How the Great Inflation of the 1970s Happened

It's the 1970s. The stock market is a mess. It has lost nearly 50% of its value over a 20-month period. For close to a decade few people want anything to do with stocks. Economic growth is weak, which results in rising unemployment that eventually reaches double digits.

The easy money policies of the American central bank were meant to generate full employment by the early 1970s. Unfortunately, they also resulted in high inflation.

Under different leadership, the Federal Reserve System would later reverse its policies, raising interest rates to some 20%. This level was once considered usurious. For interest-sensitive industries, such as housing and automotive, rising interest rates can cause a calamity, with many people priced out of new homes and cars.

The Great Inflation of the 1970s

Overall, the macroeconomic event referred to as the Great Inflation lasted from 1965 to 1982. This is the story of the painful period in the 1970s, which began in late 1972 and continued until the early 1980s. In his book, Stocks for the Long Run: A Guide for Long-Term Growth, Wharton professor Jeremy Siegel called this time "the greatest failure of American macroeconomic policy in the postwar period."

The Great Inflation was blamed on oil prices, currency speculators, greedy businessmen, and avaricious union leaders. However, it is clear that monetary policies that financed massive budget deficits and were supported by political leaders were the cause.

This mess was proof of what Milton Friedman wrote about in his book, Money Mischief: Episodes in Monetary History. Inflation is always "a monetary phenomenon."

The Great Inflation and the recession that followed ruined many businesses and hurt countless individuals. Interestingly, John Connally, the Nixon-installed Treasury Secretary with no formal economics training, later declared personal bankruptcy.

Yet these unusually bad economic times were preceded by a period in which the economy boomed or appeared to boom. Many Americans were awed by the temporarily low unemployment and strong growth numbers of 1972.

Therefore, in 1972, they overwhelmingly re-elected their Republican president, Richard Nixon, and their Democratic Congress. Nixon, the Congress, and the Fed eventually ended up failing them.

Causes of the Great Inflation

Upon his inauguration in 1969, Nixon inherited a recession from Lyndon Johnson, who had simultaneously spent generously on the Great Society and the Vietnam War.

Despite some protests, Congress went along with Nixon to continue to fund the war and increase social welfare spending. In 1972, for example, Congress and Nixon agreed to a big expansion of Social Security—just in time for the elections.

Nixon's Changing Viewpoint

Nixon came to office as a supposed fiscal conservative. Yet, one of his advisors would later classify Nixonomics as "conservative men with liberal ideas." Nixon ran budget deficits, supported an income policy, and eventually announced that he was a Keynesian. 

John Maynard Keynes was an influential British economist of the 1930s and 1940s. He advocated revolutionary measures. For instance, he believed that governments should use countercyclical policies in hard times, running deficits in recessions and depressions.

Before Keynes, governments during difficult economic periods generally had balanced budgets and waited for badly allocated business investments to liquidate. The object was to allow market forces to bring about a recovery naturally.

Nixon's other economic about-face occurred when he imposed wage and price controls in 1971. Again, these actions seemed to work during the following election year. Later on, however, they would fuel the fires of double-digit inflation. Once they were removed, individuals and businesses tried to make up for lost ground.

Nixon's deficits were also making dollar-holders abroad nervous. There was a run on the dollar, which many foreigners and Americans thought was overvalued. Soon they were proved right.

In 1971, Nixon broke the last link to gold, turning the American dollar into a fiat currency. The dollar was devalued, and millions of foreigners holding dollars, including oil barons in the Middle East with tens of millions of petrodollars, saw their value slashed. 

Election Year Politics

Still, President Nixon's primary concern was not dollar holders or deficits or even inflation. He feared another recession. He and others who were running for re-election wanted the economy to boom. The way to do that, Nixon reasoned, was to pressure the Fed to lower interest rates.

Nixon fired Fed chair William McChesney Martin and installed presidential counselor Arthur Burns as his successor in early 1970.

Although the Fed is supposed to focus solely on money creation policies that promote growth without excessive inflation, Burns was quickly taught the political facts of life. Nixon wanted cheap money. That meant low interest rates to promote growth in the short term and make the economy seem strong as voters went to cast their ballots.

Results of Cheap Money

In public and private, Nixon put the pressure on Burns. William Greider, in his book, Secrets of the Temple: How the Federal Reserve Runs The Country, reports Nixon as saying, "We'll take inflation if necessary, but we can't take unemployment." The nation eventually had an abundance of both. Burns and the Fed's Open Market Committee, which decided on money creation policies, soon provided cheap money.

The key money creation number, M1, consists of total checking deposits, demand deposits, and traveler's checks. It grew from $228 billion to $249 billion between December 1971 and December 1972, according to Federal Reserve Board numbers.

As a matter of comparison, in Fed chair Martin's last year, M1 grew from $198 billion to $206 billion. M2, which measures retail savings and small deposits, grew even more by the end of 1972, from $710 billion to $802 billion.

Adding to the money supply worked in the short term. Nixon carried 49 out of 50 states in the election. Democrats easily held Congress. Inflation was in the low single digits. However, the country paid the price in higher inflation once the election year festivities ended.

In the winters of 1972 and 1973, Burns began to worry about inflation. In 1973, inflation more than doubled to 8.8%. Later in the decade, it would go to 12%. By 1980, inflation was at 14%. Was the United States about to become another, post-WWI Weimar Republic experiencing the brutal effects of crippling inflation? Some actually thought that the era of the great inflation was a good thing.

The Great Inflation period would finally come to an end once later Fed chair Paul Volcker pursued a bold but painful contractionary money policy to control it.

The Bottom Line

It would take another Fed chair and a brutal policy of tight money—including the acceptance of a recession—before inflation would return to low single digits. In the meantime, the U.S. would endure jobless numbers that exceeded 10%. Millions of Americans were infuriated and suffering by the late 1970s and early 1980s.

Yet, few remember Fed chair Burns, who in his memoirs, Reflections of an Economic Policy Maker (1969-1978), blames others for the Great Inflation without mentioning the disastrous monetary expansion. Nixon didn't even mention this central bank episode in his memoirs. Many people who remember this terrible era blame it on Arab countries and oil pricing.

Still, The Wall Street Journal, when reviewing this period in January 1986 wrote, "OPEC got all the credit for what the U.S. had mainly done to itself."