samuelson - the great inflation and its aftermath; the past and future of american affluence (2008)

The Great Inflation, argues award-winning columnist Robert J.. The Great Inflation and Its Aftermath traces the origins and rise of double-digit inflation and its fall in the brutal 19

T H E

GREAT INFLATION

Canada $30.00

It's a giant gap in our history The Great Inflation,

argues award-winning columnist Robert J uelson in this provocative book, was the worst domestic policy blunder of the postwar era and played a crucial role in transforming American poli­tics, economy, and everyday life—and yet its story is hardly remembered or appreciated In these uncertain economic times, it is more imperative than ever that

Sam-we understand what happened in the 1960s and 1970s, lest we be doomed to repeat our mistakes

From 1960 to 1979, inflation rose from barely more than 1 percent to nearly 14 percent It was the great­est peacetime inflationary spike in this nation's his­tory, and it had massive repercussions in every area of our lives The direct consequences included Ronald Reagan's election to the presidency in 1980, stagna­tion in living standards, and a growing belief—both in America and abroad—that the great-power status of

the United States was ending The Great Inflation and

Its Aftermath traces the origins and rise of

double-digit inflation and its fall in the brutal 1981-82 reces­sion, engineered by the Federal Reserve under then-chairman Paul Volcker and with the staunch backing

of Reagan

But that is only half the story The end of high inflation triggered economic and social changes that are still with us The stock market and housing booms were both direct outcomes; American business became more productive—and also much less protec­tive of workers—and globalization was encouraged

We cannot understand today's world, Samuelson contends, without understanding the Great Inflation and its aftermath Nor can we prepare for the future unless we heed its lessons This incisive and enlight­ening book will stand as the authoritative account of a watershed event of our times

Newsweek and The Washington Post He began his jour­

nalism career as a reporter for the Post in 1969 He is

the author of The Good Life and Its Discontents: The

American Dream in the Age of Entitlement, ip^j-ipçy and Untruth: Why the Conventional Wisdom Is (Almost Always) Wrong, a collection of his columns He lives in

Bethesda, Maryland, with his wife, Judy Herr They have three children

Jacket design: Julie Metz Design Join our nonfiction e-newsletter by visiting www.rh-newsletters.com

Random House New York, N.Y

© 2008 by Random House, Inc

T H E G O O D L I F E A N D I T S D I S C O N T E N T S

The American Dream in the Age of Entitlement, ip^f—ippf

A New York Times Business Book B e s t s e l l e r

"Original, intellectually sound and fun to read."

— M A N C U R O L S O N , The Wall Street Journal

"Shrewd and optimistic combines first-rate analysis with persuasive historical, political and sociological insights."

— J A G D I S H B H A G W A T I , The New Republic

"A smart, balanced epitaph for an e r a —

with a few clues for what's ahead."

— R O B E R T J D O W L I N G , BusinessWeek

"Lucid [and] nonsectarian Samuelson traces how

the reasonable demand for progress has given way to

the excessive demand for perfection."

— R O B E R T K U T T N E R , The New York Times

I S B N 9 7 8 - 0 - 3 7 5 - 5 0 5 4 8 - 5

The Good Life and Its Discontents: The American Dream in the Age of Entitlement, 1945-1995

Untruth: Why the Conventional Wisdom

Is (Almost Always) Wrong

G R E A T I N F L A T I O N

A N D I T S

A F T E R M A T H

N E W Y O R K

Published in the United States by Random House,

an imprint of The Random House Publishing Group,

a division of Random House, Inc., N e w York

R A N D O M H O U S E and colophon are registered

trademarks of Random House, Inc

L I B R A R Y OF C O N G R E S S C A T A L O G I N G - I N - P U B L I C A T I O N DATA

Samuelson, Robert J

The great inflation and its aftermath : the past and

future of American affluence / Robert J Samuelson

p cm

Includes bibliographical references and index

ISBN 978-0-375-50548-5

1 Inflation (Finance)—United States 2 United States—Economic policy

3 United States—Economic conditions I Tide

HG540.S26 2008 332.4'10973—dc22 2008023468

Printed in the United States of America on acid-free paper

www.atrandom.com

2 4 6 8 9 7 5 3 i FIRST EDITION

Book design by Jessica Shatan Heslin/'Studio Shatan, Inc

without whom this hook would not have heen finished; and without whom

it would not have hun worth finis

A Note to Readers xi

Acknowledgments xiii

Introduction xvii

1 : The Lost History 3

2: The "Full Employment" Obsession 47

3: The Money Connection 75

Appendix 2: Post-World War II U.S Business Cycles 267

Notes and Further Reading 271

Index 301

Telling my story inevitably involves using some e c o n o m i c and fi­nancial terms that may n o t be familiar to all readers I have tried to keep t h e m to a m i n i m u m O n first usage, I have defined the terms Later references are usually freestanding For those w h o want a r e ­minder or further clarification, a glossary at the e n d of the b o o k provides detail For the numerically inclined, t w o appendixes give overviews of the American e c o n o m y since World War II T h e first shows basic annual statistics—economic growth, u n e m p l o y m e n t , inflation, interest rates, stock prices T h e second describes business expansions and recessions

A book is ultimately the responsibility of its author, but in the process

of b e c o m i n g a b o o k , it imposes burdens o n many others This b o o k

is dedicated to m y wife, Judy, o n w h o m the b u r d e n was greatest Even in the best of times, I am n o t the easiest person to live with, and as I struggled to make this b o o k say w h a t I w a n t e d it to say, I b e ­came even m o o d i e r than usual T h e b o o k evolved into an all-purpose excuse n o t to do things I should have w a n t e d to d o and that she wanted to do " O h no, we can't do that, because I've got to

w o r k o n the b o o k " became a constant refrain J u d y responded w i t h routine encouragement, patient self-restraint and only infrequent exasperation Thanks, Jude

N e x t o n the list of people w h o helped b r i n g this project to c o n ­

clusion is my longtime Newsweek colleague R i c h a r d T h o m a s , w h o

for many years was the magazine s chief economics correspondent

H e has forgotten m o r e about the e c o n o m y and its connections w i t h politics and the everyday lives of Americans than I will ever know

R i c h has that rare combination a m o n g journalists of superb report­ing skills (which are c o m m o n ) and an unconventional m i n d (which

is rare) that allows h i m to see the larger significance of events even

as they are unfolding, and well before most others R i c h read c o u n t ­less drafts of the manuscript and made many valuable substantive and editing suggestions H e also strove to be an amateur therapist, repeatedly declaring that the manuscript was "brilliant" even as he advised m e t o abandon entire sections of the "brilliant" draft or

a m e n d it to increase its "brilliance." R i c h deserves m u c h credit for the book's strong sections and w a r n e d m e against some of the re­maining weaknesses T h a n k s to h i m for improving the manuscript and toiling so hard to lift m y spirits

David Lindsey, a former top staff economist at the Federal R e ­serve, also read multiple drafts of the b o o k and worked diligently to ensure that I got the sequence of events correct and explained tech­nical issues in terms that were clear and accurate I may have failed, but if so, it's n o t Dave's fault

At a crucial p o i n t in the process of revising and rewriting, I asked

m y old friend J o n R a u c h — a w r i t e r for The Atlantic and National

Journal and a 2005 w i n n e r of the National Magazine Award, the

magazine equivalent of the Pulitzer P r i z e — t o give m e his impres­sion H e read the w h o l e thing, and by highlighting the book's strengths and weaknesses—often echoing what R i c h and my editor,

J o n a t h a n Jao, had said—convinced m e to do a fair a m o u n t of cut­ting and rearranging Jon's candor and clarity in identifying u n n e c ­essary parts of the manuscript improved it significantly

A n u m b e r of other people read the manuscript and made helpful suggestions, n o t all of w h i c h I was smart e n o u g h to include: Joel

Havemann, the longtime editor for m y c o l u m n in The Washington

Post; my brother R i c h a r d and my cousin R i c h a r d (we Samuelsons

are n o t too original o n names); Prakash Loungani, a friend and economist at the International M o n e t a r y Fund; and J o h n McCusker,

an economic historian at Trinity University in San A n t o n i o T h a n k s also to M a r k Zandi of Moody's E c o n o m y c o m, w h o provided m e with m u c h of the statistical information found in the t w o a p p e n ­dixes and, aside from that, has consistently helped m e understand the economy Malcolm Gillis, the ex-president of R i c e University, i n ­vited m e to give a lecture at the university (where m y daughter was

a student) that helped convince m e to w r i t e the b o o k Pat Jackman

at the Bureau of Labor Statistics has, over the years, helped m e b e t ­ter understand the C o n s u m e r Price Index

At the Federal Reserve, Dave Skidmore and Michelle Smith have responded quicky and cheerfully to m y many requests for informa­tion, b o t h in the course of my regular reporting and in the r e p o r t ­ing for this book Athanasios Orphanides, a former economist at the Fed w h o has studied extensively the p e r i o d from the late 1960s to the early 1980s, gave m e a very useful interview and provided some helpful background material (Orphanides has since left the Fed to

b e c o m e the head of the Central Bank of Cyprus.) Allan Meltzer of Carnegie Mellon University, author of a t w o - v o l u m e history of the Fed, was kind e n o u g h to give m e an advance copy of o n e chapter from his forthcoming second volume In an interview for this b o o k and over many years, h e has also improved m y understanding of the economy and the making of e c o n o m i c policy

Paul Volcker, former chairman of the Federal Reserve Board, submitted to two interviews for the b o o k and also reviewed parts of

the manuscript for accuracy I a m indebted to h i m for his coopera­tion A n interview w i t h Alan Greenspan, Volcker's successor, was also helpful in confirming the importance that he attached to achieving a crude price stability

At R a n d o m H o u s e , this b o o k w e n t through four editors—the

n u m b e r had little to do w i t h the b o o k and mostly reflected changes

in the editors' personal lives (two of w h o m left R a n d o m House)

B u t in J o n a t h a n Jao, I found an editor w h o skillfully maneuvered the project to completion His c o m m e n t s and suggestions were always thoughtful and often confirmed w h a t I had b e e n hearing from o t h ­ers W h e r e I was disorganized, he was organized W h e n he said he

w o u l d d o something, he did it—and did it w h e n he said he would

H e was o p e n - m i n d e d — h e listened to all my suggestions and pref­erences—but also strong-willed w h e n he t h o u g h t I was wrong A n d

h e was always pleasant M y agent and neighbor, Rafe Sagalyn, r e ­mained optimistic about the project even w h e n there were ample grounds for pessimism As w e walk o u r dogs, it will be easier n o w to have relaxed conversations

Finally, there are m y children: R u t h , Michael and J o h n T h e y didn't have anything to do w i t h the b o o k B u t they are everything that life is about T h e y help m e keep things in perspective, and they are n o w old e n o u g h to have views of their own After watching his dad wrestle w i t h this b o o k , Michael made one of his affectionately caustic suggestions: D o n ' t d o it again It seems like g o o d advice,

t h o u g h it remains to be seen w h e t h e r I will take it

Inevitably, this b o o k will contain errors of fact and interpretation For these, I claim exclusive responsibility

I decided to w r i t e this b o o k because n o o n e else had and, it a p ­peared, n o one else would It seemed obvious to m e , as a journalist covering the e c o n o m y for the past half century, that the rise and fall

of double-digit inflation had exerted an e n o r m o u s influence d u r i n g the entire p e r i o d — a n d the effects were n o t confined to the e c o n ­omy Because Americans place so m u c h stock in their economy's performance, inflation's roller coaster deeply influenced the nation's psychology and politics It also changed the way in w h i c h major corporations managed their businesses and their workers All these relationships seemed fairly plain, and I waited for s o m e o n e to make the connections Because I am a slow w r i t e r and m y previous b o o k

(The Good Life and Its Discontents: The American Dream in the Age of Entitlement, 1945-1995) had exacted a h u g e toll in time and spirit,

I was not eager to begin a project that s o m e o n e else was just finish­ing But n o one else did, and so I set o u t to do it myself lest the entire episode vanish from o u r collective consciousness

As w i t h m u c h of m y journalism, the main aim here is to explain

w h a t happened, w h y and w i t h w h a t consequences T h e basic o u t ­lines of the story are straightforward Ambitious economic d o c ­trines, embraced and p r o m o t e d by some of the nation's leading academic economists, promised to control the business cycle by minimizing or eliminating recessions, but these ideas came to grief

T h e u n i n t e n d e d side effects were n o t only higher inflation but also

m o r e frequent and harsher recessions, stretching from the late 1960s

to the early 1980s At the time, the resulting inflationary psychology was so deeply e m b e d d e d that almost everyone despaired at purging

it O n l y the unexpectedly savage recession of 1 9 8 1 - 8 2 , w h e n u n ­

e m p l o y m e n t peaked at nearly 11 percent, succeeded in doing so

T h e aftermath of inflation's decline—and, to a significant extent, a consequence of it—was a prolonged p e r i o d of national prosperity, marked by fewer and milder recessions B u t simultaneously and paradoxically, the aftermath also led to greater insecurity for individ­ual firms and their workers T h e r e is (and was) a connection T h e in­security and competitive pressures felt by individual firms and workers were consequences of a less inflationary e c o n o m y and, to some extent, helped keep inflation in check

In many ways, the book's publication—about t w o years later than

I originally expected—is m o r e timely n o w than if I had written faster and m a d e m y initial schedule U n t i l recently, the danger of higher inflation seemed fairly remote; but as I write, in the early

s u m m e r of 2008, c o n s u m e r prices are rising at about 5 percent a year in the U n i t e d States and, spurred by costlier oil and food, are rising even faster in some other countries It is n o w an o p e n ques­tion w h e t h e r this modest rise of U.S inflation is a prelude to s o m e -

thing m u c h worse or simply an unfortunate aberration that will soon give way to a return of price increases to an unthreatening range of less than 2 percent a year T h e b o o k does have an u n a m ­biguous message about inflation: If w e fail to contain it, w e are courting serious e c o n o m i c trouble, although w e can't be entirely certain w h a t form that trouble will take H i g h inflation is an e n o r ­mously disruptive force

Even if inflation subsides, there is another reason for the book's timeliness I argue that the roughly half century from 1960 until

n o w represents o n e long e c o n o m i c cycle d o m i n a t e d by inflation's rise and fall—and that, in particular, the engines of e c o n o m i c e x ­pansion of the past quarter century are n o w largely spent These i n ­cluded strong increases in consumer spending based o n rapidly rising stock and h o m e values, w h i c h in t u r n were heavily driven by the falling interest rates that accompanied declining inflation U l t i ­mately, the increases in stock and h o m e prices inspired speculative excesses that ended badly for many investors and h o m e owners

W h a t started as sensible increases evolved into "bubbles." B u t even

w h e n these excesses are purged from the economy, as has already occurred for stocks, there will be n o resumption of the outsized gains that many Americans once falsely t o o k for granted A m e r i ­cans' economic confidence and the economy's expansion will n e e d other sources, and if they are n o t forthcoming, g r o w t h will slow It

is important to recognize this change and understand w h y it is h a p ­pening T h e fact that this coincides w i t h a presidential election is also fortuitous At the end of the b o o k , I offer some suggestions as

to h o w we might improve o u r e c o n o m i c prospects

As readers will discover, I view " t h e e c o n o m y " as m u c h m o r e

than the amalgam of different markets for goods, services, labor, sav­ings, investment, w o r k and leisure To m e , " t h e e c o n o m y " is also a social, political and psychological process It is the convergence of ideas, institutions (private and public), values, beliefs, habits, tech­nologies that intersect w i t h o n e another to create o u r system of p r o ­duction and distribution W h a t this means is that changes in ideas, institutions, values and beliefs can alter the way the e c o n o m y works just as m u c h as—and sometimes m o r e t h a n — n e w technologies, changes in prices or shifts in interest rates T h e story I tell here traces the evolution of the e c o n o m y in this larger sense It recounts h o w

o n e set of ideas and values gave way to another, because the first did

n o t live u p to its promises, and h o w these changes affected politics, popular attitudes and corporate management T h e outward expres­sion of these shifting ideas was rising and falling inflation; but the price movements were consequences, n o t causes

M y b o o k aims to serve a popular audience in the best sense of the word It's w r i t t e n for people w h o are reasonably curious and intelli­gent It does n o t presuppose specialized knowledge about the e c o n ­omy I have tried to provide e n o u g h explanation and background to make the story accessible to the specialist and the generalist, the

y o u n g and the old S o m e o n e n e e d n o t have lived through all these events to grasp their significance Although the b o o k is intended mainly for a general audience, I h o p e that its different perspective on America's recent history will also prove illuminating for scholars— economists, historians and political scientists M y aim is for readers

to c o m e away w i t h a better appreciation of h o w America got w h e r e

it is n o w and to understand w h y the story of inflation holds essen­tial lessons for the future These include n o t just the importance of

maintaining stable prices but also the desirability of j u d g i n g proposed public policies not by their advertised intentions (which are always good) but by their likely l o n g - r u n consequences (which are often perverse)

E c o n o m i c c o m m e n t a r y tends to veer to o n e of t w o extremes Either we are going to paradise—some fabulous, u n e n d i n g b o o m , created by a wondrous n e w technology, entrepreneurial genius or flexible markets—or we're headed to hell, in the form of some calamitous collapse or prolonged stagnation, brought o n by foolish speculation, uncompetitive companies, unskilled workers or d u m b government policies Sensationalism, w h e t h e r for g o o d or ill, sells I have tried to avoid either extreme, believing that neither is usually realistic O v e r the years, I have b e e n fairly optimistic about A m e r ­ica's economic prospects O u r national c u l t u r e — w i t h its emphasis

on individual opportunity, hard w o r k and striving—combined w i t h

a robust business system, devoted to efficiency, growth and profits, generally has put prosperity o n a solid footing S o m e evident past problems (inflation, for one) were curable, t h o u g h often at a cost Still, I admit that I have g r o w n less optimistic in recent years, b e ­cause w e have been so lax in addressing obvious problems W e may weaken our productive machine by inattention to clear and present economic threats In the concluding chapter, I m e n t i o n some of these: an aging society; an uncontrolled health-care sector that is

n o w approaching one-fifth of the entire e c o n o m y ; a world e c o n ­omy that might b e c o m e dangerously unstable; and an uncritical r e ­action to the possibility of global w a r m i n g that may cause us to undertake costly policies that, in the end, d o little to affect global warming but do weaken o u r economy's performance

I call w h a t I have p r o d u c e d a "reportorial essay." Like my previ­ous b o o k , it makes an argument and presents reporting—facts, evidence—that corroborates the argument In earlier drafts, the

b o o k was perhaps a third longer than its final version, but o n the ad­vice of friends and m y editor, I eliminated some portions because,

t h o u g h interesting, they did n o t relate to the central argument I should also tell you w h a t this b o o k is not It is not a detailed history

of the Federal Reserve, m o n e t a r y policy or e c o n o m i c policy (in­cluding taxes and regulations) in general; n o r is it an exhaustive ex­amination of the e c o n o m i c well-being of American families and workers; n o r is it a detailed evaluation of American "competitive­ness" (technology, worker skills, business efficiency and the like); nor

is it an investigation of globalization or, indeed, of worldwide infla­tion T h e story touches o n all these subjects, but readers interested

in greater detail should go elsewhere M y story uses t h e m as pieces

of a puzzle, trying to fit t h e m together so that the final result is a c o ­herent picture of a powerful and misunderstood feature of America's

m o d e r n history

R O B E R T J S A M U E L S O N

M A Y 3 0 , 2 0 0 8

G R E A T I N F L A T I O N

A N D I T S

A F T E R M A T H

i

History is w h a t w e say it is If you asked a group of scholars

to n a m e the most important landmarks in the A m e r i c a n story of the past half century, they w o u l d list some or all

of the following: the war in Vietnam; the civil rights m o v e m e n t ; the assassinations of J o h n Kennedy, R o b e r t K e n n e d y and M a r t i n Luther King, Jr.; Watergate and President Nixon's resignation; the sexual revolution; the invention of the c o m p u t e r chip; R o n a l d Reagan's election in 1980; the end of the C o l d War; the creation of the Inter­net; the emergence of A I D S ; the terrorist attacks of September 1 1 , 2001; and the t w o wars in Iraq (1991 and 2003) L o o k i n g abroad, these scholars might include other developments: the rise of Japan as

THE L O S T HISTORY

a major e c o n o m i c p o w e r in the 1970s and 1980s; the emergence of

C h i n a in the 1980s from its self-imposed isolation; and the spread of nuclear weapons (to China, India, Pakistan and others) But missing from any list w o u l d be the rise and fall of double-digit U.S inflation This w o u l d b e a h u g e oversight

W e have n o w arrived at the end of a roughly half-century e c o ­

n o m i c cycle dominated by inflation, for g o o d and ill Its rise and fall constitute o n e of the great upheavals of o u r time, t h o u g h o n e largely forgotten and misunderstood F r o m 1960 to 1979, annual U.S in­flation increased from a negligible 1.4 percent to 13.3 percent By

2 0 0 1 , it had receded to 1.6 percent, almost exactly w h a t it had been

in 1960 For this entire period, inflation's climb and collapse exerted

a d o m i n a n t influence over the economy's successes and failures— and m u c h more Inflation and its fall shaped, either directly or indi­rectly, h o w Americans felt about themselves and their society; h o w they voted and the nature of their politics; h o w businesses operated and treated their workers; and h o w the American economy was c o n ­nected w i t h the rest of the world Although n o one would claim that inflation's side effects were the only forces that influenced the nation over these decades, they counted for m o r e than most p e o p l e — including most historians, economists and journalists—think It's impossible to decipher o u r era, or to think sensibly about the future,

w i t h o u t understanding the Great Inflation and its aftermath

Stable prices provide a sense of security T h e y help define a reli­able social and political order T h e y are like safe streets, clean d r i n k ­ing water and dependable electricity T h e i r importance is noticed only w h e n they go missing W h e n they did in the 1970s, Americans

were horrified D u r i n g most of these years, large price increases were the n o r m , like a rain that never stopped Sometimes it was a pitter-patter, sometimes a d o w n p o u r B u t it was almost always rain­ing From w e e k to week, people couldn't k n o w the cost of their groceries, utility bills, appliances, dry cleaning, toothpaste and pizza People couldn't predict w h e t h e r their wages and salaries w o u l d keep pace People couldn't plan; their savings were at risk A n d n o o n e seemed capable of controlling inflation T h e inflationary episode was a deeply disturbing and disillusioning experience that eroded Americans' confidence in their future and their leaders

T h e r e were widespread consequences W i t h o u t double-digit

inflation, R o n a l d R e a g a n w o u l d almost certainly not have b e e n

elected president in 1980—and the conservative political m o v e m e n t that he inspired w o u l d have emerged later or, conceivably, n o t at all

H i g h inflation incontestably destabilized the economy, leading to four recessions (those of 1 9 6 9 - 7 0 , 1 9 7 3 - 7 5 , 1980 and 1981-82) of growing severity; m o n t h l y u n e m p l o y m e n t peaked at 10.8 percent in late 1982 H i g h inflation stunted the increase of living standards through lower productivity growth A n d high inflation caused the stock market to stagnate—the D o w Jones Industrial Average was n o higher in 1982 than in 1965—and led to a series of debt crises that afflicted American farmers, the U.S savings and loan industry and developing countries

If inflation's legacy were n o t h i n g m o r e , it w o u l d m e r i t a sizable chapter in America's p o s t - W o r l d War II narrative B u t there is m u c h more Declining inflation—"disinflation"—led to lower interest rates, w h i c h led to higher stock prices and, m u c h later, higher h o m e

prices This disinflation p r o m o t e d the past quarter century's pros­perity In the t w o decades after 1982, the business cycle moderated

so that the country suffered only two relatively mild recessions (those

of 1 9 9 0 - 9 1 and 2001), lasting a total of sixteen months M o n t h l y

u n e m p l o y m e n t peaked at 7.8 percent in J u n e 1992 As stock and

h o m e values rose, Americans felt wealthier and borrowed more or spent m o r e of their current incomes A great shopping spree ensued, and the savings rate declined Trade deficits—stimulated by A m e r i ­cans' ravenous appetite for cars, computers, toys, shoes—ballooned Paradoxically, this prolonged prosperity also helped spawn compla­cency and carelessness, w h i c h ultimately climaxed in a different sort

of e c o n o m i c instability and the financial turmoil that assaulted the

e c o n o m y in 2007 and 2008

T h e very belief in the p e r m a n e n c e of economic growth undid

e c o n o m i c growth Initially triggered by falling inflation and interest rates, the upward march first of stock prices and then of h o m e values induced speculative dizziness People began to believe that prices of stocks and h o m e s could only rise O n c e that intoxicating mind-set t o o k hold, prices rose to silly and perilous heights, leading

to "bubbles" that burst in 2000 (for stocks) and 2007 (for homes)

H o m e loans were extended to buyers w i t h weak credit and with lit­tle or n o requirement for d o w n payment T h e presumption that

h o m e s w o u l d always be w o r t h m o r e t o m o r r o w than today provided

a false sense of security to the lenders and rationalized credit standards that, with hindsight, seemed self-evidendy doomed W h e n these

" s u b p r i m e " mortgages began to default in large numbers, the h o m e building b o o m ended, housing prices fell, financial institutions— banks, investment banks—suffered large losses o n securities backed

-by mortgages, and the e c o n o m y tipped into (or teetered o n the edge of) another recession.*

T h e significant point for o u r story is that the economy's present problems are yet another unappreciated consequence of inflation and its subsequent decline T h e immediate cause of the housing col­lapse lay in lax lending practices; but the backdrop and inspiration for those lax practices were the expectations of perpetually rising real estate values that were sown in the climate of disinflation and falling interest rates So it is w i t h m u c h else about o u r e c o n o m i c sys­tem that we n o w take for granted: T h e connections to inflation are there, but we simply refuse to see t h e m Take, for example, the way companies treat workers In the first decades after World War II, government and big business j o i n e d in an u n w r i t t e n alliance G o v ­

e r n m e n t promised to control the business cycle, to minimize or eliminate recessions Big companies pledged to raise living standards and provide economic security for workers—safe jobs, adequate health insurance and reliable pensions

But w h e n inflation overwhelmed the government's c o m m i t m e n t

to manage the business cycle, the implicit social contract broke down T h e 1980s became a watershed in changed corporate b e h a v ­ior If companies couldn't raise prices, they w o u l d (and did) cut costs Layoffs, "restructurings" and "buyouts" for early retirees b e ­came more widespread and acceptable "Capitalism," a w o r d that had essentially disappeared from c o m m o n usage in the early postwar

* As this book goes to the printer in early summer of 2008, economic statistics did not yet give a definitive answer as to whether another reces­sion had begun

decades, reentered the popular vocabulary T h e result was a paradox:

A l t h o u g h the overall e c o n o m y grew m o r e stable after 1982, indi­viduals' sense of insecurity increased, because companies were less

b o u n d by the n o r m s of earlier postwar decades to preserve jobs and shield workers from disruptive changes T h e " n e w capitalism" c o n ­trolled inflation in part by breeding anxiety that kept wages and prices in check It also tolerated greater inequality—growing gaps

b e t w e e n the rich, the middle class and the poor

O r consider "globalization": the thickening integration of na­tional economies t h r o u g h trade, finance and information flows Al­

t h o u g h w e don't c o n n e c t that w i t h inflation, we should H a d the U.S e c o n o m y remained as in the 1970s, beset by seemingly i n ­tractable inflation and ever-worsening recessions, America's confi­dent c h a m p i o n i n g of globalization in the 1980s and 1990s wouldn't have happened A m e r i c a n leaders wouldn't have attempted it; and even if they had, n o o n e w o u l d have listened T h e restored stability and vitality of the economy, w h i c h stemmed from disinflation, e m ­powered U.S leaders to pursue internationalist policies T h e same forces also gave the dollar a n e w lease o n life in its role as the p r i ­

m a r y global currency used in international business That c o m p a ­nies and individuals t h o u g h t they could rely o n the dollar to buy and sell goods and as a store of wealth p r o m o t e d b o t h trade and cross-border finance

Inflation is an example of h o w economics affects almost every­thing else, and the A m e r i c a n story of the past half century can't be realistically portrayed w i t h o u t recognizing its central role M u c h of

w h a t w e take as n o r m a l and routine either originated in the infla­tionary experience or was decisively influenced by it T h e great

shopping spree, the reemergence of capitalism and increased global­ization are three examples B u t w e have n o w c o m e to the end of this period Just what the next e c o n o m i c cycle will b r i n g is an o p e n question that, in some ways, will involve dealing w i t h the sequels of many of the effects of the Great Inflation T h e great shopping spree has ended W h a t will replace it? Globalization seems threatening to many Americans, as does the n e w capitalism Will w e shape these forces to o u r advantage or find ourselves whipsawed by them? C a n

we maintain acceptable levels of e c o n o m i c g r o w t h and stability?

T h e present e c o n o m i c turbulence signals a n e w era w i t h its o w n threats to stability and living standards At the end of the b o o k , I dis­cuss some of the threats and make suggestions as to h o w w e m i g h t respond to them B u t a n e w era hardly renders the Great Inflation irrelevant To the contrary, its history holds i m p o r t a n t lessons for the future O n e involves inflation itself As this b o o k goes to press, infla­tion has risen to the uncomfortable level of about 5 percent, driven heavily by higher prices for oil and food emanating from interna­tional markets W h e t h e r it will go higher or subside to the negligi­ble range of zero to 2 percent (a level at w h i c h most economists believe prices changes are so slight that they barely affect most Americans or businesses) is impossible to say W h a t is less uncertain

is the similarity b e t w e e n o u r present predicament and the situation that led to higher inflation in the 1960s and 1970s T h e n , a little i n ­flation seemed unthreatening; but a little led to a little m o r e , and lit­tle more led to a lot

We face an e n d u r i n g dilemma: H o w m u c h d o w e tolerate present pain for future gain? T h e easiest way to neutralize rising inflation is

to allow (or even induce) a recession that will suppress increasing

wages and prices t h r o u g h higher u n e m p l o y m e n t , less demand for goods and services and greater surpluses of unused productive ca­pacity B u t almost n o o n e enjoys such a recession, and there are al­ways intense public pressures to avoid it or minimize its severity In the 1960s and 1970s, o u r response to this dilemma proved mistaken and self-defeating O u r acceptance of present pain was so slight that

it led n o t to future gain but to ever-greater doses of future pain I n ­flation rose; recessions got worse In their early phases, the social and

e c o n o m i c costs of inflation are n o t immediately apparent Indeed, the first effects are often pleasurable People and firms believe their incomes are higher T h e y suffer " m o n e y illusion"—the mirage that higher wages, salaries and profits signify real gains in purchasing power, w h e n in fact they reflect only the deceptive side effects of i n ­flation B y the time people awaken to reality, inflation has secured a strong beachhead in wage and price behavior that can be reversed only w i t h difficulty Inflationary psychology and an upward wage-price spiral have taken hold

T h e lesson from the Great Inflation is that inflation ought to be nipped in the bud: T h e longer w e wait, the harder it becomes T h e lesson is w o r t h heeding, but as m e m o r i e s of the Great Inflation fade—for many Americans, they don't even exist—it may get lost Inflation's hazards may seem less menacing, and only by suffering

t h e m again will w e be reminded of their pernicious power O n e of the uses of history is to avoid preventable errors; but to do that, we've got to get the history right A n d this brings us to a broader lesson:

h o w w e t e m p e r and regulate o u r national enthusiasm for improvement It is a powerful A m e r i c a n virtue but o n e that, from time to time, gets us into immense trouble Skepticism in the face of

self-seductive appeals for social b e t t e r m e n t is n o t always pessimism or conservatism; often, it is p r u d e n t realism

For double-digit inflation was n o t an act of nature or a r a n d o m

accident It was the federal government's greatest domestic policy

blunder since World War II: the perverse consequence of meaning economic policies, p r o m o t e d by some of the nation's most eminent academic economists These policies promised to control the business cycle but ended u p by m a k i n g it worse T h e entire episode invites comparison w i t h the war in Vietnam, w h i c h was the biggest foreign policy blunder in the post—World War II era.* Sim­ilarities abound B o t h arose from g o o d intentions—the o n e w o u l d preserve freedom; the other w o u l d expand prosperity B o t h had i n ­tellectuals as advocates, w h e t h e r economists or theorists of limited war B o t h suffered from overreach and simplification; events o n the ground constantly confounded expectations B u t there is a big dif­ference O n e (Vietnam) occupies a h u g e space in historic memory

well-T h e other (inflation) does not

II

As I use the phrase, " t h e Great Inflation" refers roughly to the period from the mid-1960s to the early 1980s, w h e n inflation was rising from negligible to double-digit levels I lived t h r o u g h these years and, as a newspaper reporter and later columnist for

* Some would argue that the invasion of Iraq in 2003 was a worse blun­der I leave it to others to settle that dispute

Newsweek and The Washington Post, w r o t e about w h a t happened I n ­

flation is n o t just the rise of a few prices—say, gasoline or clothes General inflation is the rise of most prices In any m o d e r n economy, measuring t r u e inflation is impossible T h e r e are t o o many goods and services, and almost everyone buys a slighdy different mix of products and, therefore, experiences slightly different inflation T h e best that can b e d o n e is to survey the prices of many things that people buy Every m o n t h , the Bureau of Labor Statistics (a part of the Labor D e p a r t m e n t ) sends hundreds of data collectors into 30,000 locations t o record the prices of about 80,000 items— including soap, eggs, cars, personal computers, college tuitions, gaso­line, drugs—and 5,000 rents T h e prices are then weighted by people's c o n s u m p t i o n habits, as revealed in other surveys and the diaries of about 30,000 individuals T h e result is the C o n s u m e r Price Index, or C P I , the government's b e s t - k n o w n inflation indica­tor.1 Virtually all references to inflation in this b o o k use the C P I , precisely because it is so familiar.*

To understand w h y inflation was so pivotal first requires rebutting the arguments that it wasn't Conventional w i s d o m anoints other developments and events as the d o m i n a n t e c o n o m i c influences of

o u r time Personal computers and the Internet are favorite choices

So are globalization and the stubborn persistence of sizable U.S

* Using other inflation indicators would have slightly altered the num­bers, though not the basic trends All prices changes, unless otherwise noted, refer to December-to-December comparisons rather than year-over-year averages That's how people experience inflation—month-to-month shifts, not annual averages

budget deficits It's also frequently argued that inflation wasn't really

an independent event It was, rather, the o u t g r o w t h of other events—the war in Vietnam and the worldwide increases in oil prices in the 1970s Therefore, inflation really isn't w o r t h consider­ing on its own; it was simply one facet of these other histories All these views seem plausible O n examination, they are less so

C o m p u t e r s and the Internet have undeniably altered everyday life in countless ways B u t technological upheavals are a constant r e ­frain in the American experience, and it's unclear w h e t h e r this lat­est upheaval matters m o r e than many of its predecessors In the decades after the Civil War, large-scale industrialization (steel m a k ­ing, sugar and oil refining, cigarette manufacturing, flour milling) created massive cities and slowly transformed America from a rural

to an urban society Is the Internet m o r e i m p o r t a n t than that? O r than the mass production of automobiles that spawned suburbaniza­tion? O r than the advent of telephones, radio and television that transformed mass communications and entertainment? All these technological convulsions and others rivaled—and perhaps exceeded— the Internet and personal computers in their social and e c o n o m i c impact

As for globalization, it defines the next e c o n o m y perhaps m o r e than the last Despite growing international interdependence, the nation-state still dominates e c o n o m i c life, especially for large soci­eties such as the U n i t e d States Consider: T h e U n i t e d States, Europe, Japan and other advanced economies all have access to the same technologies and management practices If globalization were so overpowering, then all these economies w o u l d be identical, or nearly so; and yet they are not T h e i r e c o n o m i c performance and

living standards differ in m a n y crucial ways, because their cultures, histories, values, politics and e c o n o m i c policies differ Globalization

is just o n e force that comes into play It commands o u r attention mainly because it seems novel A similar caveat attaches to U.S b u d ­get deficits Since the early 1960s, the budget has b e e n in deficit e x ­cept for five years (1969 and 1 9 9 8 - 2 0 0 1 ) Still, the federal debt held

by the p u b l i c — t h e accumulation of all past annual deficits—is actu­ally smaller n o w in relation to the e c o n o m y than at the end of World War I I * T h e real budgetary threats lie in the future, w h e n the costs o f the retiring baby b o o m generation could produce m u c h higher taxes, deficits, o r b o t h

Well, w h a t about the argument that high inflation was the unfor­tunate spillover of V i e t n a m and the successive surges of oil prices in

1 9 7 3 - 7 4 and 1979-80? In this telling, inflation was n o t mainly a failure of g o v e r n m e n t policy or e c o n o m i c theory It was collateral damage from o t h e r events and therefore does n o t deserve m u c h i n ­

d e p e n d e n t attention Superficially, this seems possible In the 1960s, it's said, w a r t i m e spending created a classical inflationary hothouse:

t o o m u c h d e m a n d pressing o n t o o little supply Wages and prices rose Later, the global oil cartel ( O P E C , the Organization of the P e ­troleum E x p o r t i n g Countries) inflicted n e w damage B u t these n o -

* In 1946, the publicly held federal debt of $242 billion was 109 percent

of the country's then Gross Domestic Product of $223 billion—in effect our national income By 2006, the publicly held debt had grown to $4.8 trillion, but the GDP was $13.2 trillion The debt was only 36 percent of GDP