Inflation — Fighting the Last War

You know the old cliché about generals going into battle:  They are always fighting the last war.  Generals aren’t alone.

In the wake of the debt-ceiling debacle, freshman Pennsylvania Sen. Pat Toomey, a tea party favorite and a new member of the Congressional Super Committee, wrote an op-ed in which he said that “excessive debt leads to higher interest rates [and] serious inflation.”
There was nothing particularly remarkable about that statement.  It repeats what many conservatives have been saying for a long time:  that inflation is always the great, looming threat.  But in standing tall against inflation, Toomey and many others are fighting the last economic war.  And we are losing the current one as a consequence.
In order to understand this long march in the wrong direction, you need to go back to the late 1970s.  Inflation back then ran in the double digits and was a major cause of that era’s economic malaise.  It severely affected people’s lives, as prices for virtually everything kept going up and up.
Then in 1979 new Federal Reserve Chairman Paul Volcker set about bringing inflation under control. The Fed’s policies, along with those of President Ronald Reagan, brought on a deep recession, but they worked.  By the mid-1980s, inflation had been tamed.
One part of that inflation fight was a major shift in the goal of our economic policy.  From the end of World War II until 1980, with the memory of the Great Depression still alive, our goal had been “full employment,” and we tailored our monetary, fiscal and social policies to achieve that end.
But by the 1970s, a number of economists and policy makers had decided that full employment, with the upward pressure on wages that it brings, was a cause of inflation.  They mapped it on something called the Phillips Curve, which, crudely put, showed that as unemployment dropped, inflation rose, and vice versa.
Since 1980, however, our goal has been “low inflation,” and that has meant keeping unemployment higher than it might otherwise have been.
So, for example, unemployment was under 5 percent at the start of 1955, about the same at the beginning of 1965, but stood at nearly 7.5 percent in 1985.  Unemployment during the Reagan years never dropped below 6 percent and was usually in the 7-to-8 percent range.  It was a whopping 11 percent at the end of 1982.  High levels of unemployment became more or less structural, keeping wages stagnant and eliminating hopes of job security for many.
As the Clinton economy heated up during the 1990s, unemployment dropped and average wages began to rise.  Yet inflation remained remarkably low.  When Clinton left office, the nation had a 3.9 percent unemployment rate and a 3.4 percent rate of inflation.
This left many economic pundits scratching their heads.  It seemed that the Phillips Curve described a historical moment — the 1970s — but did not predict the future very well.  As often happens, economic theory turned out to be economic history — that is, an explanation rooted in a specific time and place. 
Of course, inflation is a serious matter, without a doubt.  When prices rise fast and furiously, life does get more difficult for all of us.  But it is not the threat it once was.  Furthermore, inflation matters less for ordinary working people if wages are also rising and jobs are plentiful.  Rising wages can offset rising prices, and there is strong evidence that secure employment leads to a healthier economy.
Inflation matters more for those people whose business is money:  bankers, investment managers and other Wall Street types.  As inflation rises, making money worth less, the value of their only asset declines.  Thus, the policies of low inflation benefit the financial sector of the economy more than the rest of us.
Pat Toomey, it won’t surprise you to learn, was once a Wall Street banker.
Many Republicans objected to the Bush Administration’s TARP program and voted against President Obama’s stimulus package because they believed both would be inflationary.  Now the consensus is that both of those measures kept our economy from descending into a calamitous deflationary spiral.
Inflation has been under control for a quarter of century. Even so, conservative politicians and some Federal Reserve governors continue to fight the now-imaginary inflation dragon.
So when you hear politicians such as Sen. Toomey fret about inflation, remember they are facing backwards, fighting the last war.  Meanwhile, they are ignoring the battle for jobs that we really need to be waging right now.

Steven Conn is Professor of History and Director of Public History at The Ohio State University, Columbus.

August, 2011