The Arduous Path Back to Stability and Growth

At a time when terms like “supply shock”, “cost of living”, “industrial action” and “stagflation” proliferate in the media and inflation is becoming people’s biggest private fear in one country after another, it seems worthwhile to recall how the stagflation of the 1970s was overcome.

In two waves between 1971 and 1981, the cartel of major oil producers pushed the price of a barrel of petroleum up fivefold. This shock came on top of the massive costs of the Vietnam War and the proliferation of redistributionist public welfare (Kennedy and Johnson’s Great Society and even more interventionist welfare-statism throughout Western Europe) to upset the broad equilibrium between a slowly growing aggregate supply of goods and services and the more fickle demands of consumers, investors and governments. Public-sector deficits and easy money allowed many to raise prices, while few felt obliged to mark their prices down. The weighted average of all prices—the price level—rose at an accelerating clip. Further inflation was widely expected. Whoever had market power built inflationary expectations into next year’s prices and costs. Price-wage-price spirals were set off. As the anchor of stable cost and price expectations was lost, strikes, uncertainties and unexpected losses hampered production and employment. The poor became poorer, the rich richer, and the public mood more sombre. A new word—stagflation—was coined.

This essay appears in September’s Quadrant.
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International currency crises added to the dislocation. They became an almost regular weekend event. Countries such as West Germany, whose citizens were ready to make greater sacrifices to stop the chaos, suffered unwanted balance-of-payments surpluses and imported inflation. Strike-and-deficit-prone countries, such as the UK and Italy, suffered capital flight, grievous balance-of-payments deficits and “corrective” interventions in markets. The direction, though not the exact timing, of stepwise exchange-rate adjustments was predictable. Anyone with access to credit was able to place almost risk-free bets against weak currencies: you borrowed a few million of the weak currency and bought strong currencies over the weekend, and repaid the loan on Monday with funds bought on Friday cheaply in the futures market. If bad came to worst and a devaluation was postponed, this arbitrage set you back by a few days’ loan interest. But a devaluation, when it eventually occurred, would make you effortlessly as rich as George Soros. 

The Bretton Woods regime of fixed, but occasionally adjusted exchange rates had been inven­ted in the early 1940s by Dexter White—an official in Roosevelt’s Treasury who was later unmasked as a Soviet spy—and British wunderkind John Maynard Keynes. The system was named after a huge crate of a hotel in the woods of northern New Hampshire, where officials from forty-four governments met in 1944 to sign the agreement that established a new regime of international finance. But that system could only function as long as international capital flows were controlled and participating governments followed similar monetary and fiscal policies. By 1960, the system began to crack. Tying currencies to the US dollar, and indirectly to gold, forced authorities to lie and deny, disrupted trade and capital flows, made some countries lurch from one crisis to the next, and enriched the few able to bet against slow-footed governments. By the late 1960s, it was patently evident that fixing the price of national currencies was sheer folly.

For a long time, a country’s volume of money had been tethered to some scarce material, such as the slowly growing quantity of gold, or cowrie shells in the Papua New Guinea highlands (but of course not on the beach where shells could be easily picked up). This was necessary, because money can only function, as a means of payment, store of value and unit of account, if it is scarce. Gradually, these tethers, which inhibited the opportunism of the rulers, were jettisoned and replaced by a discretionary “finance-minister standard” around the US dollar. By the 1970s, this standard had proved unreliable, crisis-prone and inflationary.

The traumas of the 1970s stagflation refocused the minds of policy-makers on price-level stability. The insights of classical monetary theory were again widely accepted: inflation is a monetary phenomenon. No increase in the money volume, no inflation! Inflated quantities of money were the real, the underlying cause of inflation, whatever the immediate triggers were: oil-price increases, pandemic shutdowns or strike waves. With a stable money volume, such triggers would be compensated by the drop of other prices. Over the medium to long term, price-level stability thus requires the consistent control of the money volume. Flexible exchange rates among national currencies—coupled with credible controls of national money volumes, that is, an apolitical “central-bank standard” of money—was seen as essential to overcome stagflation.

Many national central banks were now given the task of strictly controlling the printing press to finance government deficits. To this end, they were made more or less independent of opportunistic politicians. They were empowered by the flexibility of exchange rates, which eliminated the danger of imported inflation. Indeed, they were handed a powerful new instrument: at a time of overheating, monetary policies could not only push up interest rates and thus curb borrowing by investors, but also appreciate the exchange rate, thus making imports cheaper and curbing export demand. Central banks got this new power to affect the economy, but they were now obliged to use it in the service of price-level stability. No central bank could again claim that national inflation was due to inflation elsewhere.

The redesign of monetary policy owed much to a meeting of leading bankers and academics initiated by Chicago economist Milton Friedman. Many of the academics he invited belonged to the Mont Pelerin Society, an international academy of freedom-oriented scholars and opinion leaders. About five dozen experts and practitioners from the US, Europe, Brazil and Japan came together. After a preliminary meeting at Oyster Bay, New York, the group met over ten days on the Bürgenstock ridge high above Lake Lucerne in Switzerland. I became the Benjamin of what became known as the Bürgenstock group when I was co-opted as a greenhorn economist, because I had analysed these issues for the German parliament’s Council of Economic Advisers. 

At meetings between 1968 and 1971, the Bürgenstock group first established that freely floating exchange rates were technically feasible. Sceptics argued that all the world’s telephone lines would not suffice to handle the spot and futures currency markets, that flexible rates would trigger ceaseless litigation, economic disintegration and political conflict, that it would handicap “export champions” like Japan and West Germany, and much more. 

At a time when bids to buy or sell currencies were communicated over the telephone with slide rule in hand, concerns about technical capacities had to be taken seriously. But the practitioners in our group put our minds at ease. Of course, no one in 1968 could have foreseen how the communications revolution would enhance speedy interaction, calculations and the recording of deals. On fears of costly litigation, the practitioners predicted correctly that massive litigation would not be an issue. Currency traders would rely on the speedy resolution of disputes by private arbitrators, so as to let their business run on, instead of wasting time and money on appeals to slow and expensive national courts. Nowadays, trillions of dollars are traded every year, millions of dollars of profits and losses are at stake. Yet, have you read much about court cases? Most in the Bürgenstock group were agreed that the slight undervaluations of the mark and the yen, which advantaged German and Japanese exporters, ought to give way to genuine equilibrium rates. And most agreed that freely floating prices for national currencies would enhance international economic integration as compared with the crisis-plagued present.

Over ten days of intensive conference sessions, private argumentation and intellectual arm wrest­ling, the protagonists of free currency markets won the day. All participants signed a letter to the New York Times and the Neue Zürcher Zeitung that summarised our findings. The conference papers were later published by Princeton University Press.

The Bürgenstock conference was a mammoth exercise in honest analysis and mutual persuading, in the course of which the particular self-interest of certain bankers, of finance directors of multinationals like IBM and Exxon and of high-level officials like Kennedy’s Treasury Secretary Robert Rosa capitulated to facts and compelling logic.

The epoch-changing outcome of the meeting owed much to the atmospherics on the Bürgenstock. Professor Fritz Machlup, who acted as a kind of maître d’, made sure that antagonists sat together at meals or walked the hotel corridors together, as the Alpine weather was foul most of the time. When I contradicted an Italian colleague, who advocated a fixed exchange rate between Italy and Germany as a means of forcing hitherto divergent inflation cultures and fiscal-monetary policies together, Machlup obliged me to sit down at my travel typewriter and hammer out the argument that divergent inflation trends were so deeply entrenched that fixed exchange rates or a common currency would lead to grave political tensions and eventual disruptions of cross-border trade and investment. A common European currency would also lead to higher inflation in economies with hitherto stable price levels. Alas, the lamentable story of the Euro block has proven me right.

Not all analysis and argumentation took place in the cold light of day. The evenings saw us consuming the duty-free that the overseas participants had brought. Bedrooms became cocktail lounges, with room service being kept busy with orders of soda, tonic water and buckets of ice. When the duty-free ran out, accompanying wives descended to the lake below, took the steamer into Lucerne and returned with suitcases full of grog. Thus, many differences of opinion were resolved not only with the rational side of the brain, but also by gut reactions in a more tipsy manner. No approach to consensus was left untried.

Half a year after our hyper-intensive seminar on the Swiss mountain top, our group met again, this time in mid-winter in a grand mansion in the Adirondacks, upstate New York. We were joined by top policy-makers, such as the earnest, even sombre Paul Volcker of the United States and the jovial Otmar Emminger of Germany. Officials from the International Monetary Fund and the United Nations were deliberately not invited, as we wanted to focus our messages exclusively on genuine decision-makers. In official sessions and many face-to-face encounters, we argued with our guests about the consequences of sundering the residual ties of national currencies to gold and the US dollar. With that tenuous, failing standard gone, money-supply policies had now to be bound by credible rules. None in our group was more outspoken than the brilliant debater Milton Friedman, who was in top form and held us all spellbound. 

This is where the post-war Bretton Woods system was intellectually buried, and rule-bound national monetary policies, freed from fixed ties to the US dollar, were born. The Nixon administration’s sundering of the dollar-to-gold link and the floating of the German mark were, for us, mere implementations of what we had thought through. Paul Volcker ended the entrenched inflation in the US, most certainly not a pain-free cure. And the stability-oriented Bundesbank joined in launching a period of low inflation and decent economic growth around the Western world.

Australia came late to the era of new monetary policy. The exchange rate was only floated by the Hawke government during the mid-1980s and the essential corollary to exchange-rate flexibility—strict control of money printing by a central bank independent of the politicians and bureaucrats—was only adopted imperfectly and belatedly in the 1990s. The cost of the reform lag was the prolonged pain of masochistic monetary restraint under the Fraser government, who left the highly regulated real economy untouched. Many businesses went broke, and unnecessarily poor economic growth turned the 1970s into a lost decade. Monetary expansion and fiscal spending programs translated into more inflation, and unemployment ratcheted up with each downturn in the business cycle. Ubiquitous Keynesian demand stimulation failed conspicuously.

The monetary reforms of the late 1970s and early 1980s in the major economies were flanked by more of an opening of national borders to trade, investment and enterprise, as well as an across-the-board deregulation of domestic markets. The often hotly contested and painful reforms paved the way for over thirty years of prosperity, a decent degree of price-level stability and peace among the major nations. The improvements in economic freedom, which are rightly linked with the names of Reagan and Thatcher, brought globalisation and a new, contagious can-do optimism. The spirit of capitalist enterprise spread to more and more countries. Some 600 million of the world’s poorest joined the ranks of the lower middle class, and dire poverty became the fate of a minority in warring and dictatorial Third World nations. The new openness helped the citizens of the affluent nations to benefit from cheap imports, as several hundred million workers in the Third World learnt the skills and work attitudes needed to compete in modern industry. In neo-capitalist China, more—though far from perfect—economic freedom turned producers in this huge economy into effective inflation fighters for the affluent economies. Observers spoke of a new “golden era”. A leading book on monetary history (by Glyn Davies in 1994) even concluded that inflation was now a problem of the past.  

Our expectations have been sorely disappointed. Were those right, who argued that trusting central bankers and allowing currencies to float freely was an unwarranted risk? That only a return to the gold standard could ban inflation for good? What went wrong?

The premature creation of the transnational Euro block knocked the resolutely anti-inflationist German Bundesbank out of the stability front, to the satisfaction of many politicians. At least since the 1997 Asian financial crisis, all central banks have broken the rules by pumping out unprecedented volumes of paper money to bankroll the deficits of short-sighted, unscrupulous governments and influential private borrowers. For a while, price expectations remained stable and thus postponed the full inflationary consequences. But as of 2022, we are bound for persistent inflationary turmoil and an economic crash landing.

The history of healing the major economies of stagflation forty or fifty years ago will not be precisely replicated. New and diverse political and economic players have joined the ageing Western nations; the volumes of public and private debt now far exceed what plagued us in the 1970s; the printing presses have churned out volumes of money that cannot be easily hauled back. The real value of excessive money stocks will probably need to be reduced by years of inflation. The political priority of combating assumed man-made global warming is now creating massive energy bottlenecks, pushing up energy costs and thereby feeding future inflation.

Arguably, more seriously still, generation change has brought profound cultural changes. People now expect governments to protect them from all pain, everybody is averse to sacrifice and the denial of facile satisfaction. Overcoming the prospective stagflation of the 2020s and early 2030s will in the final analysis require changes in deep-seated values and moral attitudes. And we know how hard and time-consuming such changes are. I—constitutionally given to optimism—dare not assume that the trauma will be temporary. A dark decade lies ahead. Some nations will slay the inflation dragon sooner—I would place a bet on Switzerland. Others will struggle with repeated crises—I think of centuries of Spanish bankruptcies, Tsarist Russia bombing out of the gold standard, or Italy’s far niente in the face of near-permanent bankruptcy.

Half a generation of traumatic experiences will eventually make firm rules of monetary stability acceptable. This time round they will have to be strictly and consistently enforced. In most nations, it will be necessary to cut back the burdens of government, although international conflicts will impose unavoidable new costs. And it will require courageous politicians who permit as much competition in capital, labour and product markets as it takes to produce a rise in entrepreneurial creativity. Nonetheless, the core elements of the 1980s recovery—stable money, smaller government, freer markets—and the political courage to oppose particular interests will again have to become the policy priorities if the huge task ahead is to be resolved.

Professor Emeritus of Economics Wolfgang Kasper worked on international economic issues at the German Council of Economic Advisers, the Malaysian Treasury, the OECD, the Reserve Bank of Australia and the Federal Reserve of San Francisco

One thought on “The Arduous Path Back to Stability and Growth

  • Elizabeth Beare says:

    It will take courageous politicians indeed, Professor Kasper, to return to small government, stable money and freer markets to tame the inflation bear. Especially when we have such huge market interference in the engery supply. Also, given the outline of the changes in popular expectations in the past two or three decades that you recognise, I doubt if we will readily see such political courage and suspect we’ll see more chaos first.
    As a child, I recall the British Housing Commission dwellers (for such there were in those days in Australia as newcomers found their feet) all talking together about something mysterious called ‘the gold standard’ which seemed to have popular approval in the 1940’s and even early 1950’s amongst these seekers of better times in Australia. It was a myth even then, but people clung to it as a sign the post-war world would be stable.
    There is far less sense of currency stability now.
    On a personal rueful note about international currencies and our credit reliances, we arrived last night after the flight from hell (five hours spent locked in transit in a New Zealand airport corridor on the floor, no seats) on holiday to Rarotonga, arriving in this Pacific paradise clutching two credit cards with our perfect credit rating, to find them both declined for a hotel holding deposit! Computer says no was a sad reality. Luckily, we had others with another bank and, as a woman of another generation, to my husband’s derision I always carry spare cash, so I did a Nigel Farage. Who’s laughing now? I asked him.
    A small reminder of how easily such currency things can gang awry.
    Will we ever be reduced to pawning our diamond rings?

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