In 1971 the rate of inflation was about 4 percent per year, and the rate of unemployment about 6 percent. Although inflation was down from the prerecession peak and was
Probably falling, the public was still annoyed about inflation. In addition, there was a new problem: the United States was awakening to the seriousness of its international financial position.
After World War II, the world’s major trading countries had adopted what came to be known as the Bretton Woods system, named after the New Hampshire resort where the meeting establishing the system was held in 1944. At that conference it was decided that the world would adopt a system of fixed exchange rates with all currencies fixed in terms of dollars. Various rules were set up that allowed countries, under certain circumstances, to devalue their currencies. The International Monetary Fund was also set up to provide short-term liquidity for countries experiencing balance-of-payments deficits, and the World Bank was created to provide long-term investment funds.
The system was, in some ways, like the gold standard, except that the base of the world’s monetary system was the dollar rather than gold. Immediately after World War II, the central problem had been the “dollar shortage”: Countries devastated by the war had difficulty earning the dollars they desperately needed to buy food and capital equipment. Gradually, as Europe and Japan recovered, the dollar shortage turned into a dollar surplus: U. S. imports regularly exceeded U. S. exports. Inflation in the United States contributed to the dollar surplus by making U. S. exports and U. S. goods that competed with imports more expensive.
The U. S. balance-of-payments problem became acute in the second half of the 1960s. Private holders and foreign central banks were accumulating far more dollars than they wanted. America was faced with a run on its gold reserve. On August 15, 1971, the Nixon administration simultaneously “closed the gold window” and imposed a system of wage and price controls. Closing the gold window simply meant refusing to exchange dollars for gold. This action freed the dollar from its “golden anchor” and allowed its value to fluctuate. A brief attempt to reestablish fixed rates, the Smithsonian Agreement, was reached in December 1971; it called for fixed exchange rates, with the price of gold raised from $35 per ounce to $38 (an 8 percent devaluation of the dollar). The growing worldwide inflation made it difficult to stick to fixed exchange rates, however, and one country after another began to float its currency against the dollar.
This sequence of events was reinforced by the ideas of free market economists led by Milton Friedman, who argued that the prices of foreign currencies should be set in the marketplace like the prices of wheat, automobiles, and computers. For a time, some economists hoped that the world would get back to fixed exchange rates, but this did not happen. The resulting system is frequently described as a “dirty float.” Private supplies and demands are the main determinants of exchange rates, but governments often intervene, buying or selling currencies when the outcome of market forces is not to their liking.
Nixon’s system of wage and price controls was intended to show the public that something was being done about inflation, and improve the balance of payments. They were not intended as a permanent policy, but rather as a way of buying time while the United States put its house in order by adopting appropriate monetary and fiscal policies.
Price controls went through a series of phases. The first three-month period, known as Phase I, was a price freeze. In Phase II, a system with greater flexibility, prices were set by the Price Commission and wages by the Pay Board. These bureaus were given considerable discretion so that individual markets could be addressed. Inflation in 1972 under Phase II was only 3.3 percent, lower than it had been since 1967, and lower than it would be again until 1983. Price controls got much of the credit, although some economists believe that inflation would have slowed in any case. The time seemed right to begin dismantling controls before they became a permanent part of the economy.
Milton Friedman, staunch defender of free markets.
His advocacy of slow and steady expansion of the stock of money, flexible exchange rates, an allvolunteer military, and free trade gained increasing acceptance during the 1970s, 1980s, and 1990s.
In Phase III, which began in January 1973, the rules were eased, and their administration was placed in the hands of businesses. Inflation accelerated from 3.3 percent in 1972 to 6.2 percent in 1973. Worse still, the volatile food index increased at an astonishing
14.5 percent annual rate.
In response to the acceleration of inflation, meat prices were frozen in March 1973 and a freeze on all prices was imposed again in June. A shortage of meat resulted; meat counters in many supermarkets were empty. The shortage was aggravated by the announcement of a future date when controls would be lifted; ranchers held their animals off the market in the almost certain knowledge that they would get a higher price later. This sequence is a dramatic illustration of Economic Reasoning Proposition 3, incentives matter (see page 527). Note that here the incentive is the possibility of future large gains. With meat shortages, distortions in other sectors, evasions, and rising prices, the control program was in a sorry state. Phase IV replaced Freeze II in August 1973. (It was really Phase V, but by that time, no one was counting.) During this phase, prices were decontrolled sector by sector.
What was the control program’s overall effect on prices? In 1974, consumer prices rocketed upward at a 12.2 percent annual rate. Some observers thought that this was the release of inflationary pressures built up under controls. Others doubt that much repressed inflation was left after Phase III and look to other factors—such as supply-side shocks in oil and food and the lagged response to previous increases in the stock of money—to explain the acceleration of inflation. Most statistical studies agree that controls were successful in repressing inflation for a time, but they differ on how much and how long.
If the calm created by Freeze I and Phase II had been used to impose restrictive monetary and fiscal policies, the economy might have emerged from this experiment with controls as it had from the Korean War, with stable prices. This, however, was not to
Be. The stock of money rose at the unprecedented peacetime rate of 13.5 percent from December 1970 to December 1971 and at 13 percent from December 1971 to December 1972. The inflation of 1974 was to some extent the result of these increments to the stock of money working through the economy. Fiscal policy was also inflationary. Deficits of $23 billion and $23.4 billion were run up in 1971 and 1972. In only one previous year during the postwar period had the deficit been larger, and typically it had been far smaller. It is not clear why monetary and fiscal policies were so expansionary in these years, but it is possible that the controls themselves were partly to blame. By creating the false impression that inflation was under control (and creating a new set of people to blame if it accelerated), the existence of controls encouraged the Fed to concentrate on reducing unemployment. In any case, an opportunity to return to a stable price level, bought at considerable expense, was lost.
World History
