Almost Since Pandora’s Era, Inflation Has Been Hard to Contain
Those who complain about efforts to curb inflation should be glad they didn’t live during the Roman Empire.
In an edict of AD 301, the Emperor Diocletian decreed that any merchant who raised prices beyond official limits should be put to death. The policy didn’t work, and inflation continued unabated for at least another 100 years, according to economist David Ranson.
These days, the efforts to curb rising prices are not nearly so draconian, but they’re still causing a fair amount of commotion. The Federal Reserve Board, the nation’s central bank, is always drawing heat because its anti-inflation policies supposedly impede the growth of the national economy.
Although many praise Fed Chairman Alan Greenspan for engineering a “soft-landing” of the economy last year--steady growth with low inflation--critics say the Fed has slowed the economy far more than necessary and believe the nation may be headed for a recession in 1996.
“Inflation has been very quiet and very modest ever since the Gulf War . . . and I think this Federal Reserve has been too apprehensive, so they’ve slowed down the economy too much,” said Lawrence R. Klein, a retired economics professor at the University of Pennsylvania.
With prices now rising less than 3% a year, the lowest annual rate since the days of Beaver Cleaver, the question is: Why all the paranoia about inflation?
One need only look at the lessons of the last three decades to understand inflation’s threat.
Although economists disagree about its causes, inflation usually begins when demand for goods and services exceeds supply, forcing prices up. This can occur during a period of strong economic growth, when production of goods and services is at or near capacity. “Too much money chasing too few goods,” is a common short definition.
The government can fuel inflation by running a deficit, spending much more than it collects in taxes. Or it can occur when a nation’s central bank increases the money supply by making it easier to borrow money.
Too much cash in the economy could lower interest rates because there is more money to lend than borrowers need. However, once capitalists and savers catch on, they insist on higher interest rates to make up for inflation.
As prices rise, an expectation is created among wage-earners that prices will continue to rise. That leads them to seek higher wages by, for example, tying union contracts to cost-of-living increases.
As wages rise, this increases the costs for employers. Given strong demand for their goods, they pass on the cost increases to consumers with higher prices.
This roughly describes the situation that existed in the late 1960s and early ‘70s under a growing national economy fueled by President Lyndon B. Johnson’s Great Society programs and the Vietnam War.
At the beginning of the 1960s, prices increased less than 2% annually. By the end of the decade, prices were increasing near 6% a year.
Later, inflation spiraled upward in part because of price shocks from the Arab oil embargo of the 1970s, under which the price of crude oil rose from less than $4 a barrel to nearly $30. Grain prices also went up as the Soviet Union bought up stocks in the early 1970s. By 1980, prices were rising nearly 14% a year and mortgage interest rates had soared beyond 20%.
Over the last 45 years, rising inflation usually has meant low economic growth, according to economist Ranson.
The most obvious effect is on consumers’ ability to maintain their standard of living as every dollar earned buys less in goods and services. Inflation is hardest on the elderly who live on fixed incomes; on the young, whose cash savings quickly lose their value, and the middle class, who find their incomes creeping into higher tax brackets as their wages rise, with no commensurate rise in their buying power.
But inflation has other effects. It encourages borrowing over saving and investments, because borrowers can expect to pay back their loans with cheaper dollars. And runaway inflation distorts the market signals that prices send to investors: They are motivated to put their money in places that may not necessarily translate into economic growth.
Once inflation accelerates, it is difficult to stop without drastic measures. For example, price controls, such as those in place in Diocletian’s time, do little to stop inflation, and often distort the economy.
President Nixon instituted price controls when inflation reached 4% in 1971. They did little to stem price hikes.
Similarly, efforts to “jawbone” away inflationary psychology are usually doomed to fail. The most obvious example is President Ford’s “Whip Inflation Now” campaign of the mid-1970s, which did little to hold down prices and wages.
Only intervention by the Fed under Chairman Paul A. Volcker was able to bring inflation under control. By raising short-term interest rates near 20%, Volcker was able to halt the acceleration of prices and wages.
But he also set off the punishing recession of the early 1980s, and put in motion the events that led to the costly savings and loan crisis of the 1980s.
Still, Volcker’s drastic surgery worked in cooling the nation’s inflationary fever. By 1986, a year when oil prices collapsed, the increase in the consumer price index was only 1.1%.
Inflation again became a worry in 1990, when the Gulf War threatened to send oil prices rocketing upward again. Fortunately, that didn’t happen.
But as the nation’s economy heated up after the recession of 1990-91, growth in consumer spending threatened to light the inflation fires again.
This time around, however, one element may be missing: the wage pressure. In a global economy, U.S. industries are restructuring to remain cost-effective and competitive.
“That keeps wage growth at bay,” said Adrian Rangel Sanchez, regional economist with First Interstate Bank in Los Angeles.
Is it time for the Fed to ease up? “They think that the economy cannot grow faster than 2.5% a year without generating inflation,” Klein says. “I think that number is much too low.”
