A Treatise on Unsound Money: Part 3
Written by Derryl Hermanutz
The 1970s were the nursery rhyme monster under the bed to sound money, as CPI inflation assaulted the buying power of the helpless hoards of saved money. Ash writes,
"At the surface level," Brad DeLong explained long ago, in a 1996 paper, the awful inflation of the 1970s happened because no one who could "placed a high enough priority on stopping inflation." Worse still, "no one had a mandate to do what was necessary." Beating unemployment with cheap money was thus the only tool in the box. So by God they would use it, even if it worked about as well as beating an egg with a shovel."
So what caused 1970s stagflation, which was a mix of high inflation and high unemployment that were supposed by the heretic Keynes to run in opposite directions? Sound money guys assume with Milton Friedman that "inflation is always and everywhere a monetary phenomenon", which is true, except when it's not.
Nixon removed the US$ and the world from the postwar gold-dollar standard in 1971, making the dollar a freely floating fiat currency the quantity of which was not restricted by the quantity of gold owned by the US government. So the stage was set to allow increased money creation. We have already noted that banks create our money supply by making loans and by purchasing government securities like Treasury bonds. Banks create new credit money every time they buy a government bond, which adds to the economy's money supply when the government spends the new money into the economy; just like new mortgage money or any other bank loan does not 'relend savings' of money that already exists but rather "adds" new money to the economy's money supply. (mortgage securitization sold new mortgages as "asset backed securities" to money that already existed; and government debt sold to non-banks is also bought by money that already exists, but ultimately all that saved money originated when somebody spent their new bank loan into the economy, where somebody earned and saved the money that somebody else borrowed and spent)
So who, in 1971, was borrowing and spending lots of new US dollars into the economy? Nixon was, to pay for the Vietnam war. War spending is far and away the most inflationary use of newly created credit money, as is well known to economic historians. The government hires an army of workers and orders a whole bunch of production and pays for it with the new money. Then the government ships those goods to a foreign country and blows them up. All the money the government spent has been earned by the economy contributing to the war effort, but the borrower and spender of the new money has not produced anything that will be "for sale" in the economy, to absorb the money and to use the revenue earned from sales to repay its loans. So the increased supply of income money is chasing a not-increased supply of consumer goods, and you get CPI inflation. (essentially, all "consumer" loans have this same effect: borrowed money is spent by people who are not using the money to produce things for sale that will allow them to reabsorb the money and repay their debts, but that's another story for another long day)
Ok, debt-financed war spending causes inflation, which is a monetary phenomenon as Friedman said. But what else happened around that time? OPEC happened, in 1973. Remember the "energy crisis"? The Arab oil embargo and oil shortages and rationing? 55 mph speed limits to conserve fuel? Gas station lineups, and even-odd license plate days when you were even "allowed" to line up for gas? OPEC quadrupled the price of oil virtually overnight, from $3 to $12 per barrel. Not to mention the Iran-Iraq war of 1979 when oil spiked to $42 per barrel (before collapsing back to $10 in 1982).
Do you think rocketing oil prices caused by supply disruptions had any inflationary effects in the 1970s, or any effects on employment? Or that a return to $10 oil might have had anything to do with ending the inflation (which is usually attributed to Volcker's catastrophic 20% interest rates)?
Friedman recognized only one of the two drivers of inflation. Too much money chasing too few goods is "demand pull" inflation. Money in the hands of spenders is "demand". When too much new money flows into the economy faster than producers can ramp up production to satisfy the increased demand, you get demand pull inflation of CPI prices. Producers can raise their prices because people have plenty of money and want the stuff, which is a really good thing for producer profits and investment even if savers and people on fixed incomes are not happy about contributing their money to inflated prices and producer profits. Friedman's inflation is caused by a too rapid increase in the economy's supply of spendable money.
But there is another kind of CPI inflation that is driven by a non-monetary phenomenon, "cost push" inflation. Oil is a primary commodity for which there is no immediate substitute. Oil is used to make a wide variety of products. It is also used as heating fuel, and was used to fire electricity generation. But the main use of oil is for making transportation fuels. Oil is an input cost into everything that has to be "transported" anywhere, as pretty much all transport is oil-fueled. Since pretty much everything is transported, pretty much every price has an oil cost component imbedded in it. So when oil prices quickly quadruple from a long term stable low price, and a few years later spike to 14X, you get cost push inflation of CPI prices. So OPEC (plus money creation to finance the Vietnam war) was a major contributor to 1970s CPI price inflation when the goods producers' cost-price of everything went up dramatically.
So why did the economy stagnate and unemployment rise during this double bladed cost-push and demand-pull inflation? Think about what "triggered" the subprime meltdown in 2007 - 2008. We know there had been extreme asset inflation in real estate, but as long as lenders kept lending and borrowers kept buying and real estate prices kept rising the gravy train kept rolling. Then suddenly in 2008 lots of people found they were not able to make their mortgage payments and they began defaulting on their mortgages en masse. Why did this happen just when it did? (This is the kind of question economic historians study, by the way, and we should read them because they come up with some really good answers that improve our knowledge of how our economies work.)
Do you remember $147 per barrel oil in the summer of 2008 and gas over $4/gallon? What happens to an already stretched household budget when it costs $400/month instead of $200/month to fill up to drive to work? In many cases what happened is that this final straw broke the household's budget. People ran out of money: their monthly bills rose higher than their after tax incomes. They had to choose to either gas up the car and go to work, or make their mortgage payment, so they chose not to lose their job by missing work. Many Americans NEED a car to get from suburbia to work, so it's not like they had any immediate alternative to their cars. So they spent their money on gas instead of mortgage payments and the real estate bubble suddenly popped.
All else being equal, adding new money into an economy is inflationary. There will be more money chasing a not-increased quantity of stuff to buy, and spenders of the new money will bid up prices. But all else is never actually equal, and other monetary factors actually deflate prices, which reduces profits, investment spending, and employment, which further reduces incomes and spending and profits, in the familiar downward spiral. Borrowing and spending of newly created bank-credit money adds new spending power into the economy that generates first round inflation of the asset classes that the new money is loaned for, such as real estate (mortgage loans) or college education (student loans) or consumer goods (credit card debt). That spending becomes incomes to the receivers of the spending. "Spending" drives the economy. "Saving" has the opposite effect." But that is a story for Part 4 of this series.
The Five Parts of the Treatise on Unsound Money