The Great Inflation and Its Aftermath: The Past and Future of American Affluence
Random House, 336 pp., $26
Random House, 336 pp., $26
AI: Thanks for coming by to talk about your new book, The Great Inflation and Its Aftermath. I learned a lot from it, and found it intriguing.You’re making a bold argument here, what comes to a structural thesis that inflation and disinflation are not dependent variables, but independent ones that have driven, perhaps more than anything else, what has gone on economically and otherwise in this country since the early 1960s. Inflation led to not only the economic problems of the 1970s, in particular, you argue, but to the dour political tone of the age and ultimately to the election of Ronald Reagan. Disinflation from the beginning of the Reagan era until quite recently not only led to the bubbles—first the stock market bubble and then the housing bubble—but to much else besides, including, possibly if not presumably, the election of Barack Obama.You do say that other factors come into play in describing how an economy inflates and disinflates, and you’re not making a unifactoral argument or claiming that that causality runs one and only one way. But you are taking a key dimension essentially of monetary policy out from behind the curtain and putting it stage center. This is an unconventional argument if I understand you correctly. Robert J. Samuelson: You do, and you’re one of the only people who has gotten it so far. My argument is not that disinflation directly caused the current financial crisis, for instance, but that it created the conditions in which the current financial crisis was nurtured. Basically, monetary policy and the ideas that shape it are much more important than generally acknowledged.The argument is basically this: After Volcker and Reagan crushed double-digit inflation in the early 1980s, there was a precipitous decline in inflation and a gradual decline in interest rates as people began to realize that there had been a major change. The Federal Reserve simply was not going to let inflation get out of hand in the future the way it had in the past. And as this happened, first, stock prices began to rise consistently, year in and year out. There were some interruptions, including some dramatic ones in 1987, but generally the direction was up, and it was up by large amounts. You have to remember that in 1982 the Dow Jones Industrial average averaged less than a thousand; it was no higher in nominal terms than it had been in 1965. By 1999 it was over 10,000. So a whole generation of investors and portfolio managers was conditioned to expect that, basically, the market goes up. Sometimes it goes down a bit, or pauses, but, if you wait, it goes up again, and by substantial amounts.In time this climate encouraged a kind of recklessness; risk seemed to disappear as a practical matter. The first consequence of this was the tech bubble of the 1990s, where not only did the prices of these dot-com companies rise to stratospheric levels, but companies were financed that essentially had no plausible business models. They were financed on the theory that having a business model didn’t make any difference, because you could take these fledgling companies public, sell them at high multiples, and clear your investment many times over. So a very permissive psychology developed that rationalized what proved to be in retrospect silly decisions by people who were pretending to be sophisticated.AI: And the same logic migrated from the tech bubble to the housing bubble, right?Robert J. Samuelson: Yes, the same thing happened with housing. As interest rates went down, housing prices went up. Credit conditions got easier and easier because people said, well, prices are going to go up forever, so even if we make bad loans we can sell the underlying asset—the house—for more than the loan. So this basically facilitated and enabled all the things we’re now blaming for the current crisis.It is, unfortunately, the last climactic consequence of this inflation/disinflation cycle that I think is the most important economic event of the past fifty years. Unfortunately, it’s a very bad consequence, but you have to remember that until quite recently the effects of disinflation on the economy and on American society were extremely favorable. What has happened here is that favorable consequences bred unfavorable consequences.AI: Irrational exuberance, as it were, some famous guy once said.Robert J. Samuelson: Self-destructive exuberance, I would call it.AI: You seem to be touching on something deep in human nature that transcends mere economics: the “too much of a good thing” problem. You show that the earlier inflationary era started out looking very good. In 1964 and 1965, when the Keynesian model produced pretty impressive results, people thought, “hey, this works! We actually can control the business cycle. We can create an economy with hardly any unemployment and virtually no inflation at the same time.” Then it went bad, we fixed it and excessive optimism stretched in the opposite direction. Reminds me of that old James Thurber remark: “You might as well fall flat on your face as lean over too far backwards.”Robert J. Samuelson: I myself have used that exact phrase, “too much of a good thing.” And you’re right: We now have two glaring examples of it in our lifetimes that are in fact closely connected.The first example was the Keynesian experiment you just alluded to. The economy in the 1950s performed quite adequately. There were short-lived recessions in 1954 and 1957, but these were mild in comparison to pre-World War II recessions and business cycles. Living standards rose rapidly, and the country generally considered itself to be prosperous and growing.After the war in the 1950s and 1960s, a rising group of academic economists thought we could do better. We could control the business cycle scientifically; we could fine-tune economic behavior. Thanks in part to their advocacy, the country came to be dissatisfied with what it had, so we adopted policies that promised more. We went in for scientific pump-priming, the government itself became a key economic actor as opposed to a moderator and regulator, and we learned to like deficits and ahead-of-the-curve increments in the money supply.These policies did not work for very long. Instead of the business cycle becoming more stable it became less stable. Instead of average unemployment going down, it went up. Instead of a little more inflation being okay by people, we got a lot more inflation that was not okay by people. It was a complete disaster.AI: And when the disaster peaked in 1979 the political culture was enough shaken to resolve to change course, whatever the price.Robert J. Samuelson: Yes, that’s what helped bring Reagan to office, and he and Paul Volcker rung inflation out of the economy, ushering in twenty years of prosperity.AI: Only 16 total months of recession out of twenty years; that’s pretty good. But the key is your account of why this happened. It wasn’t the Vietnam War or the oil shocks that caused inflation, as so many think, and it wasn’t the Reagan tax cuts that really caused the good times thereafter. In both cases, you argue, it was ideas about monetary policy—first bad ideas, and then better ideas (that nonetheless gave rise to other bad ideas).Robert J. Samuelson: Right, the good times have now ended badly because people drew the wrong conclusions from too much prosperity for too long.AI: It’s really about hubris when you get right down to it, isn’t it—the idea that we believe we can control more than we can in fact control? On the way up, the inflationary spiral seems to me to have been of a piece with the so-called behavioral revolution then washing over the social sciences. A lot of people were sure that we could harden the social sciences statistically to be as predictive as the natural sciences. On the way down, after 1979–80, we seem to have been in one of these periodic libertarian swings in American thinking, a kind of socio-economic Darwinism, that markets would be self-regulating. But this was just hubris in a different form: the idea that the new macroeconomic orthodoxy—the Washington Consensus in its export form—had put an end to economic risk and brought forth eternal prosperity. It was just the flip side of the earlier Keynesian hubris, wasn’t it?Robert J. Samuelson: In a way, yes. I’m a great fan of markets. I think they’re both economically and politically attractive. But they’re not infallible. Free markets often go to excess, and when that happens they can do an enormous amount of economic, social and political damage. We are now at one of those moments.I think even free-market types have now begun to realize that you can’t have free markets without a common political system that is competent, legitimate and accepts certain basic principles. The idea of a kind of state-of-nature free market is not socially and politically acceptable in most parts of the world, including the United States. Unless there are institutions that cushion some of the variability of free markets, you won’t have free markets at all, because people just won’t accept them.AI: One of the things I like most about the book is the way you describe the people behind these various ideas. You talk about Walter Heller, about the Phillips curve, about James Tobin and Robert Solow, about Arthur Burns and many others. The pocket biographies are fascinating, but you insist all along that the people have mattered less than the ideas they introduced.Robert J. Samuelson: Yes, this a dramatic case where ideas drove policies. When the ideas were good, the policies and their outcomes were good, and the reverse was also true. That had nothing to do with intentions: Everyone involved was smart and public-spirited. It had everything to do with the fact that when you try to make something work that won’t work, you’ll fail—and the longer and harder you try, the worse the failure.What we discovered is that initially these Keynesian policies worked—or were perceived to work—in part because they were implemented against a backdrop in which people took certain things for granted. They took a crude kind of price stability for granted. So when they implemented policies that were inherently inflationary, they didn’t have inflationary effects right away because people were basing their behavior on what they knew—and what they knew was not inflation. It took a while, but we eventually got the delayed effects of inflation. Once that was injected into the system, people tried to reconcile this higher inflation with the promises that had been made of higher productivity growth, full employment, few if any recessions and certainly no wild recessions. This ultimately led to accelerated inflation, increasing frequency of recessions, harsher recessions and, most importantly (even if there had been no adverse economic consequences to inflation) to the public outrage and fright at what was happening.People hated high inflation because it undermined all the middle-class values of hard work, thrift, saving ahead, deferred gratification. All that was undermined because people didn’t know if their salaries would keep up with prices, or whether their savings would be eroded, or how to plan for the future. All these things were ravaged, so even if one could keep ahead, people didn’t know they could.AI: The psychological effects are crucial—this you make clear throughout the book—and they in turn affect politics. After the Depression and World War II, both Republican and Democratic politicians were terrified of the political consequences of unemployment. They feared that far more than they worried about the eventual inflationary consequences of driving for maximum full employment. Do you think this had anything to do with what was going on more broadly in the ideological domain? Was the obsession with full employment somehow a way to compete with the communists, a way to match their facility at producing full employment but without a command economy?Robert J. Samuelson: Could be. People forget it now, but the word “capitalism” basically went out of the language after World War II. Capitalism as a word was associated with a system that was cruel and capricious.AI: And which crashed in 1929 and caused untold pain.Robert J. Samuelson: Right. Neither businessmen nor government officials wanted to be associated with capitalism, and trade unions were always against it—and this was the age of trade unionism, which joined with management to guarantee stability in return for government promises of “no more big recessions.” So we were said to have a “mixed economy”, which John Kenneth Galbraith described in The New Industrial State in terms of control by the technocrats, the managers. It was managerial capitalism, though, again, no one called it capitalism. The idea was that the marriage between macroeconomic management—which would keep the economy at full employment—and the power of managerial oversight and planning would give you the best of socialism and capitalism at the same time.AI: Let’s move to the international aspects of all this. In the 1950s and 1960s, and even into the 1970s, when people talked about the American economy and talked about inflation, they could pretty much discount the role of foreign governments and foreign trade. Capital flows weren’t what they were to become in later years. The American economy was less dependent on trade. When the government ran deficits, it mainly owed its own citizens. Now we’re seeing an unprecedented transfer of wealth overseas and, until recently anyway, an equally unprecedented flow of that money right back into U.S. financial institutions. Doesn’t this create an essentially different environment from both the inflationary and disinflationary periods you talk about in the book?Robert J. Samuelson: Oh, I think we are in a new era, yes. The book’s relevance to this new era is that, as I explain it, disinflation to a great extent created the world we’re now in. The dismantling of capital controls and the spread of globalization almost certainly would have been much less, and might not have occurred at all, if the United States had not gotten control of inflation. The United States had the most important economy in the world. It had the dollar, which was the central international currency in the world. If we had allowed continued inflation, countries would have attempted to insulate themselves from the adverse effects of our erratic economic policies.What actually occurred, of course, was that confidence in the dollar was restored, the dollar went up, our exports became less competitive on world markets, imports became more competitive here, and we started running trade deficits. As a practical political matter, U.S. trade deficits subsidized the spread of globalization, because most governments regard job creation as a plus. Our deficits were their surpluses. To the extent that job creation was linked to export growth, that was a big plus. Because export growth was stimulated by the high dollar and the large market here, foreign countries faced less competition with American firms based in the United States than abroad. So all of this gave a real impetus to globalization of goods—global supply chains, all that sort of thing.AI: That explains the part about how our money went there; now how about the part where it returns?Robert J. Samuelson: Another way in which disinflation promoted globalization was that it encouraged the free flow of capital. First, as countries began accumulating dollars from the trade surpluses they were increasingly running with the United States, they had to find something to do with those dollars. If they had simply allowed them to be sold on foreign exchange markets, they would have lost the advantage of their currencies being low against the dollar.So they began investing their surplus dollars back into the United States, and the more that kind of reinvestment or recycling occurred, the more pressure mounted to reduce capital controls of all sorts—first on the outflows, because foreign governments wanted their domestic institutions to have as many opportunities as possible to recycle these dollars. But once that happened, it became harder to justify restrictions on inflows. Americans wanted to invest abroad, too, and they didn’t want to be restricted. They argued that the free flow of capital was a good thing for everybody. So you got these pressures resulting from the stabilization of the dollar, the rising value of the dollar, the trade surpluses that they generated, and the general sense that all this was all a good thing.Now, this wasn’t the only influence. Some pressures to dismantle controls came from higher oil prices, which also created trade surpluses among oil producers that had to be recycled. But I think low American inflation, which helped stabilize and strengthen the U.S. economy, was the fundamental change that resulted in the dismantling of capital controls after 1980.AI: Some have argued that, with capital flows basically free, U.S. banks and investment houses had so much money on hand that they were essentially trying to bribe money into being borrowed. The U.S. government was running deficits, but not on a scale to soak up so much money. American businesses already had enough money to reinvest in capital, so they were not going to borrow it. So, the argument goes, a lot of the money was funneled into consumer loans with low interest rates. If so, then this shopping spree we’ve been on for so long now is partly a function of these looser capital flows bringing more money here than we could possibly use wisely. You buy that, so to speak?Robert J. Samuelson: It’s partly a function of that, but I think disinflation was a greater force. As inflation went down and asset prices went up—first stock prices and then housing prices—people began either borrowing against their higher wealth or spending more of their income because they considered their rising asset values as savings. And interest rates came down, not only in nominal terms, but in real terms as well. So the impetus to borrow was greater.The rates came down in real terms because in a very general way interest rates can be deconstructed into three components: one, some offset against expected inflation; some real return that the investor expects; and some inflation risk premium, since you don’t know what the inflation rate will be, so you demand a bit more. As inflation went down, I believe, the inflation risk premium also went down. So you got a reduction in both real and nominal rates and people were encouraged to borrow. I think that was ultimately more important than the recycling of foreign savings here.Now, obviously, this has gone too far. People who were lending relaxed their lending standards too much; people were borrowing who assumed they could borrow forever. Now we’re in a situation where not only financial institutions have to deleverage, but average households have to deleverage. This is a real shock to the economy, and I don’t know how it’s going to come out.AI: Well, while we’re hunting for reasons for our thriftless behavior, what do you make of the influence of advertising culture in the United States, first with television and now the Internet as main vehicle for it? Maybe the inflation/disinflation cycle is necessary but not sufficient to explain what you claim it explains.Robert J. Samuelson: There’s a large set of cultural issues here, no doubt about it. I wrote about that in my 1995 book The Good Life and Its Discontents: The American Dream in the Age of Entitlement. Essentially, Americans are like the dog on the racetrack chasing the mechanical rabbit always just ahead. Americans always want a bigger car, for example, or a car with leather upholstery, or a GPS device or a DVD player in the back seat. It’s a familiar cycle that turns luxuries into necessities.Our proclivity to borrow is to some extent a reflection of our optimism. I think the post-World War II access to consumer credit is basically a good thing, but we overdid it.AI: Maybe it’s a good thing, but I worry about what looks to me to be a fundamental conflict between what we’re taught to believe is good and virtuous behavior on the one hand—patience, thrift, savings, self-reliance—and what financial market success calls for on the other—spontaneity and speed, borrow-and-leverage, consume and do whatever works.Robert J. Samuelson: It bothers a lot of people, I suspect.AI: The past few months have been pretty unusual, I think you’ll grant. Is there anything about your book that you’d change in light of these recent developments?Robert J. Samuelson: I talk about certain tendencies that have come true more quickly and violently than I thought they would. I talk about how finance has become a new source of instability. I talk about how the last effects of disinflation have turned out to be bad, while the earlier effects were generally good. It promoted speculative activity in both the stock market and in the housing market. It promoted lax lending standards among investment bankers. I talk about how the Federal Reserve is attempting to cope with a dilemma: On the one hand, it’s supposed to be the guarantor of currency stability, which would have it restrict how much money and credit to put out. On the other hand, it’s supposed to be the lender of last resort, which would have it shovel out money and credit to stabilize the system during a crisis. It’s not always easy to reconcile these things.So, if I were finishing the writing today rather than in May, I would make it clearer that, in a perverse and paradoxical way, the good of disinflation has ultimately led to the bad of this financial crisis. I could have written that easily without tearing up the book.AI: You talk about the Fed a fair bit, and about the ambiguity inherent in the fact that it’s independent, but still can’t ignore political reality. How does that observation apply now, when what the Treasury and the Fed have done recently in intervening into markets is unprecedented? If it’s an emergency situation we’re in that requires a temporary emergency fix, that’s one thing. But if, as has been the case in past economic dislocations, we end up coming out on the other end of this with a different relationship between the government and the economy, that’s something else. When all is said and done, do you think that relationship will look permanently different than it did a few years ago, or will we find a way to deal with the emergency but then go back to what has passed for normal?Robert J. Samuelson: It’s hard to believe that the relationship won’t be fundamentally changed, because the financial system will be so much more regulated. The reason has to do with two more developments that imply that success or failure in the marketplace will be increasingly mediated by Washington. One is the expansion of the health care sector, which is heavily regulated both by actual regulations and by spending exigencies like Medicare and Medicaid. So the economic well being of actors in the health care marketplace is to a large extent, though not exclusively, determined by political outcomes. The second is the expansion of the domestic energy sector, where the same sort of thing is going on. So you have three sectors now that will be heavily regulated: finance, health care and energy. The fact that you have a backlash against free-market ideology now because of this recession just makes it that much easier to change the relationship.AI: How nervous should we be about that?Robert J. Samuelson: Well, Herb Stein once wrote a marvelous essay about how enormously adaptive American capitalism has been through the years. The capitalism that followed World War II looked very different from the capitalism that preceded the Great Depression; government played a far greater role. And yet, in time, it proved equally dynamic and vibrant. The interventions that we’ve seen recently are certainly unprecedented, but they’re not the most intrusive government intervention in the economy since World War II. That was the wage/price controls introduced by Richard Nixon, which controlled everything from 1971 to 1974. Of course, that policy did fail abysmally, but capitalism survived that failure as well.I don’t want to offer any sweeping conclusions or generalizations, but this is obviously a very critical time. Over the next two to five years we are going to redefine the boundaries between public and private, government and market control, in ways that may last for a generation or more. We’ll have to see what happens.