How could an inflationary environment persist, actually flourish, during a time when macroeconomic slack was at an extreme? Conventional economic theory uniformly said that when so many workers are sidelined by recession, this acts as a deflationary pressure on first wages before everything else in an economic system. Companies that can therefore choose from a large pool of relatively cheaper labor should then be able to pass along savings to customers in order to boost sales.
A virtuous circle of discounting that helps kickstart the recovery side.
Shockingly, this didn’t happen during the recession of 1970. On the contrary, come the contraction the ranks of the unemployed swelled enormously (the unemployment rate began the cycle at 3.5% in December 1969 and jumped to 6.1% just one year later) and it did absolutely nothing to slow down the quickened pace of aggregate consumer prices; both the CPI and its core kept up at the same rates as if they hadn’t noticed the severe downturn whatsoever.
The Federal Reserve’s Chairman at the time, the befuddled Arthur Burns, was hauled before Congress in August of 1971, compelled to make some kind of statement about the sordid state of economic America. This was that month, too, the one when President Nixon had decided to make changes; these remembered much more for the end of dollar convertibility, closing the gold window, in reality more important was the dark introduction of top-down central planning in the form of wage and price controls.
Nixon had been convinced by Burns and others, such as the President’s confidante, Office of Management and Budget Director George Shultz, that the inflation raging then was made up from wage demands and irresponsible companies fixing prices. Not money.
Or “liquidity”, as it was said. On one of those infamous Oval Office tapes, Nixon recorded himself speaking with Arthur Burns (Conversation #607-11) in October 1971 about the money supply issue. The Fed’s Chairman was worried that maybe it was money, particularly given some influential voices at the time had claimed “liquidity” had “gone wild.”
The President scoffed, declaring the “liquidity problem” as “just bullshit.”
He wanted more money, not less, with a possibly contentious election campaign looming for 1972. And it had been Burns more than anyone who had conveniently convinced the President to attempt to strangle what was then becoming the Great Inflation using these macro rather than any monetary means.
One major reason he did was what the Chairman told Congress back during that highly antagonistic August enquiry:
“A year or two ago it was generally expected that extensive slack in resource use, such as we have been experiencing, would lead to significant moderation in the inflationary spiral. This has not happened, either here or abroad. The rules of economics are not working in quite the way they used to.”
Yes, but why?
Blaming union workers at first for demanding higher wage gains in the face of unrelenting consumer price advances seemed at least plausible. But only a few months after implementing the wage and price boards, Burns (and others) was beginning to waver.
Liquidity. Bank credit. Out-of-control consumer prices. Maybe, just maybe something was there.
A somewhat exasperated Nixon spoke with Shultz privately on February 14 – Valentines Day! – in 1972. Burns was hesitating, blaming European (offshore, in reality) dollar flows. Shultz says to the President (Conversation #670-5) just prior to a meeting with the Fed Chairman:
“What’s the problem there? So, we don’t have a return flow of money from Europe? So what? Keep the money supply going up!”
When Arthur does show up probably a short amount of time later on the same day (Conversation #670-7), his monetary angst was even more direct than it had been previously; “banks are just loaded down looking for customers,” Burns says, before then getting to one of those unappreciated yet incredibly understated findings.
The Chairman is recorded as telling the President about Milton Friedman’s latest paper which noted, in Burns’ words, “M2 is more important than M1.” The President merely replied, “hmmm.”
Both Nixon and Shultz, as well as Burns and the FOMC, for that matter, had been exclusively referring to M1…because that was established convention. The science, the monetary science as everyone understood it, had been long ago “settled.”
But whereas the M1 tabulations had made it seem like “liquidity” growth wasn’t all that robust, certainly nothing to be wary over, therefore inflation maybe was wages or something else, it was much less of a liquidity leap when coming at consumer prices by way of their relatively new M2.
This wasn’t a monetary policy issue, except in how central bankers were beginning to wonder if they were losing touch with effective, real economy money itself. Predicating that monetary policy and setting it by way of only M1, policymakers therefore the entire government was at risk of being consistently blindsided – just how the Great Inflation would continue to unfold.
Central bankers, however, are bureaucracies first and foremost. A profound change radically redrawing the economic landscape (Burns’ August ’71 comments) from the territory of that central bank’s very own backyard isn’t easily tolerated; if at all. Institutional inertia is heaviest in places like that during times like those.
Out of control money? No! Just look at M1. Blame union wage agitation. That M2, though. Hmmm.
Even after the Great Inflation grew only more “great” – meaning painful for Americans – several years further toward the middle seventies there was still as much doubt about the role of money supply - what supply - in the pain.
Picking up the topic now at the FOMC two years later, Nixon heading toward his own exit and Arthur Burns still around and anguished as ever, FRB Member John Sheehan just wasn’t having it. The January 1974 FOMC Memorandum of Discussion records the Governor’s bristling dismissal:
“Looking back over the 2 years that he had been a member of the Committee, he [Sheehan] did not feel that the System had made a significant contribution to the inflation; the rise in prices had resulted much more from such special factors as the devaluations and supply problems affecting foods and fuels than from an overly expansive monetary policy.”
On that last bit, Governor Sheehan was right. The inflation was never made from expansive monetary policy, just plain expansive money that policy had continuously failed to prevent; even define.
A few more years later, and still more agonizing inflation along with recession, a truly bad one in 1974, Economists and central bank staffers, at least, had caught on with “money demand.” Still holding fast to M1, the FOMC was told that its stats just wouldn’t add up.
So, neither would an inflationary, now stagflationary economy which persisted despite discussion after discussion, theory after theory all based on obvious flaws (below from the January 1976 FOMC Memorandum of Discussion):
“All of the shortfall has been in the demand deposit component of M1. By the fourth quarter of 1975, the error had grown to $18.7 billion--about 6-1/4 per cent of the actual stock of money. Translated to growth rate terms, this means that if past relationships had held, growth of M1 at an annual rate of around 8-1/2 per cent would have been required since mid-1974 to finance the expansion of GNP that has occurred--while still keeping interest rates where they are. The actual growth rate of M1 over those 6 quarters was only 4-1/4 per cent.”
Understand what staff Economist and future FOMC Board Member Lyle Gramley was trying to say here; the economy grew at a wildly inflationary rate which, by their monetary framework and worldview, should have been financed by nearly double the M1 growth rate, an equivalent 8.5%, instead must have been sourced by other monetary forms than what was included in narrow M1.
There was little demand for M1 because banks offered other money real economy participants increasingly used to excess. And M2 was already behind and too low itself to have explained the full inflationary domestic circumstances (let alone those outside and offshore).
Quite simply, during the Great Inflation, the US and global economy had progressively turned to other kinds of money beyond the reach, even conception of the Federal Reserve.
This had put the entire monetary policy structure in a “quandary”, in Gramley’s estimation, “Since we are not sure why demand for money has been so weak, we cannot be sure when the period of weakness will end.”
It never did.
You would naturally believe, given this overwhelmingly consequential situation, the entire Federal Reserve was put on notice if to drop everything else to make figuring out this money demand issue Job #1, especially with this profound and fundamental transformation in money itself taking place during the worst inflationary outbreak in US history.
Throughout the rest of 1976’s FOMC discussions, the topic of “money demand” was brought up on only one other occasion and really just in passing. Again, Lyle Gramley, here in July, the nation’s sullen bicentennial celebrations a few weeks before (below is from an actual transcription of that meeting; the Federal Reserve has gone back into the archives to offer more complete records of these policy events than previously with only memorandums of discussion):
“MR. GRAMLEY. I would say that one of the chief problems we have had in developing our judgmental forecast is that we have not been able to come to grips with the kinds of financial restraints that past experience suggests should be developing with the growth rate of M1 at 5-3/4 percent.”
Still using M1, the Federal Reserve was stumped at how a formerly restrictive target for it around 5.75% just wasn’t causing any anticipated constraint at all. As if the entire system effortlessly bypassed such “financial restraints.”
The “central bank” had been reduced to little more than a stunned bystander as money, especially offshore and overseas, had evolved wildly. The Federal Reserve would never catch up; to this day.
To really drive home the power of such bank-centered money creation, look no further than the core CPI’s track during that first, initial 1970 recession. Putting it on any chart, it goes up in an almost-perfect, unbroken 45-degree straight line even though at the very same time the US economy was grappling with a severe contraction – no dot-com or 1991-style mildness.
Now plot on that same chart the current core CPI even after this year’s “massive” bout of “inflation.” It doesn’t even measure up. Yes, during a bad recession, an entire year of one, the core CPI from 1970 easily bests the core CPI of 2020-21 during recovery, reopening, and unmatched “stimulus.” All those trillions sent via federal government helicopters and stipends, the severest supply bottlenecks since the seventies, and it still pales in comparison to consumer prices buffeted by actual money expansion.
It just wasn’t M1.
It was never what you could see during the Great Inflation which had spelled fifteen to seventeen years of an unrelenting consumer price nightmare, it was everything that the Federal Reserve had prevented the public, the President, Congress, from realizing they didn’t which unleashed such economic tragedy. Federal Reserve, targets, M1, bank reserves, all irrelevant.
Americans today, many of them, way too many, are expecting a repeat of the seventies. Boosted by several CPI rates, four now, at more than 5%, the theory may seem more plausible than at any point in the QE-era.
Still no. The actual, effective global money “we” still don’t see is what determines the economic shape. We can, and I have tried, to tell essentially the same story as the Great Inflation from the proper monetary perspective, if only this time going in the other direction.
Who do we turn to for answers on these things? Do we examine the evidence sitting right in front of our eyes (low interest rates, for one)? No. Like Nixon, even today everyone will call up the Fed still trusting the people who run it to know better than anyone the monetary details.
They do not. And have not in a very, very long time. This not only explains the Great Inflation and its “bullshit”, but also the Global Financial Crisis as well as its tortuous aftermath.
With consumer prices already decelerating the past few months, sharply in services, we will quickly go back to viewing CPI’s in their proper context. All the world’s a liquidity problem because it’s not what you see that matters. One day, someone just might figure out what that really means. Leaving it up to central bankers, that day will be far, far off into the future.
The true power of actual money lurks in the shadows: it can make inflation out of a bad recession, several, when there really is too much of it regardless if policymakers ever say so; and it can render the biggest government interventions and supply problems not-inflationary though you never once hear why.