1965-1982 - The Great Inflation
With the exception of the Great Depression of the 1930s, the Great Inflation from 1965 to 1982 is generally viewed as the most dramatic failure of macroeconomic policy in the United States since the founding of the Federal Reserve. Following the euphoria and apparent success of stabilization policy during much of the 1960s, macroeconomic events during the 1970s were agonizing and perplexing. After all, this was meant to be “the Age of the Economist” (Walter Heller, 1966, p. 2); when the latest scientific advances in macroeconomic theory, model building and forecasting were brought to bear on policy decisions; when, having mastered optimization techniques, economic advisers could rely on the tools of activist stabilization policy to guide the economy to its “optimum feasible path”.
Was the high inflation of the 1970s mostly due to incomplete information about the structure of the economy (an unavoidable mistake as suggested by Orphanides, 2000)? Or, to weak reaction to expected inflation and/or excessive policy activism that led to indeterminacies (a policy mistake, a scenario suggested by Clarida, Gali and Gertler, 2000)? Both explanations do a good job in accounting for the great inflation. Even with the commonly used specification of the interest policy rule, high and persistent inflation can occur following a significant productivity slowdown if policymakers significantly and persistently underestimate "core" inflation".
The United States first had a deficit of merchandise exports over merchandise imports in 1971, the first time in this century that the United States had incurred a deficit in its trade balance. The deficit was generally explained by asserting that the poor wage price productivity performance of the U.S. economy between 1965 and 1969, compared with that of its trading partners, had significantly lowered the competitiveness of U.S. goods in domestic and foreign markets.
The appearance of the trade deficit led to a massive speculative run on the dollar culminating in President Nixon's announcement of sweeping policy changes on August 15, 1971. A series of actions were taken to try to induce this country's major trading partners to revalue their currencies. First, and most dramatic, dollar holdings of foreign central banks would no longer be redeemable in gold by the United States.
The 1960s was a time of relatively rapid economic growth; subsequently, there was an increased awareness of the plight of those left behind. Various programs begun in the Kennedy-Johnson years continued their expansion in the 1970s. The federal government's role in this period was transformed from provider of goods and services to redistributor of income, taxing some people to provide benefit payments to others.
By dollar volume, the government's major role was to redistribute income, not provide goods and services. The result was a tremendous social achievement- a sharp reduction in poverty, from 22 percent of the population in the early 1960s to about 11.7 percent by 1979. Among other effects, the growth of government transfers and the large growth of Social Security benefits led to a substantial amelioration of poverty among the elderly, who were particularly prone to it. The increased spending for social programs was offset by a dramatic reduction in the share of GNP spent on national defense.
In the late 1960s, a substantial productivity slowdown began, and this continued through the 1970s. While its causes and remedies are complex, certainly a major reason for the slowdown was the erosion of incentives to produce income and wealth. This erosion was caused in turn by high and fluctuating inflation and high and rising marginal tax rates, especially on investment income. In 1980 President Reagan was elected by a public concerned that domestic spending was out of control.
From 1966 through 1968, the unemployment rate was below its previous interim target of 4 percent. Furthermore, this record was accomplished with very low rates of increase in prices through 1967 and especially through 1965. A rate of inflation above 4 percent did not occur until 1968. All in all, the economic policymakers of the era felt that there was much reason for selfcongratulation. They regarded the prolonged economic expansion as the triumph of Keynesian economics. "Is the business cycle dead?" was a seriously asked question.
The following decade witnessed two recessions, the latter of which was the worst downturn since the 1930s. Occurring simultaneously with that latter recession, were some of the highest rates of inflation thus far in this century.
In the 1970s, the standard of living for most working, taxpaying Americans improved hardly at all, as most of the gain in income came from increased employment, not productivity and real after-tax wage increases. This contrasts strongly with the experience of most advanced economies, which experienced slower, but significant productivity growth. Between 1973 and 1980 real growth per worker had declined to virtually zero, compared to about 2 percent per year in the previous decade. By international standards, inflation has been quite modest, but keeping it in perspective has been a problem: by 1983-84 inflation was regarded as "more or less" under control because it had declined from the high, double-digit rates of 1979-80 to about 3 or 4 percent, while President Nixon imposed wage and price controls in 197l when inflation "soared" to 4 percent. The point is that inflation rose from its relatively low rates (averaging two or three percent per year) in the 1950s and 1960s.
The cyclical behavior of the economy in the 1970s was very different from its behavior in either of the previous two decades. The 1950s had been characterized by a pattern of mild business cycles superimposed on a weak growth trend, a trend considered much too weak by the economic advisers of Presidents Kennedy and Johnson. They advocated fiscal and monetary policies which they believed would raise the growth rate and prevent recessions.
And indeed, the period from 1961 through 1968 was one of continuous, generally strong, expansion. Although the rate of this expansion was not constant from year to year (starting slowly in 1961, and falling appreciably in 1967), not a single calendar quarter, let alone year, of negative growth was experienced in those eight years, by far the longest period without such a decline in the nation's history.
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