~ $ ~
The Specter of Inflation

With this chapter we encounter the first of the problems that set this edition so sharply apart from the one that preceded it. We call it the specter of inflation, because in our last edition inflation was anything but a specter. Indeed, its causes and consequences and possible cures were realities that permeated a good deal of our book.

Today, inflation appears in a different guise. It is still with us in the sense that the prices of most things tend to go up a little each year, but that rate of rise has declined dramatically since inflation became a national threat in the 1970s. In 1980 consumer prices were rising at the rate of 13 percent a year, enough to double the cost of living every five to six years! In 1982 that rate had been cut in half, still enough to double the cost of living in less than a decade. Ten years later the yearly rise had been cut to 3 percent-a big improvement, but not so much that people weren't nervous about it. In fact, for 1997 the Consumer Price Index (CPI) showed a yearly rise of only 2.2 percent, the lowest since 1965. If we make adequate allowances for improvements in the quality of many goods, for all intents and purposes the inflation problem seems to be licked.*

*As we write these pages, there is considerable discussion as to the confidence that can be placed in the consumer price index. The question is the accuracy with which the index reflects changes in the cost of living beside the ups and downs in the prices of what we buy-namely, changes in the quality of what we buy. Is the higher price of today's new car, compared with yesterday's, the only thing that affects our standard of living? What about the greater safety of today's car, which in effect gives us more for our money? And how about longer delays on our under maintained highways, which in effect makes using a car more expensive? A trust worthy cost of living index is important because it is used to adjust Social Security payments, and the interest paid on the Treasury's new "inflation proof" bonds, or the fear of impending inflation. Conventional wisdom has it that our CPI is now rising at only about 2 percent a year, perhaps even less, but the fact is that we do not know if that measurement is correct. Our bet is that you will be reading and hearing about this for some time to come

But if inflation is effectively banished from the system, why do we introduce its specter as the first of those disturbing problems that are the central purpose for this edition?


Let us begin from an elemental but often overlooked fact of economic life. It is that capitalist economies are always in a state of nervous tension, of actual or potential movement, of overt or latent disequilibrium. Wars, changes in political regimes, resource changes, new technologies, shifts in consumers' tastes-all constantly disturb the tenor of business life. Ask any businessman if he lives in a calm pond or a choppy lake.

It may not seem important to begin from a stress on this deep-seated vulnerability characteristic of capitalist systems. But once we place the fact stage center, a striking question immediately faces us: how does it happen that the vulnerability results in inflation, and not depression or some other malfunction? For when we think of it, it was not inflation but other kinds of dysfunction that troubled capitalism in previous periods-think of the slump of 1893: six years of unemployment ranging from 12 to 18 percent of the labor force; or the collapse of the 1930s, with unemployment rates up to nearly 25 percent! Or recall the traumatic emergence of the new giant industrial trusts in the late nineteenth century, pushing up like corporate icebergs and cracking the floe of small enterprises of that time.

From this perspective, inflation appears as the way in which the capitalist system responds to shocks and disruptions in the institutional setting of the late twentieth century. Take, for example, the impetus given to inflation from the famous "oil shock" of 1973, when the Organization of Petroleum Exporting Countries (OPEC) suddenly boosted the price from three to eleven dollars per barrel, followed by another boost from thirteen to twenty-eight dollars per barrel in the wake of the Iranian revolution of 1980. But now suppose that comparable companies band together as a coal cartel and suddenly announce a fourfold increase in coal prices. Would such a coal cartel have produced inflation? The question is ludicrous. It would have brought on a massive depression. Coal mines would have closed, steel mills shut down, car loadings fallen. That imaginary but unchallengeable scenario then puts the right question: What happened between 1873 and 1973 so that the same shock-an abrupt rise in energy prices-produced depression in one era and inflation in another?

The question is not hard to answer. Far-reaching changes had taken place within the social and economic structure of capitalism all over the world. Of these, by far the most visible and important was the emergence of large and powerful public sectors. In all Western capitalisms, these public sectors pumped out 30 to 50 percent of all expenditures, sometimes even more. These public expenditures provided a floor for economic activity that did not exist before. In itself that was enough to shift a depression-prone world toward an inflation-prone one.

The floors of public expenditure do not prevent the arrival of all recessions, as we know from experience. The difference is that a market system with a core of public spending does not easily move from recession into ever-deeper depression. The downward tendency of production and employment is limited by the support of government spending such as Social Security, unemployment insurance, insurance of bank deposits, and the like. Cumulative, bottomless depressions change into limited, although recurring recessions.

A second aspect of the sea change that came over capitalism in the last century was the rise in private power. We saw it in the vast organizations-the icebergs-that dominated the waters of business and labor alike.

The emergence of massive institutions of private power made an important contribution to our inflationary propensity. A striking difference was that in the past inflationary peaks were regularly followed by long deflationary periods. Prices tended irregularly downward over most of the last half of the nineteenth century. Why? One reason is that the economy was much more heavily agricultural in those days, and farm prices have always been more volatile, particularly downward, than the prices of manufactured goods. Hence an industrial economy, just by virtue of being dominated by manufactures, is much less likely to have price declines than a farming economy. A second reason is that the character of the manufacturing sector also changed. In the early decades of the twentieth century, it was not unusual for big companies to announce across-the-board wage cuts when times were bad. In addition, prices declined as a result of technological advances, and as a consequence of the dog-eat-dog price wars that continually broke out among industrial competitors.

That is all part of a chapter of economic history largely written finis. Agriculture is now only a small part of GDP. Technology continues to lower costs, sometimes dramatically-look at what has happened to the computer during the last decade!-but until recently these lower industrial costs were offset by a "ratchet tendency" shown by wages and prices since World War II. A ratchet tendency means that prices and wages go up, but rarely or never come down-always excepting technological revolutions or market debacles. In normal times and normal business, we saw the ratchet at work. Concentrated business and union power, coupled with a general horror of cutthroat competition, meant that wages and prices generally moved in only one direction-up. Except that when business was bad and competition got nasty, big companies did not cut wages or salaries.

These changes help us understand why we have moved so far from the world of our parents and grandparents who worried about many economic possibilities, but not about inflation, to our own world, in which a susceptibility to inflation always seems to hover in the background.

But susceptibility is one thing and its advent another. To complete our brief history we need to know what started the process off, in the way that stock market panics or unforeseen business failures pulled the rug from under the system in the old depression days.

Probably the initial impetus was the boost to spending that followed from the Vietnam War, which was shortsightedly financed by borrowing rather than by taxing, no doubt because of the general unpopularity of our involvement. A second powerful stimulus to inflation in other countries arose when the United States used its then dominant power to force other nations to accept our dollars in lieu of gold in settlement of foreign obligations. This built up large holdings of dollar credits abroad that eventually fed back on our own price levels as foreign nations used their dollars to buy U.S. exports. We have already mentioned the dramatic effect of these oil shocks on the price level in the United States, and we have compared their inflation-creating effect with the depression creating effects that would likely have accompanied an imaginary "coal shock" in the 1870s.

Now we must pay heed to a very important change that made oil shock so contagious. This was the effort of the government to protect Social Security pensioners by "indexing" their payments to the cost of living, once a year raising their pensions by an amount equal to the rise in the previous year's cost of living. Similar arrangements were soon extended to many wage and salary earners in big private institutions, so that as prices rose, so did employees' incomes. Alas, by supplying more purchasing power when the national interest required just the opposite, this well-meant effort to counter the effects of inflation only served to strengthen its persistence. A tax increase on inflation-swollen incomes would have served the national purpose more effectively, but tax increases are not vote-winning political policies.

Against all these built-in tendencies, how did we finally get out of the inflationary spiral? One of these was sheer good luck. The major inflation-generating forces during the 1970s were "outside" the system exogenous shocks, in economists' language. Inflation gained a good deal of its underlying momentum from rising oil prices whose cause lay in the Middle East, not in our own economy. Also important was a consistent upward pressure of food prices, partly the consequence of serious food shortages in the underdeveloped world, partly the result of adverse weather. A third cause was the generally rising trend of many other raw material prices, pulled up by the worldwide boom. All these exogenous shocks acted as a constant inflationary stimulus whose effects were spread throughout the system by indexing arrangements.

Now comes the good luck. By the 1980s, all these pressures had disappeared. The OPEC cartel had set the price of oil so high that oil production soared, while oil consumption was dramatically economized. As a result, the price of oil fell from forty dollars a barrel to just above ten dollars. In the underdeveloped world, population growth gradually slowed down and agricultural production finally speeded up. With good weather as a big assist, long-persisting food shortages slowly gave way to exportable food "surpluses" with the consequence of failing agricultural prices. As the boom in the developed world lost its momentum in the early 1980s, demand for raw materials slumped, sometimes disastrously; after correction for inflation, copper prices fen to levels below those of the Great Depression.

Taken together, these exogenous developments cut the inflationary pressure by at least half during the 1980s. But because none of these developments was within the control of U.S. (or European) policy makers, we can only call this first reason for the decline of the inflationary spiral good luck.

A second reason was tough policy. Everyone had always known that there existed one sure cure for inflation. It was to send the economy deliberately into a really deep recession. Until the 1980s, however, no one was prepared to try the medicine, because no one was prepared to risk the political consequences of attempting such a cure.

The situation changed in the early 1980s, first under the administration of President Jimmy Carter, then with redoubled intensity under that of President Ronald Reagan. Tight monetary policies pushed interest rates over 20 percent, with the desired consequence of a steep and prolonged business recession. At 20 percent interest rates, small businesses found themselves unable to afford the normal loans needed to provide them with working capital. Consumers were driven out of the mortgage and household-appliance markets. Even the biggest corporations were themselves caught in a devastating squeeze as interest costs mounted and as buyer demand declined.

Thus, as expected and desired, tight money brought on a recession. By 1982, unemployment had passed the 11 percent mark; in Europe unemployment soared even higher. As unemployment rose, wage cuts-unheard of during the previous long boom-were instituted in hard pressed industries. And as the pressure of wage costs declined, and the easy days of ever-expanding markets gave way to hard days of stable or contracting markets, corporations were forced into strategies that many economists thought had been permanently relegated to the history books: They began to shave prices.

A final coup de grace was administered by the pressures of foreign competition. As U.S. interest rates soared, foreigners began to move their funds into high-yielding U.S. bonds. The inflow of capital thereupon drove up the price of dollars as foreigners exchanged their domestic currencies for the dollars needed to buy U.S. Treasury or other securities. As the dollar rose in value, Americans went on a shopping tour for foreign merchandise that could be bought in America at bargain basement prices. At the same time, foreigners found themselves unable to afford American goods, now priced out of sight. Thus the pressures ,of foreign competition provided another source of inflation-taming competition.

Psychologically inflation came to an end with the crash in asset values in the late 1980s and early 1990s. Stock markets crashed in Japan, and Taiwan. The fall in the Japanese stock market in real terms was even bigger than that in the American stock market from 1929 to 1932. Housing and real estate prices fell dramatically in most of the world. A post-World War II era of ever-rising real estate prices was over.

Together, good luck and tough policy broke the back of inflationary expectations. Double-digit inflation disappeared. Single-digit inflation subsided until a non inflationary world was once again in sight. This brings us back to the opening page of this chapter, in which we watched the gradual fading away of what was once a very real and very dangerous inflationary threat.


Great Inflation came to an end-rather ignominiously, but an 'end just the same. And what about the Great Inflationary Propensity? That, too, takes a brief historical word. We got out of the Great Depression by the spending generated by the advent of World War II. But not until the 1950s did we lay in the structure to prevent another Great Depression, mainly by the extension of Social Security, unemployment insurance and a welfare support system. The efficacy of those measures is shown by the fact that two back-to-back recessions in 1980 and in 1981 did not bring on the cumulative collapse characteristic of the economy's behavior in the presupport days.

We would seem, then, to be in the best of all worlds today- the Great Inflation lies behind us, an effective anti depression program in place, and we have seen the evaporation of the forces that made us so inflation prone in the 1980s. Now, however, comes the first of those disturbing changes that are a major reason for this new edition. The change lies in one further effect of the Great Inflation that we have left unmentioned until now. It is that an anti-inflationary viewpoint has become something like an obsession on the part of most economic policy makers. Above all, this frame of mind has found its spokesmen in the central bankers of the world, who hasten to put on the monetary brakes at the first sign that the rate of unemployment may be exceeding what is assumed to be its proper rate, with the threat of rekindling inflationary tendencies. Hence, perhaps the most important legacy of the inflationary years following Vietnam and the oil shock is a tendency to look with suspicion on "too high" employment, with its consequence of "too rapid" economic growth! Thus, the new problem we face is not inflation, but the specter of inflation. We are paying for our successful fight against a very real inflationary condition in the past by denying ourselves the noninflationary growth that is both possible and much needed in a radically changed economic setting.

What allows economists like ourselves to dissent from the conventional central bank view? The first argument is that unemployment is, in fact, much higher than the official statistics show. These statistics only count as "unemployed" individuals who are actively looking for full time work, in vain. There are something like 7.5 to 8 million such workers-something between 5 and 5.5 percent of the total number of individuals in the work force itself. But that count does not include another 5 to 6 million jobless workers who have given up the search as hopeless: they are simply not considered "Unemployed." Then there are another four-plus million who are working, but at part-time jobs because they cannot find the full-time employment they seek.

Add together these groups and the number of unemployed workers rises from the official count of around 5.5 percent of the work force to about 10 percent. Then there are still another 18 million workers who are in what might be called underemployment-working on call, or in temporary jobs, or as self-employed "contractors. " Finally, there exist, somewhere or other, another nearly 6 million "missing" males-men of working age who exist in the national census but not in the statistics of the labor force. Presumably a good number of them would appear from their statistical limbo if good, steady jobs were around.

In all, then, the potential work force is much larger-perhaps as much as 15 percent larger-than the number that the Fed takes to be our bulwark against an inflationary explosion of "over-full" employment. The fact that we have found jobs for some 20 million workers since 1985-about the number we need to absorb legal immigration and natural growth of the working force as children come of working age seems impressive until we take into account these overlooked or unmentioned numbers. Thus the first of our new problems is that the country is being denied much needed potential growth because of a specter-the threat of an inflation that is very unlikely to occur.

Does that mean that the scourge of inflation has finally been laid to rest, like the once dreaded prospect of a "bottomless" depression? No one could be so brash in the face of the possibilities for a new rearmament boom, another oil shock, or some such dangerous inflation-breeding misfortune. But these are possibilities, not likely prospects-and we know from experience how to limit their selffeeding dangers.

Meanwhile, in addition to the presence of a very large unrecognized body of the "un- or under-" employed, there are other reasons to doubt that inflation constitutes a clear and present danger. International competition has increased at all levels, as we shall see when we study globalization. American firms have much less price-setting power. New kinds of technology permit dramatic cost-cutting, including labor costs. Together these forces have produced a world in which real wages are eroding steadily. It is difficult to construct a plausible inflationary scenario in such conditions.

At the same time, the specter of inflation is regularly invoked to limit increases in government spending for such purposes as pensions and health care benefits for the elderly. This reluctance to allow government spending to rise because of its presumed inflationary consequence has meant a cutback in projects on education, infrastructure, research and development-the very areas of public spending most likely to generate prosperity in the future. So, too, within the private sector slow growth leads business firms to cut back on plant and equipment investments as well as skills training for their work forces. Underemployed workers similarly don't see the payoffs they need to justify investments in their own education. As a result the war on inflation leads to squeezing out precisely the public and private investments that are necessary to create future prosperity.

So all things considered, it seems to us that the Age of Inflation has come to an end, and that our present need is to prevent its memory from standing in the way of strengthening the programs aimed at dealing effectively with the challenges of tomorrow. That is why we say that it is not inflation, but the specter of inflation, that constitutes the first of our new problems. We shall have to wait to see how effectively we will deal with it.

Source: Robert Heilbroner & Lester Thurow, "Economics Explained", p.177-185, 1998.

$ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $