Inflation and the economic crisis of the 1970s and 1980s

In this article, Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2017-2021) goes back on the inflation issue of 1970’s/1980’s and the lessons it teaches us for the 2020’s.

In the developed capitalist countries, the fight against inflation became the top priority of economic policy in the 1970s. Georges Pompidou’s famous formula: “better inflation than unemployment” was buried for good. Inflation can be defined as the continuous and self-sustaining rise in the general price level. It is the result of a monetary struggle conducted by the various economic agents to maintain or increase their income or their capital: it has winners and losers. For economic decision-makers, inflation is a “sweet poison”: on the one hand, it is a factor of growth (by stimulating investment and consumption, and at the same time favoring production and employment); on the other hand, it is a danger for this same growth if the rise in prices gets out of hand (trade deficit, capital flight, ruin of savers). By what mechanisms does the inflationary growth of the 1960s give way to the rapid stagflation of 1973-1986?

Low inflationary growth was at the heart of the virtuous circle of the Trente Glorieuses

The Second World War and the post-war period were times of great inflationary pressure due to the large-scale expenditure by governments to finance the war effort, economic reconstruction and the establishment of the welfare state. France struggled with the problems of currency and price stability. Germany had the lowest inflation of the OECD countries since the monetary reform of 1948 and the priority given to a strong currency. Some countries, such as France, had chronic inflation. The debate raged in the years 1945-1952: a man like Mendès-France resigned from the government in 1945 to protest against monetary and budgetary laxity, stating that “distributing money to everyone without taking it from anyone is to maintain a mirage… “(extract from his letter of resignation, June 6, 1945). The growth of the 1950s and 1960s was generally not very inflationary in the developed countries: the Bretton Woods agreements ratified the stability of exchange rates around the dollar, the only reference currency convertible into gold. However, it was not until 1958 that European currencies regained their convertibility. Wartime periods remained inflationary: the Korean War (1950-53), for example, during which there was a rise in the price of raw materials, an increase in public spending in the United States and an increase in the circulation of dollars. From the beginning of the 1950s, once reconstruction had been completed, to the beginning of the 1960s, inflation fluctuated between 1 and 4% per year in the industrial countries. Moreover, Keynesian economic policies aimed to stimulate demand through deficit spending, which created inflation, and then to contain the pressure of demand when tensions were too great, so that inflation was limited. The alternation of stimulus (inflation) and austerity (deflation) took the form of the stop-and-go policy that characterized Great Britain and the United States in the 1950s. Consequently, in a period of full employment, a certain amount of “natural” unemployment is accepted in order to avoid too much pressure on wages and therefore on prices, as demonstrated by the British economist A.W. Philllips (Economica Journal, 1958).  Inflation is in this perspective a lesser evil: it is seen as a painless way of financing growth: in fact, it works in favor of companies that go into debt, it has a favorable effect on their financial profitability. In a country such as France, it makes it possible to arbitrate social conflicts by defusing profit/wage tensions (the government negotiates both wage increases and low-cost credit).

 The 1960s: the “inflationary spiral” begins to get out of control

From 1961-62 onwards, the developed industrial countries experienced an acceleration in price increases: a significant and lasting rise in inflation, from 3 to 5% until the early 1970s. During this period, there was no significant reduction in unemployment and even a slight increase in the number of job seekers: is this the end of the jobless era? In any case, the Phillips curve seemed to apply more and more poorly to the economic situation. There are several causes for this. Firstly, the growing importance of budget deficits: due to the use of deficit spending in the Keynesian logic; due to the implementation of the welfare state and social programs: for example, in the United States, the New Frontier programs of J.F. Kennedy and the Great Society of L. Johnson. Secondly, the deterioration of the international monetary system: devaluation of the pound sterling, crisis of the dollar at the end of the 1960s. Lastly, the wage increases outstripped productivity gains, which were slowing down: the “crisis of Fordism”: in other words, inflation through wage costs.

The 1973 and 1979 oil shocks

As seen previously, the 1970’s inflation is a consequence of economic phenomena already observed in the 1960’s.  However, the two oil shocks were game changers. This time we are talking about cost inflation: the cost of energy supply is at stake, with the price of a barrel of oil multiplying by more than 11 in 1973 and 1979. This explains why inflation continues even when demand is lacking, when there is stagflation and part of the production capacity is unused. During classical crises, overproduction results in a general fall in the price level and a collapse of production, as shown by the Great Depression of the 1930s. On the contrary, during the crisis of the 1970s, prices rose continuously after the two oil shocks of 1973 and 1979, while production was very unstable (after a collapse in 1973-1974, it picked up again in 1975-1976). Inflation was now high: from an average of around 5% per year in the early 1970s, it rose to double-digit figures between 1973 and 1975, and again between 1979 and 1982.

The economic consequences of inflation

The crisis is industrial and commercial: companies’ profits collapse because of rising costs; their international competitiveness is severely damaged because of the relative rise in prices. The crisis is social: the unemployment curve follows that of inflation, but without showing any real inflection between 1973 and 1982: it calls into question the Phillips curve analysis, as there is a simultaneous rise in unemployment and inflation. The number of unemployed in the OECD rose from 10.1 million in 1970 to almost 33 million in 1983, which roughly corresponds to a tripling. European countries seem to be particularly affected: unemployment has multiplied by almost 4 in the same period. The crisis is also financial. On a national scale, part of the population is ruined by rapid inflation (savers, rentiers, farmers, employees), while another part makes significant gains (speculators). On an international scale, the debt of Third World countries literally exploded: from 130 billion dollars in 1973 to more than 660 billion dollars in 1983. Currencies tend to depreciate, which causes a generalized rise in prices: galloping inflation becomes global (Mexico for example). What’s more, Keynesian policies further reinforced the symptoms that had been combated, and were strongly criticized by the monetarist movement. Double-digit inflation makes Keynesian anti-crisis policies ineffective. For example, with an inflation rate of 13.5% in 1980 in France, the inflationary policy of President F. Mitterrand had disastrous effects on the competitiveness of French firms: it wiped out their margins, caused them to lose market share and finally penalized foreign trade. The fight against inflation became the main objective of monetarist policies. For Mr. Friedman, it is necessary to return to Phillips’ interpretation: it applies in a transitory way in the history of capitalism, when economic agents cannot predict or anticipate the rate of inflation. It is no longer a question of explaining inflation by the state of the labor market, but the opposite: it is the inflation anticipated by consumers that explains the tensions on the labor market; he shows that Keynesian recipes increase inflation through money creation without any effect on employment (because consumers anticipate it, consume less, which translates into a reduction in employment among producers). More inflation leads to more unemployment and, in an open economy, a decrease in the competitiveness of companies. The 1970’s crisis sheds light on how inflation works and to what extent the Phillips curve model can be applied to real-world situations. This useful to remember in a time when inflation is coming back for the first time in thirty years.

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About the author

Article written in July 2021 by Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2017-2021).