargaining power of organised labour.

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