The true cost of beating inflation vs. the cost of letting it run...
"AT THE SURFACE LEVEL", as Bradford De Long explains in a 12-year old paper, the destruction of money's purchasing power during the 1970s happened because no one in power "placed a high enough priority on stopping inflation."
The three US presidents that decade – Nixon, Ford and then Carter – all inherited "painful dilemmas with no attractive choices". The forlorn hope of trying to grow jobs at the expense of sound money had long since locked in that problem during the '60s.
Moreover, "no one had a mandate to do what was necessary," our Berkeley professor goes on. "It took the entire decade for the Federal Reserve as an institution to gain the power and freedom of action necessary to control inflation."
But at the very deepest level, "the truest cause of the 1970s inflation was the shadow cast by the Great Depression of the 1930s," De Long concludes. Fearing a slowdown that might speed into reverse, policy makers the world over kept trying to grow jobs by allowing just a little inflation to juice everything up.
"It took the 1970s to persuade economists, and policy makers...that the political costs of even high single-digit inflation were very high," says De Long. How high exactly?
- Amid fuel shortages and the energy-price crisis of 1979-80, the inflationary bubble ended with Jimmy Carter's complete rout at the polls;
- Western Europe suffered all-out strikes over pay both by public sector and many private-sector trades unions;
- The trades unions' role in apparently stoking inflation – by demanding near-inflationary pay rises – gave the Thatcher and Reagan administrations in Britain and the US a mandate to dismantle their power, both legally and politically.
- Here in Britain, the union-backed Labour government collapsed thanks not to the state's near-bankruptcy and IMF bail out of 1976, but during the "Winter of Discontent" of 1979 when grave-diggers and rubbish collectors went on strike for more pay. It took four elections and 17 years before UK voters let Labour take power again.
And the costs for investors?
- "US stock prices declined in real terms by three quarters between 1966 and 1982," notes Martin Hutchinson at PrudentBear;
- London's FT30 index fell by one-half in 1974 alone;
- Government bonds became known as "certificates of confiscation" as their annual returns – paid in fast-depreciating currency – fell far below the rate of inflation;
- Real estate values just about kept level with prices, twice falling sharply in real terms (1976 and 1980 in the US; 1975-7 and 1980-2 in the UK);
- Cash savers and fixed-income retirees were eaten alive.
Put another way, the developed world of the early 1970s preferred to let inflation run wild because few people guessed what a mess it would cause – neither for workers, business or capital investors.
A little inflation never hurt anyone, after all. Least of all politicians looking for re-election during a boom in the credit cycle! And so the great and the good balked at their chance to act early. Because they didn't dare "liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate," as US Treasury secretary Andrew Mellon famously cried in the '30s.
Let's face it; destroying wage-earners, equity markets and real estate will never be much of a vote-winner. And the '70s ended with a peanut-farmer sat in the White House.
So instead, interest rates remained beneath the growth in inflation, trying to juice the economy and side-step a slowdown forever. Tinkering with price control – first imposed in the US by Richard Nixon when Consumer Price inflation broke 4.0%, just as it has in 2008 – government ripped off manufacturers. It also rigged the inflation figures applied to new pay claims, cutting into real wages. Cash savers – meaning anyone who didn't spend all they got on the first of the month – were left watching their purchasing power shrink by the day.
Even the authorities caught on in the end, as consumers, business and savers were all hurt so badly, fixing the problem finally grew urgent. At a series of policy meetings in 1979, staff from the Federal Reserve and US Treasury noted how the rush to Buy Gold was merely "a symptom of growing concern about world-wide inflation." People just wanted to get some kind of foothold as the value of money collapsed in a landslide. Whether investors, laborers or land-owners, no one could ignore what was happening to prices – and what was happening to prices started and ended with money.
As Jürgen Stark – a member of the European Central Bank (ECB) – noted of Germany's early 20th century hyperinflations in a speech last week, "a strong coalition supported an open inflation aimed at real debt relief...But the long lasting costs of such a policy [were] the destruction of people's trust and confidence in their currency."
Whereas today? "I know that many believe it is somehow sinful or immoral for the Fed to hold [interest] rates so low as to render the real return on cash to be negative," writes Paul McCulley in his latest Central Bank Focus for Pimco, the world's biggest bond fund. "[But] I don’t buy this proposition."
Pointing to the chasm between unionized labor's power in the 1970s and today's sub-inflationary pay claims, McCulley asks why cash savers – those folk providing investment capital through their bank deposits – shouldn't suffer as well.
"Why should it be that those who only have labor to offer to the market should not be made whole [amid rising inflation] while those with cash should be made whole? If indexing to headline inflation is inappropriate for labor wages and capital’s profits, why should cash yields be indexed by the Fed?"
Why indeed? Sacrifice enough cash savers along with non-unionized labor, in fact, and maybe this sweet little inflation can just keep running for ever. No pain, no costs! Other than the destruction of trust and confidence in currency. Which might just prove expensive long-term.
The value of money directly relates to its price. Sub-zero returns, Paul McCulley forgets, will only force investors to Buy Gold as businesses fold and wage-earners lose out.
Those who buy early might at least get ahead.