As Mark Twain is reputed to have said, “History doesn’t repeat itself, but it often rhymes.”
How seriously should we take the recent report that inflation has surged to 4.2 percent? If history is about to “rhyme,” we should take it very seriously.
In 1968, inflation jumped from approximately 2.7 percent to 4.27 percent. Sound familiar? In the preceding years, the government embarked on massive increases in spending through the War on Poverty and the Vietnam War. Following textbook monetary theory, the Federal Reserve raised interest rates from 5.4 percent (on the 10-year treasury) to just under 8 percent in 1970. Inflation rose through 1969 until it peaked in 1970 at around 5.8 percent. The higher interest rates helped to throw the country into a small recession lasting roughly a year.
The Fed then swerved into recession-fighting mode and lowered interest rates again to around 5.5 percent in March 1971. But the Fed was forced to reverse itself again when inflation again roughly doubled from 3.2 percent in 1972 to 6.2 percent in 1973. Then inflation almost doubled again to 11.05 percent in 1974. The country fell back into a longer recession that continued until 1975 while inflation still raged at nearly 10 percent. This “stagflation,” a phenomenon during which a country suffers both high unemployment and inflation, should not have existed according to a theory that held that inflation and unemployment rose and fell inversely.
It takes a lot of education and years of experience to be as wrong as our best economists.
Inflation declined again to the still-unacceptable level of 5.7 percent in 1976. Then, all hell broke loose. Inflation climbed steadily until it peaked at 13.5 percent in 1980. The Fed then went to war against inflation raising interest rates to 15.8 percent at their peak. The inflation/recession combination that crushed so many in the middle class in the late 1970s and early 1980s resulted from a toxic cocktail of heavy government regulation, deficit spending, and supply shocks initially sparked by OPEC-led oil supply restrictions.
Before you conclude that the current era is about to repeat the miserable 1970s, it’s important to review a couple of key differences. Before interest rates and inflation could be re-normalized, the federal government paid huge interest payments on its outstanding debt-peaking in 1985 at 19.2 percent of total tax revenue. Back in 1985, the federal debt was around 42 percent of GDP. Today, the debt is 127 percent of GDP. In the late 1960s, government spending increased from approximately 16 percent of GDP to 19 percent. In the past year, government spending has increased from approximately 20.7 percent of GDP (in 2019) to over 31 percent of GDP (for 2020).
Allow me to restate: In 1985, the government used 1 in 5 tax dollars merely to service the interest on the national debt in an era when the debt was less than one-third of our current debt value in relation to the total national income. If the government is forced to pay double-digit interest rates again, we could see a federal budget all but consumed by interest payments. That could mean drastic cuts in military spending and social services.
So what happens if the inflation genie has again sprung from the bottle? The Fed says the 4.2 percent inflation figure is surprising, but not to worry because the spike is “transitory.” Considering the Fed expanded the money supply by approximately 40 percent in just the last year, the only actual surprise is how resilient the value of the dollar has remained, at least for now. Increasing the money supply intuitively dilutes its purchasing power. Only a subscriber to the idiotic “Modern Monetary Theory (MMT)” could be surprised by inflation at this point.
If you want to know what happens when the interest payments approach total tax revenues, ask Greece. As noted by The Balance, “As a result [of debt repayment austerity], the Greek economy shrank 25%. That reduced the tax revenues needed to repay the debt. Unemployment rose to 25%, while youth unemployment hit 50%. Rioting broke out in the streets.”
In the late 1960s and early 1970s, there were a number of false reprives from inflation. The Fed would be lulled into reducing interest rates again only to have the problem return worse than before. Raising interest rates is a very clumsy tool to use against inflation. Small adjustments have little or no effect. Only when the rates become painfully high do prices stabilize.
Moreover, inflation compounds year over year. Four years of 10 percent inflation erodes purchasing power by 46 percent. Interest rates have to be higher than inflation, or else holding cash becomes financially toxic.
The recent announcement of 4.2 percent inflation is not something we can just shrug off. There’s no easy way to put the genie back in the bottle. There’s a ton of cash being held in banks and vaults. As the cost of holding cash grows (by loss of value through inflation), more cash holders will look for assets to hedge against inflation. When nobody wants to hold cash, more of it is deployed to buy assets, driving prices up even more. It creates a vicious circle that’s hard to stop.
It’s also hard to know where to “hide” from inflation. Higher interest rates will wipe out value in assets that are typically purchased with debt—such as real estate. Borrowers with variable interest rates will be forced to sell assets to cover debt payments. Lenders with nonvariable loans will find themselves stuck with loan payments in dollars that are worth far less than what they lent out.
Is this 4.2 percent inflation rate just a false start of a meltdown that might not happen for years? Or is it the first gust of an approaching hurricane? One thing I will predict: When the storm does come, the Biden Administration will shift blame to the Trump Administration while rushing headlong into the same policies that aggravated the mess in the Carter era: higher taxes, more regulation, and lots of debt. As bad as the pain inevitably will be, bad policies can always make it worse.