"Those of us old enough to have lived through the 1970s remember the bad old days when prices were escalating at a sickening pace"
Those were the good old days...I was buying 30 year zeros for $85 each in my IRA.
"An item that cost $1 on Jan. 1, 1969, cost $1.31 five years later"
The $200 house payments I was making on 5/74 were costing me $200 on 5/85.
I was buying gas for 32 cents/ gal (when there wasn't a gas war) in '64, and I was paying 32 cents/ gal in 9/73. Then the Arabs shut off the pumps and I was paying over a buck in about 2 months, when I could find gas. Tripling the cost of energy and the feedstock of the petrochemical industry causes rampant price increases everywhere, from the cost of fertilizers to the cost of mechanical harvesting to the cost of packaging to transportation.
Four letters: OPEC, or Organization of the Petroleum Exporting Countries. It’s a long (but fascinating, in no small part because my first love is military history) story as to how they came to decide to exercise their power at the close of 1973. In short, they, being primarily Arab nations, were very upset with US support of Israel in the 1973 Arab-Israeli War (which the latter came perilously close to losing). This gave them the focus to agree on how they would go about raising prices by voluntarily reducing supply. You can have a glance at the results here:
http://www.eia.doe.gov/aer/txt/ptb1107.html
Saudi crude oil jumped from $2.10 in 1973 to $9.60 in 1974. By 1982, it was $34. This was not demand-pull and it was not the kind of cost-push related to acts of God (like anchovies not showing up or hurricanes destroying resources). It was market power, pure and simple, and it was a massive redistribution of income to OPEC countries and oil companies. It served no useful purpose (unless your goal was to see the West punished for helping Israel–it certainly did that).
These are the three kinds of inflation. I’ll call them demand-pull, cost-push/act of God, and cost-push/market power. All three redistribute income, but the first two do so on a basis that makes economic sense. They enrich those who should be enriched and thereby create signals for entrepreneurs and consumers regarding what should happen next. If the prices of lumber go up because there has been a massive boom in housing, then the fact that lumber manufacturers get more money acts as a signal to others to enter that industry (which is what consumers want) and it is an incentive to builders to find a substitute for lumber. If the prices rise because a forest fire burned down our trees, it still makes sense for lumber prices to increase. That’s the appropriate signal to the market. Only inflation created by market power is clearly harmful. We should stop it. But how? What policies are available to us?
Policies to prevent inflation
The obvious way to stop demand-pull inflation is to lower demand. The government could, because there is a housing boom leading to bottlenecks in the building industry, throw the entire macroeconomy into recession. That makes little sense, however, because demand-pull inflation sends appropriate signals and redistributes income on a logical basis. And, anyway, it’s hard enough to get the economy in expansion without causing recessions on purpose. What moron would do that!? (HINT: The Federal Reserve. More on this in a moment.)
With cost-push/acts of God, there is little that can be done (prayer?) directly and, besides, the price changes make sense. The government could act to make any transition easier, but if there ain’t no anchovies, there ain’t no anchovies.
Cost-push/market power is bad, about that there is no question. Unfortunately, while solving it in theory is very easy (get rid of the market power!), doing so in practice is messy. You have to directly address the problem, meaning that you’ll have to fight some business, labor group, country, or set of countries that really, really like having market power. If it’s one of the first two, they’ll line up their lawyers and economists and fight it out with the government’s. Who wins is an open question. Not that I am suggesting that we shouldn’t do this–we absolutely should, the survival of capitalism depends on making sure that accumulations of market power like this do not occur. They will because those greedy business people are also smart. But, we have to fight back. Unfortunately, there is no magic wand we can wave to make it all better. The only basic defense here is a general understanding on the part of citizens and their government that this is a constant problem, one for which we must remain vigilant. It’s funny that Americans, to whom democracy is supposedly such an important ideal, have very little trust for their democratically-elected government and yet at the same time have such faith in the market system. In terms of giving power to the people, it works just about as well as democracy: it’s not terrible, but it’s certainly not perfect. Keep a close eye on both.
Policies we actually employ
I entitled this post, “Inflation: What Really Causes It and What We Truly Have to Fear.” What I’ve said so far is that demand-pull inflation and cost-push/act of God are reasonable responses to economic stimuli but that cost-push/market power is all-around bad. However, my reference in “What We Truly Have to Fear” was not to market power, but to the Federal Reserve. In the US (and most other countries), policy does not follow what I’ve discussed above. Cost-push/market power inflation is almost completely ignored (maybe this is starting to turn around again, but since the 1980s we have had a very lax anti-trust attitude in the US) and it has been demand-pull inflation that has been made out to be the villain. The economists at the Fed see it as their job to force the US economy into recession when they see demand-pull inflation threatening–and they see all inflation as demand-pull. Hence, they act to stamp out expansions in response to the perfectly reasonable response of the market to increases in demand (I have a whole class in how they would have developed such a theory, but it’s a bit much for the blog).
If you are old enough to remember the early 1980s, you may recall the incredibly high interest rates. This was on purpose, a policy response of the Voclcker Fed to the inflation caused by OPEC. It caused the worst recession since the Great Depression (a title it only lost very recently!). Unemployment skyrocketed from 5.9% in 1979 to a peak of over 10% during 1982. This was all done on purpose in order to control inflation that they viewed as demand pull. It was, of course, not.
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