Ben Bernanke's Lessons From 'The Great Inflation'
The party's over. Over the last few weeks, asset prices have tumbled, and investors in stocks, bonds, cryptocurrencies — pretty much everything — have been forced to wake up and face the brutal hangover of collapsing fortunes. Who broke up the rager? Largely, it seems, a little institution called the U.S. Federal Reserve, which has begun to raise interest rates and tighten monetary policy in order to wrangle inflation. What a buzzkill.
What is this mysterious institution? How has it evolved to play this important role in our society? Why does it, as one former Fed official put it, seek to have "the punch bowl removed" at moments like this? And what happens when it doesn't?
Well, the former Fed Chairman Ben Bernanke has some answers. Amid the downturn, Bernanke has swooped in and published a new book: 21st Century Monetary Policy: The Federal Reserve from the Great Inflation to COVID-19. They say it's impossible to time the market, but the man seems to have some killer timing. The book offers some important historical insights for the present economic moment.
The Great Inflation
Bernanke begins his book with a cautionary tale from American history known as "The Great Inflation." For most of the country's history, Bernanke writes, inflation had rarely been a big problem. Sure, the nation had bouts of high inflation. But it was usually around wartime, and the episodes were short-lived. America had never seen a decade-long stretch of high inflation.
That changed during the Great Inflation. Stretching from the mid-1960s to the early-1980s, it's a period known for itty bitty shorts and tube socks, roller disco parties, cocaine, long lines at gas stations — and, oh yeah — climbing prices. Between 1965 and 1981, annual inflation averaged more than 7 percent. In 1979 and 1980, average inflation peaked at almost 13 percent a year.
In Bernanke's telling, the story of the Great Inflation begins with deficit spending. John F. Kennedy had run for president during a recession and promised to "get America moving again." As president, Kennedy proposed a big tax cut to boost the economy and lower unemployment, which stood at almost 7 percent when he entered office. After Kennedy was assassinated, Lyndon B. Johnson, his successor, followed through with the tax cut, which helped bring unemployment down to 4 percent by the end of 1965. That was the level of unemployment that macroeconomists at the time believed was full employment, or the theoretical threshold when the labor market starts to get so tight that wages and prices start to explode. "From a macroeconomic policy perspective, it would have been a logical moment to ease up on the accelerator, but foreign policy and social goals took priority over economic stability," Bernanke writes.
When President Johnson plunged America even more deeply into the war in Vietnam in 1965, he opened up a firehouse of federal spending. Defense spending rose about 44 percent between 1965 and 1968. America would spend almost $850 billion on the war (in today's dollars). Because the war was already unpopular, Bernanke writes, Johnson was reluctant to support tax increases to pay for it, meaning this was a bunch of new money juicing the economy.
At the same time, Johnson launched his War on Poverty and the Great Society programs. This included creating the government healthcare programs Medicare (for elderly Americans) and Medicaid (for low-income Americans), which both began in 1965. "Many Great Society programs would ultimately have important benefits," Bernanke writes, "but they also had the effect of adding further to government spending."
All this deficit spending heated up an economy that was already running hot. Military contractors used government money to build guns, bombs, planes, and helicopters. Medical providers used government money on procedures, check-ups, hospital expansions, and so on. This increased demand for labor and materials already in short supply, pushing up the price of everything.
By the time President Nixon came into office in 1969, inflation was surging. Nixon continued the inflationfest with policies like an intensification of the Vietnam War, deficit spending, and, as we shall see, sticking his nose where his nose didn't belong: monetary policy.
Why The Fed Failed During The Great Inflation
Early in his presidency, Richard Nixon appointed a close ally to head the Federal Reserve: Arthur Burns. Often pictured smoking a pipe, Burns was an economist at Columbia University who served as the economic adviser to Nixon's 1968 presidential campaign.
"Once Burns was installed at the Fed, Nixon had no reservations about using their relationship to his political advantage," Bernanke writes. "With unemployment having risen during the 1970 recession, the president wanted a strong economy going into the 1972 election." Leaked recordings from the Nixon White House — the so-called Nixon tapes — provide smoking-gun evidence that Nixon directly pressured Burns to stimulate the economy with looser monetary policy (even though a temporary boost in economic growth did not serve the long-term interest of the economy or the public).
We don't know exactly why Burns ended up agreeing to Nixon's demands. Bernanke entertains the possibility that Burns was acting with some personal conviction. Burns apparently believed that the Congress and the President should tackle inflation with more surgical price controls rather than the Fed whacking it with the brute force of higher interest rates. The Nixon administration did, in fact, impose price controls at various times, including on gas.
In 1973, when the supply shock of skyrocketing oil prices hit the economy, inflation got worse and so did economic growth. Inflation became stagflation, or inflation combined with stagnating growth, something many economists at the time did not even believe was possible. Nixon's response was to try and cap the price of oil. Bernanke and most other economists blame this policy for creating shortages and infamous lines at gas stations — while also failing to get inflation under control.
Whatever the reasons, Burns failed to use the powers of the Fed to end high inflation. Even after it was clear that price controls failed — and even after Nixon resigned — Burns continued to shy away from raising interest rates to the level needed to end inflation, fearing it would cause a deep recession. Instead, he let inflation fester throughout the 1970s, which, Bernanke writes, convinced the public that inflation was here to stay. Companies and workers conducted their business and contract negotiations accordingly. These "inflation expectations," as economists refer to the psychological component of inflation, made price increases even worse.
It would take President Jimmy Carter appointing a new Fed chairman, Paul Volcker, in 1979 for the Fed to change tack. "The Fed had lost its credibility as an inflation-fighter, and the challenge for the new chair was to restore it," Bernanke writes. Fiercely independent and often working directly counter to the short-term electoral interests of the president, Volcker waged an epic war against inflation. He ended up raising the Fed's main policy interest rate, the federal funds rate, to almost 20 percent — the highest it's ever been. In doing so, he plunged the nation into a deep, albeit temporary recession. But, Bernanke writes, he also set the stage for decades of stable prices and economic growth.
Then vs Now
America is now being forced to reckon with high inflation for the first time since the days of the Great Inflation. Bernanke believes this historical experience offers important lessons for the Fed.
First, the Fed needs to take the lead on inflation. Burns had believed that Congress and the President could use policies like price controls to get the job done, which only made the economic situation worse.
Second, the Fed should take inflation expectations seriously. It needs to credibly work to keep inflation in check from the start. Kicking the can down the road only allows the psychology of inflation to fester in the minds of the public, forcing future Fed chairs to take even more draconian measures to get it under control (as Paul Volcker was forced to do).
Finally, political interference in Fed policy-making can be dangerous. Presidents, like Richard Nixon, have a personal interest in juicing the economy before elections. This interest can run counter to the long-run interest of the economy and the public.
And, here, Bernanke has some worries. In his book, he frets about former President Donald Trump's frequent Twitter tirades against Fed Chair Jerome Powell, a man Trump himself had appointed to be Fed chair. More broadly, Bernanke expresses concerns about current political trends. "The rise of populism, with its conspiracy theories and distrust of elites, poses a particular threat to technocratic, nonpartisan institutions like the Fed," he writes.
That said, the Fed *is* currently working to end inflation, and, so far, it seems like most people are cool with it. In many ways, the effects — like nosediving asset prices — create a headache. But, if history is any guide, the hangover caused by the alternative sucks even more.
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