The Spectre of the Severe Stagflation of the 1970s Resurfaces in America

Some people are beginning to remember the radical method used by Paul Volcker.

Following Bill Clinton's victory in the 1992 U.S. presidential election, some people wondered why the Democratic candidate won the election against the incumbent Republican President George Bush. One of Bill Clinton's advisors uttered a phrase that will forever remain in legend: “It's the economy, stupid”.

America was in the midst of a recession at the time, and voters made him pay for it by electing his Democratic opponent.

As the mid-term elections in America approach, many are preparing for a defeat of the Democratic camp by considering an explanation in the same tone: “It's the inflation, stupid”.

The rise in prices, which reached 7.5 percent in January 2022, a record since 1982, is turning into a poison for President Joe Biden. Admittedly, inflation is not yet the number one concern of Americans, as it was in the early 1980s. But it is eroding the purchasing power of wage earners, while pessimism is spreading in the United States: consumer sentiment measured by the University of Michigan is at its lowest in a decade, while only 25 percent of Americans think that now is a good time to buy a home.

The neo-Keynesian economist Larry Summers, who warned of the risks of inflation in the spring of 2021, warns of the political damage that could be done, especially on the left. Here's what Bill Clinton's former Treasury Secretary says:

“Inflation contributes significantly to distrust of institutions and pessimism about the future. This is terribly important at a time when our democratic institutions are being challenged. If inflation had been better controlled, it is quite possible that the election of Richard Nixon in 1968 and Ronald Reagan in 1980 would not have happened.”

After having long underestimated the risk of inflation, even though it was increased by his massive stimulus plan voted in March 2021, Joe Biden is making it his number one topic, as is Fed Chairman Jerome Powell. On the markets, the Fed's monthly meetings are seen as emergency meetings, from which an unexpected and brutal rate hike would emerge.

Paul Volcker's radical cure

The memory of Paul Volcker, Fed chairman appointed in 1979 by Democrat Jimmy Carter, is constantly mentioned, as he brought down inflation by making the Fed's key rates soar to 19.1% in the first half of 1981. The remedy was radical. It plunged the United States into two recessions, in the first half of 1980, then from July 1981 to November 1982.

The cost for the job market was painful, with the unemployment rate peaking at 10.8% in 1982. It provoked a debt crisis in emerging countries. But inflation was defeated: from a high of 14.8% in May 1980, it fell back to 2.5% in July 1983. The collective memory traces inflation back to the oil shocks of the 1970s. This is not correct.

Paul Volcker not only had to deal with a supply shock, namely that of a surge in oil prices after the Arab-Israeli war of 1973 and the Iranian revolution of 1979. It was also confronted with the legacy of twenty years of Keynesian policies that had deregulated the economy in the name of fighting unemployment, starting in the 1960s.

In the United States, inflation was non-existent at the beginning of 1965, falling to 1%. But it quickly soared under President Lyndon Johnson, who had to finance the social programs of the Great Society and the American military commitment in Vietnam. Inflation reached 4% in February 1968 and 6.2% at the end of 1969. At the time, the central bank did not fight against rising prices.

The United States was still deeply affected by the Great Depression of the 1930s, and it was felt that a compromise had to be reached between unemployment and inflation, the latter being the lesser evil. Except that this system no longer worked, and inflation, far from boosting the economy, actually stopped it: unemployment was certainly at its lowest in 1968 (3.4 percent), but it rose to 6.1 percent in 1970.

The first to denounce this false inflation-unemployment balance in 1968 was Milton Friedman, the father of monetarism. Instability set in, while inflation soared even further with the two oil crises. The United States then experienced stagflation, a mixture of inflation, unemployment, and economic stagnation.

In 1977, a federal law reiterated the Fed's dual mandate of full employment and price stability, and Jimmy Carter appointed Paul Volcker as Chairman of the institution to curb rising prices. In October 1979, the Fed changed its policy and explained that it would henceforth control the quantity of money in circulation, leaving interest rates de facto set by the market.

This method allows the Fed to get out of the political way. The Fed was not responsible for having raised rates and caused a recession since this phenomenon was fixed by the markets - but technically allowed the Fed to effectively bring down inflation.

So, should we adopt the Volcker method again? The US is not there yet. To do so, the Fed would have to raise rates to around 10% above inflation, whereas today we are talking about a maximum rate set at 2.5%. The impact would be devastating for the world's creditors: governments, households, and companies, suddenly afflicted with financial burdens, and the financial markets would collapse.

Many believe that the Volcker technique is not workable in the current environment and that the Fed will have its work cut out for it in the coming months to find the right balance

For many economists, the Volcker technique is unusable. There is even some talk that raising rates is useless since the economy is suffering from a supply problem, bottlenecks in the economy that will eventually be resolved. Raising rates to combat soaring gas prices, what's the point?

This argument, while defensible in a Europe that has spent less during the pandemic, is not so in the United States, which has flooded the economy with liquidity. Larry Summers worries about the analogy with the discourse of the 1970s:

“Back then, people resisted the idea that inflation was caused by accommodative monetary policy. They preferred to talk about oil prices or even changes in ocean currents that caused changes in anchovy prices that caused changes in grain prices. In the end, it seems that we made a mistake in the 1970s, not realizing that, in the end, higher demand meant mainly higher inflation.”

This risk is looming again. Reducing demand and inflation will therefore require reducing the ardor of the American consumer, by making him pay more for his loans - that is the rise in interest rates - and by reducing his purchasing power: the end of budgetary aid should contribute to this as well as inflation. But at the risk of an economic slowdown, without it being possible to exclude a recession. The hardest part is therefore yet to come.