The period of high inflation in the 1970s and the approaches to solving it

Monetarism and Keynesianism clashed during the hyperinflation of the 1970s over solutions to combat inflation. The parallels to today are striking.

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The high-inflation period triggered by the oil price shock shook the economic policy of the 1970s. Never before had policymakers been confronted with a situation in which supply and demand drifted apart practically overnight, and the money supply—previously the connective mechanism of the market—lost its ability to signal prices. Two schools of thought, especially in the Anglo-Saxon world, competed for intellectual dominance in finding a solution to curb inflation.

Keynesianism, in this situation, advocated a demand-oriented economic policy. This means steering the economy through government regulation of demand and public-sector consumption—for example, by building infrastructure. The regulation of the money supply through monetary policy, however, plays only a subordinate role in Keynesian thought. According to Keynesians, the market reacts too slowly to monetary influences to be effective during a crisis. Consumption, government spending, and export surpluses thus formed the main pillars of Keynesian economic policy.

Monetarism, by contrast, promotes intervention in the economic cycle through control of the money supply. If fewer industrial goods can be produced due to an oil shock, the central bank must adjust the money supply downward to preserve the value of money. “The recognition that substantial inflation is always and everywhere a monetary phenomenon is only the beginning of understanding the cause and cure of inflation,” said Milton Friedman of the University of Chicago in 1980. Controlling the money supply, he argued, influences inflation, and by controlling the money supply one can influence future interest rates. Money is subject to supply and demand just like goods, and thus shapes business expectations and the production of goods.

The Keynesians counter this monetarist argument by stating that due to the unstable and often speculative demand for money, monetary policy cannot be relied upon to regulate demand. In contrast, the state incurs no costs when it needs to obtain money itself. Therefore, it does not require financial reserves. Most of the time, it finances its expenditures through the banking system. A state's monetary holdings are negligible, but banks generously finance it with government bonds and similar short-term securities. By the end of 1976, for example, the money supply in Great Britain amounted to 45.1 billion pounds sterling, whereas the government’s bank deposits amounted to only 0.9 billion pounds. According to Keynesian theory, recessions should be fought through public spending. The money supply is relevant only as a factor influencing fluctuations in the private sector. The public sector, however, can borrow money at will and is not constrained by a lack of liquidity.

The problems with this approach became evident in the 1960s and 1970s. Keynesian theory, whose proposed solutions and policy recommendations ultimately prevailed in public discourse, was used by ideologically driven politicians and bureaucrats as a pretext to further expand public spending. This would not have been a problem if, after a generous round of government expenditures during recession periods, these expenditures had been scaled back again during economic booms. In reality, recessions were fought with public spending, while booms were dampened with restrictive monetary policy. The private sector was disadvantaged in every respect: during recessions, government spending crowded out private investment, while during boom periods, entrepreneurs had to pay excessively high interest rates due to the state’s competition for credit.

The Austrian School Between the Two Camps

Caught between the two major Anglo-Saxon schools of thought, the views of the Austrian School were largely sidelined. Hayek agreed with the monetarists that an expansion of the money supply triggers a so-called “demand-pull inflation”—an increase in the money supply raises nominal incomes, which pushes up demand while production remains unchanged. The main difference between Hayek and the monetarists, especially Friedman, is that Hayek criticizes the quantity theory of money. It focuses too narrowly on changes in the money supply and their effects on the price level, the negative effects of inflation and deflation, and the relationship between debtors and creditors. In doing so, it ignores the negative effects of injecting and withdrawing money from circulation on relative prices and the resulting misallocation of resources, particularly in investment decisions.

Figure 1: Friedrich August von Hayek, January 27, 1981, on the 50th anniversary of his first lecture at the London School of Economics. (Source: LSE Library, Wikimedia Commons)

A stable price level and a high, stable employment rate do not require the money supply to remain constant or grow at a fixed rate. A constant money supply does not automatically mean that the flow of money remains constant. Instead, the money supply must be maintained at a level that prevents people from either reducing or increasing their overall spending, even when their liquidity preferences change. To keep the flow of money stable, the money supply must therefore possess the flexibility that centrally controlled monetary systems lacked. Central banks, according to this view, cannot determine the optimal money supply—this can only be achieved through the free interaction of market forces. Hayek also rejected Friedman’s idea of a constant growth rate of the money supply, arguing that if the permitted expansion is fully used while the public’s demand for money continues to increase, no additional liquidity could be created.

Inflation, in decentralized monetary systems, can be stopped anywhere and at any time. A high inflation rate signals to money providers that too many of their banknotes are in circulation—they must respond by reducing their money supply. A gradual stabilization of inflation rates is not advisable, as it would unnecessarily prolong the subsequent recession. This was the case in the United States between August 1920 and February 1921. During this period, prices fell by one-third. Although the economy suffered significantly, it recovered substantially within six months. The German Reich faced a similar situation during the hyperinflation of 1923 and eventually contained it by restricting the money supply.

The High-Inflation Phase of the 1970s

In the United States, the central bank (the Federal Reserve) focused in the 1950s and 1960s on a monetary policy intended to keep inflation under control while maintaining stable economic growth. A central guiding framework of U.S. monetary policy was the Phillips Curve. New Zealand economist A. W. Phillips identified a negative relationship between unemployment and inflation: when inflation was high, unemployment was low, and vice versa. In the Keynesian-inspired environment of the time, policymakers believed that the main economic policy tools could offset one another: loose monetary policy could counter restrictive fiscal policy, and restrictive monetary policy could counter loose fiscal measures. Thus, negotiations on tax increases began in 1967 to address the growing federal deficit. However, it was not until mid-1968 that an agreement was reached, turning the deficit into a budget surplus. Despite this tax increase, the money supply continued to expand significantly, and inflation kept rising.

In the United Kingdom, a kind of consensus existed at the same time between trade unions and companies: unions agreed to moderate wage demands below productivity levels, while companies in return implemented only modest price increases. But this harmony broke down when the economy began to stagnate: productivity growth slowed, and inflation surged in 1969. When inflation reached seven percent at the end of 1970, trade unions demanded sector-specific wage increases of up to 37 percent. Measuring actual inflation in the UK was additionally problematic, because wage and price controls obscured the true rise in individual prices. One year later, the money supply expanded explosively—growing by 60 percent over the next two years. This was primarily due to a massive increase in bank lending, exacerbated by high levels of government debt, which further inflated the money supply.

The contrasting development of high inflation combined with low unemployment, and vice versa—described by the Phillips Curve—also disappeared during this crisis period. The loose monetary policy of the 1970s, which accepted high inflation rates, did not lead to falling unemployment. Instead, a new phenomenon emerged, which became known as stagflation: an economy with almost no growth but simultaneously high inflation.

The Oil Price Shocks Hit the USA and the UK

Under these already critical conditions, both Anglo-Saxon countries were struck by a tightening of global energy markets, as OPEC states—driven by geopolitical tensions—sought to demonstrate their power. Oil prices in the United States quadrupled. The United Kingdom, whose oil supply depended even more heavily on OPEC, was hit even harder.

The Federal Reserve argued that this had nothing to do with monetary policy and instructed that oil and energy-intensive goods, which made up 11 percent of the consumer basket, should simply no longer be included in the calculation of the Consumer Price Index. Shortly thereafter, food prices rose—this was attributed to the weather conditions of 1973. Consequently, food items, which carried a weight of 25 percent, were also removed from the consumer basket. This adjusted basket became known as the core inflation rate, and it is still used today by economists to assess the current cost-of-living crisis in the aftermath of COVID-19 and the war in Ukraine. The justification is that energy and food are volatile goods whose prices fluctuate due to distant wars and weather phenomena such as El Niño in agriculturally important export countries—and these fluctuations cannot be influenced by domestic economic policy.

Although this reasoning is understandable, it overlooks the fact that high food and energy prices eventually spill over into the prices of all other goods in the consumer basket—as current economic forecasts, for example in the United States, indicate. Moreover, consumers must bear these costs regardless of where they arise. But the Federal Reserve went even further. Using similar arguments, additional goods were removed from the basket: motorhomes, used cars, children's toys, and even gold jewelry. In the end, only 35 percent of the original consumer basket remained—yet the Consumer Price Index still rose at double-digit rates. It was only at this point that the U.S. authorities admitted: the United States had an inflation problem.

In the United Kingdom, recurring strikes disrupted the country and led each time to higher wages. However, productivity gains were insufficient to finance these wage increases. As a result, wage growth no longer led to higher real wages but instead drove inflation to unprecedented levels. Overall, the economic situation in Britain was dire: 1.5 million unemployed accompanied the economic downturn, and living standards fell. The country earned the label “the sick man of Europe.”

Confidence in the British pound also deteriorated after the recessions of 1974 and 1975. Financial markets sold off the currency, and the pound plummeted further. In the end, Britain was left with high debt, cut off from international financial markets, and an inflation rate of 25 percent. Attempts by the Labour government, together with trade unions, to regain control failed. The growth of the money supply exceeded the annual target of 9 to 13 percent. Even raising the Bank of England’s key interest rate from five to seven percent was insufficient, and massive rate hikes followed—up to 17 percent.

The Turning Point

In 1979, a decisive shift occurred at the Federal Reserve under its new chairman, Paul Volcker. In the United States as well, interest rates were raised rapidly. However, the high unemployment rate of seven percent made authorities nervous, leading to a temporary reversal of the rate increases. The Federal Reserve then adopted a new monetary policy approach: instead of managing the daily interest rate, it focused on controlling the money supply—specifically, the volume of bank reserves. Under this restrictive policy, the key interest rate rose to 20 percent by the end of 1980. These high rates triggered a severe recession, rising unemployment, and liquidity shortages for businesses.

The government in office at that time under Ronald Reagan was fully aware of these consequences. However, combating inflation had priority, and Reagan supported the Federal Reserve’s efforts—even though the institution faced harsh criticism. But inflation began to fall: in 1982 it dropped to 6.1 percent, and further to 3.7 percent the following year. The recession reached its low point during this period, while unemployment peaked at 10.8 percent. Yet, as inflation subsided, the economy and employment finally began to grow again. In retrospect, although the interventions were extremely painful in the short run, they succeeded in stabilizing the uncontrolled rise in prices and its damaging effects on the economy in the long term. The sharp fluctuations in inflation rates also subsided, and the economy entered a phase of more stable growth.

Figure 2: Demonstration during the British miners’ strike of 1984, protesting against the Thatcher government’s measures to break the power of the trade unions. (Source: Nicksarebi, Wikimedia Commons, 2008)

Britain continued to be shaken by strikes. By the late 1970s, inflation reached 12 percent. The strategy of maintaining an undervalued pound to boost exports also failed—imported inflation still had to be compensated for by wage increases, meaning the country did not become more competitive. The trade unions stifled nearly every economic advancement that could have led to higher productivity. For example, they opposed the electrification of locomotives because it would have rendered coal shovelers on trains unemployed. It was only the succeeding government under Margaret Thatcher that managed to regain control of the situation—through strict laws that put unions on a very short leash.

New approaches were also taken in monetary policy. The growth of the money supply was to be limited much more than before. Its expansion was reduced to 7–11 percent in 1980 and further to 4–8 percent in 1983. The budget deficit was cut by more than half, from 3.75 percent to 1.5 percent.

Milton Friedman’s Interpretation of the Inflation Phase in the Anglo-Saxon World

In his 1980 book Free to Choose, Friedman lists three key reasons for the runaway inflation in the United States from 1965 to 1980.

First, increased government spending does not lead to more inflation if these additional expenditures are financed by taxes or loans. But since taxes are unpopular—while inflation, which likewise acts as a form of taxation, is far more convenient for governments—policymakers preferred the latter. No one notices this form of taxation, yet the government can still finance more spending.

Second, the goal of full employment, while noble, is in practice poorly defined and far more complex. The labor market is constantly in motion: new products and services enter the market, others disappear. Demand for one rises while declining for another. Achieving full employment amid these constant changes is difficult. Government spending lowers unemployment, while taxes increase it. Thus, the policy of full employment creates a strong incentive to continually increase government spending while lowering taxes. This widens the fiscal gap, which governments then cover by drawing money from the central bank—leading to state-driven inflation. Commercial banks further fuel this process by selling government bonds to the central bank and then lending the proceeds privately—expanding the money supply even more.

Lastly, Friedman argues that the Federal Reserve focused too much on interest rates instead of monitoring and controlling the money supply through the buying and selling of financial assets. As a result, central banks in industrial countries ultimately lost control of both interest rates and the money supply.

Friedman rejects the claim that the oil shocks of the 1970s were responsible for the decade’s extreme inflation. He illustrates this using the example of Germany and Japan in 1973. Both countries were one hundred percent dependent on oil imports. Yet Germany's inflation fell from seven to under five percent during the oil crisis. Japan succeeded in reducing its inflation rate from 30 percent to five percent. Both countries pursued monetarist monetary policies. The United States, however—although only fifty percent dependent on foreign oil—experienced very volatile inflation.

Lessons for a New Period of High Inflation

The parallels to Europe’s current situation are difficult to ignore. The challenges in the real economy are manifold:

• The lockdowns during the COVID-19 pandemic disrupted consumer behavior,

• global supply chains were thrown into disarray,

• production facilities struggled to keep up with demand for numerous consumer goods,

• while many service businesses lay idle for nearly two years.

Finally, Russia’s invasion of Ukraine shook global markets. Both countries are major exporters of agricultural raw materials and fertilizers, and Russia in particular is essential for Europe’s energy supply—providing gas, oil, and uranium.

Figure 3: Synchronization of restrictive monetary policies in both industrialized and emerging economies. (Source: OECD, 2022)

A significant difference from the situation in the 1970s is the very solid labor market. Unemployment has barely risen—on the contrary, the shortage of skilled workers is preventing many companies from laying off employees, out of fear they would not be able to rehire them later. In addition, the global economy today is far more interconnected than it was back then, and the monetary policy of one country now has much stronger effects on others. When the United States raises interest rates, this has a massive impact on many developing countries where loans are denominated in U.S. dollars. Capital flows also shift for other industrialized nations, and these flows are now hardly slowed down by regulatory restrictions.

Most current forecasts underestimate the persistence of inflation following the recent crises. The European Commission predicts a period of stagnating growth accompanied by relatively high inflation rates for most countries in 2023—from just above three percent in the Benelux countries to as high as 16 percent in Eastern European countries. However, we are still far from interest rates of twenty percent and a recession like that of the 1970s. Even though improvements are forecast for 2024, it remains to be seen whether Europe will be able to catch up to the global economy again as it did in the 1970s—because circumstances are changing here as well. Other world regions have long since moved ahead and are now exploiting the weaknesses of the European economy to their advantage.