Whatever happened to inflation? When last seen, it vanished in the early 1980s, when we still had a Soviet Union and we had never heard of the internet. That inflation had been accompanied by unusual economic doldrums and gave us the term “stagflation.” It seemed to be evolving, but that turned out to be its last hurrah.
Inflation had been the scourge of economies for hundreds of years. It was thought to be the byproduct of too much of a good thing, either growth or currency. When Fed Chair William McChesney Martin likened the job of the Fed to taking the punch bowl away just as the party got going, inflation was the hangover he was worried about.
Inflation happens when prices rise and the value of currency falls because the currency buys less or, as economists say, loses purchasing power. There are many ideas about what causes inflation, and until the 1980s, no proven ideas of how to control it. One theory is that it is caused by growth and the subsequent increased demand—for everything—that drives up prices. Another cause is a resource shortage, especially a sudden one, that pushes up the costs of producing things and thus their prices.
For most of the modern era, the amount of currency in circulation and its value were tied to a supply of precious metals, such as gold or silver. As more ore was discovered, more currency could circulate and allow for more trade and more growth. But that also meant that the currency unit was less valuable.
In its last century, battered by periods of extreme growth and contraction, the equivalence of currency to hard assets became more and more tenuous, until finally it was gone, replaced by the principle of fiat money, that is, currency backed only by the “full faith and credit” of its issuer. For the U.S., that happened in 1971, when we went “off the gold standard.” Other developed economies followed.
By then the American post-War boom was getting old, as our trading partners recovered their productivity and became competitors again. Meanwhile, expansionary fiscal programs during the 1960s, as well as the expensive Vietnam War, drove prices and interest rates higher, and inflation began.
And then came a supply shock: the Arab oil embargo. As oil was such a widely used input in our economy, the inflationary effect was profound. At the same time, growth was slowed by the sudden jump in the costs of production. Hence stagflation.
And then the Federal Reserve stepped in. For decades, the conventional wisdom was that fiscal policy, the getting and spending of the government, was more useful in guiding an economy than monetary policy: control of the money supply and thus interest rates. But the Fed Chair at the time, Paul Volcker, shrank the money supply and raised interest rates until the economy contracted, and prices did stop rising. It was not a popular move—the immediate consequence was a recession—but inflation disappeared.
Since then, we’ve had lots of growth and growth of the money supply, but without significant inflation. We’ve had expansions, bubbles, and booms without inflation. When the world’s central banks created quantitative easing, introducing unimaginable increases to the money supply and even negative interest rates, we still didn’t have inflation. By now, inflation has ceased to be a fear and maybe even a consideration in economic planning.
Many credit Volcker, who died recently, with “taming” inflation, with discovering the monetary strategy that would put it in its place for good. His tenure certainly ushered in an era of taking monetary policy more seriously. In 2009, Volcker was brought back into public service after another, much more ominous, crash. And he put the brakes on again, with the Volcker Rule, included in the Dodd-Frank Act of 2010.
Volcker insisted that commercial banks not be allowed to engage in proprietary trading or make speculative investments that do not benefit their customers, that is, that they not be allowed to act like hedge funds, so as to limit risk in the financial system, It was not a new idea, but it was time to put it back into law and, as the eminence grisé of economic policy, Volcker did.
Volcker saw the need to limit the inflation of our currency and of our risk taking in order to maintain a working financial system. His ideas were not popular at the time, and certainly not politically expedient, but he had the courage of his convictions, and we are, so far, the better for them.