Super Inflation

January 29, 2012 12:27 AM

Why did inflation increase so dramatically in most Western economies in 1975? Why did inflation remain at 10-15% levels around the world through the recessions of the late 1970s and only return to "normal" 3-5% levels in the 1983 recession?
posted by dave99 to work & money (10 answers total)

The oil shock, and the subsequent crisis and stagflation.
posted by pompomtom at 1:13 AM on January 29, 2012

IANAE (I Am Not An Economist) so I may be oversimplifying.

Price increases are not inflation, in spite of what the news readers say. Price increases are often an indication of inflation but they are not, in themselves, inflation.

Inflation is an over-supply of money in the economy. This is controlled soley by the government.

Governments pretend that inflation is just something that happens, like a typhoon, when it starts and ends with how much money they print.

Governments like inflation because it allows them to pay off debts with money that has the same face value but less actual value than when the debt was incurred.
posted by trinity8-director at 1:21 AM on January 29, 2012

As I understand it, the main cause was the 1970s energy crisis. A combination of advanced depletion in old oil-producing regions like the US and political turmoil in the Middle East resulted in rapid increases in the price of oil.

This damaged economies around the world and sent many into recession. The standard response to recession back then was old-style Keynesian demand stimulation, which basically pumps more money into the economy so that people have more to spend and invest with. This helps deal with a lack of demand - when there's not enough money floating around, as in the current situation where a period of excessive risk-taking has been followed by a period in which people are reluctant to take risks by lending or investing money.

Unfortunately it doesn't help with a lack of supply - where people have as much money as they did before but there is suddenly less of what they want to buy. The energy crisis was a perfect example of this kind of supply shock. When governments responded by pumping money into their economies, this just meant that everyone had more to spend on things that were becoming more scarce (because the availability of almost everything in the economy was, and still is, based on the availability of oil). Prices rose. Wages tried to catch up. Cue many years of dramatic inflation, which as pompomtom says turned into stagflation (inflation with unemployment and without growth).

Things only calmed down in the early '80s, when new oil supplies started to come on line.

There were probably other reasons, but I think this is generally accepted as the main one.
posted by A Thousand Baited Hooks at 1:22 AM on January 29, 2012 [2 favorites]

Inflation in the 1970s was triggered by the 1973 oil crisis and the 1979 energy crisis. These sudden increases in oil prices are what are known as negative supply shocks. The general price level rises (i.e., there is inflation) when there are negative supply side shocks to the economy through what is known as cost-push inflation. It can take years for the economy to adjust to the higher price of inputs. (People can’t put new insulation in their homes overnight and fuel-efficient cars take time to develop as well).
posted by Jasper Friendly Bear at 1:24 AM on January 29, 2012 [2 favorites]

The collapse of the Bretton Woods System was also important. It wasn't just the oil shocks. The West's money system shifted from specie currency to fiat money and exchange rates caused problems.

Between the end of WWII and the early 1970s there were fixed exchange rates between the various currencies. In the early 1970s there were clear problems. The 1971 'Nixon Shock' shows problems with inflation and predates the oil shocks. The increase in government spending on welfare and the war in Vietnam contributed to the problems.

Floating exchange rates between countries with fiat money enable substantial shock absorption between economies. It is interesting to note that the Euro, which has removed that buffer between countries has also resulted in severe problems of a type that bear some similarity to the problems between countries in the Bretton Woods system.
posted by sien at 3:34 AM on January 29, 2012 [1 favorite]

...This is controlled soley by the government.

This is just not true. By far, the main source of "new" money is from the issuance of debt from our fractional-reserve based lending system, not the government. Some might think I'm splitting hairs but I think they are actually very different phenomena and if more people understood this then otherwise esoteric things like the yield curve and what the fed is trying to do would make more sense to people.
posted by H. Roark at 4:45 AM on January 29, 2012 [5 favorites]

I think sien has the right answer. In Bretton Woods, as I understand it, currencies were fungible. If you had a trade excess with the US, you'd just back a truck up to Fort Knox and unload pallets of dollars and the government would have to give you gold. You bring that gold back to your country and put it in your vault. The US in this case had two choices: put those dollars back into circulation and adjust the exchange rate down, since there was less gold backing the same number of dollars. Or destroy the dollars and suffer deflation, since there were fewer dollars out in the wild to support the same amount of economic activity. (And the inverse would happen in your country.)

What also could happen was that because exchange rates were fixed, there were ways to arbitrage that process before the powers that were adjusted the exchange rate. You could start with some GBP, exchange for gold, buy DM, exchange for gold, buy USD, exchange for gold, and then buy your GBP back at a profit. If you did it quick enough.

This meant that if a country had a couple of bad quarters of growth, their gold reserves would be seriously depleted, and then the exchange rate boards would readjust the exchange rate, meaning that when that country started to recover, they couldn't buy their gold back for the same price they were forced to sell it for.

This would work out fine in a more or less closed system with relatively stable populations, because everything would be a big circle. Especially if you were a net exporter of goods and services, as the US was in the early postwar era. But what was happening in the late 60s and early 70s? The baby boomers were graduating from high school and college and entering the workforce, looking for jobs and building houses and generally increasing the demand for both goods and currency at a higher rate than could be supported under the current system. You've got all these new people borrowing and saving and your money supply is growing, but your gold supply is not.

You can maybe visualize it by imagining a classic nuclear family, the Smiths. Parents work and make money, and the kids do chores and earn allowances. Except their allowances are paid out via Smith-bucks, one per week per kid, exchangeable for cash on demand, based on the age of the kid. If the kid is 12, one smith-buck gets him $12. Further, the parents budget a fixed pool of dollars each week with which to redeem the Smith bucks based on the ages of the kids that week. Everything works out fine, until they start getting older. The kids were saving and trading Smith-bucks between each other. Then the shit hits the fan. The older kids started doing the chores for the younger kids in exchange for their bucks, and redeeming them at Dad's exchange window. Dad's pool of cash is shrinking in relation to how many Smith-bucks are outstanding.

And there's the problem with the gold standard. Money supplies can inflate based on the activity of the economy, but the gold supply cannot.

So the US, along with some other countries before it, said "fuck it" and unpegged their currencies from gold. The USD would be worth what you could get for it on the open market, rather than some arbitrary amount of gold. Meaning that the USD (and the rest of the currencies) would be worth the total value of that country's economy divided by how many units were out in circulation.

Inflation resulted because suddenly, currencies were free of the gold restraint. People with excess currency had to spend it somehow because they couldn't just demand gold. The velocity of money increased and fed upon itself (attitudes shifted from "I've got to spend this SOON, because prices keep going up" to "I've got to spend this NOW, because prices are going up even faster!")

Inflation is bad, but the other choice was worse: force the currency to deflate to protect your gold. The value of labor drops because everyone is competing for a fixed amount of gold. Where inflation incentivizes people to spend and invest, deflation incentivizes them to hoard. Why should I buy something (whether goods or labor) today when I can get the same thing tomorrow, for cheaper?

And that's why rich guys want to go back to a gold standard.
posted by gjc at 6:28 AM on January 29, 2012 [6 favorites]

Two other things as well, not to contest much of the above.

(1) A lack of defenses in the corporate culture. Corporations in the US and Europe today have a tremendous facility to keep their costs down. That facility simply didn't exist then -- in fact, the high-inflation era in large part created the modern industry of supply-chain consulting, much of strategy consulting, much inventory management practice and theory, the beginnings of off-shoring and outsourcing ... to say the least of creating a powerful discounting-based retail culture. Like it or not, Wal-Mart is a huge bulwark against inflation.

(2) Perverse contract structures. Past mild inflation has led to the negotiation of consumer price and wholesale price indices-based escalators into many long-term contracts for goods and services, as well as cost of living wage increases in collective bargaining agreements. These contract provisions created a very powerful feeback loop as inflation accelerated. Someone on the wrong end of those contracts had to raise prices to spot-market customers, and because of the lack of defenses, people had to pay those higher prices (and raise their prices) in turn, all of which led to another ratchet up in the indices, starting the cycle again. Inflation-based escalators are hard to find in contracts for goods and services these days, and private sector production unionization is dramatically less as a percentage of consumption (when you consider private sector unions are high diminished in the US and that essentially no Asian or Eastern European production is effectively unionized).
posted by MattD at 6:51 AM on January 29, 2012 [2 favorites]

The best discussion of inflation as a major economic problem that I've seen is The Way Ahead: A Framework for Discussion, a 1975 paper published by the Government of Canada (written primarily by Ian Stewart). From the paper:

A search for future directions must begin with an understanding of current economic conditions and, in particular, the inflationary process. Simplistic explanations of inflation are bound to be incomplete and misleading. Inflation is a complex economic, social and political phenomenon, both in its origins and in its effects.

One of the characteristics of a period of continuing, rapid inflation is that expectations that prices will continue to escalate become deeply entrenched. Groups with market power demand higher wages and prices in order to offset not only past inflation but anticipated future price increases. Those individuals and groups who cannot 'keep up' in this process—those with fixed incomes, those who cannot work or cannot find work, and many who simply lack market power—suffer a loss of real purchasing power.

This leads to increased demands on governments to redress the inequities bred by inflation. Increased government spending can lead to higher prices if the government simply prints the money or if additional taxes levied to finance these expenditures are passed on to others through higher wages and prices. Excessively high wage settlements and pricing decisions impose higher levels of cost, leading directly to higher prices. Expectations escalate and inflation continues to feed upon itself.

The debilitating effects of inflation extend beyond economic considerations to threaten the very nature of our institutions and traditions.

How was inflation brought under control? The Federal Reserve, under Paul Volcker, raised the federal funds rate from 11% to 20%. This brought on a major recession, but succeeded in bringing down inflation.
posted by russilwvong at 9:19 AM on January 29, 2012 [1 favorite]

Price increases are not inflation, in spite of what the news readers say. Price increases are often an indication of inflation but they are not, in themselves, inflation.

Inflation is an over-supply of money in the economy. This is controlled soley by the government.

Not necessarily. From Wikipedia: In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services....Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply...The term "inflation" originally referred to increases in the amount of money in circulation, and some economists still use the word in this way. However, most economists today use the term "inflation" to refer to a rise in the price level. An increase in the money supply may be called monetary inflation, to distinguish it from rising prices, which may also for clarity be called 'price inflation'. Economists generally agree that in the long run, inflation is caused by increases in the money supply. However, in the short and medium term, inflation is largely dependent on supply and demand pressures in the economy.

This topic is the subject of some debate. In any case, the wikipedia article on inflation is a good place to start to get a general understanding. Here are a few more:

The Inflation of the 70s by Brad DeLong

What Causes Inflation? on Seeking Alpha
posted by triggerfinger at 9:29 AM on January 29, 2012