Inflation isn’t a major issue in Britain today, with the inflation rate averaging at just under 2% over the past decade. However, those living in the 1970s weren’t so fortunate, with the inflation rate reaching 25% in 1975. Prior to the 1970s, economists thought that there was an inverse relationship between unemployment and inflation. However, during this period, economic growth was stagnant; at the same time as there were high levels of both inflation and unemployment – the latter reaching 8% by 1978. This unusual phenomenon became to be known as stagflation, with the cure not clear at the time. Keynesianism, which had dominated much of the economic debate post-WW2 era, maintained that in times of slow economic growth, the central bank could simply increase the money supply to induce both increases in demand and prices. Falling unemployment would follow this increase in the money supply, without inflation. However, with high rates of both unemployment and inflation, Keynesian economists had to reconsider their ideas, to explain the slow economic growth coupled with high rates of inflation.
The influence of trade unions
A misinterpretation of the events that unfolded during the 1970s, is the attributing of rising inflation to the strong power wielded by unions. The logic lies in cost-push inflation – the growing capacity of trade unions to boost salaries, as well as the growing power of business to raise prices in step with salary increases, resulting in an ever-increasing wage-price spiral. Government fears over potential rises in inflation, led to the imposition of wage and price ‘guidelines,’ then later wage and price controls. As ever with government intervention in the economy, the problem was only exacerbated, with this policy creating suppressed inflation, distorting the reality of the economy. To paraphrase Milton Friedman – suppressed inflation can be likened to filling a kettle with water, putting it on the stove, turning on the burner, then finally putting a brick on top of the kettle. This suppressed inflation later added to the inflationary crisis.
The first OPEC oil price shock occurred in late-1973. This led to the price per barrel increasing from $10 to $50 in the space of a year. Another common misconception is that these oil shocks were the primary contributor to the inflationary crisis that defined the 1970s. The thinking follows that these price increases in oil and the resulting increase of prices at the pump, drove up the prices of all consumer goods (again, cost-push inflation). However, had Keynesian theory prevailed at the time, then these increases in oil prices would’ve had a positive effect on economic growth, due to the inverse relationship between inflation and unemployment. However, unemployment levels remained high, rendering Keynesian theory as inaccurate. The real culprit was the excess liquidity in the money supply at the time, which was largely responsible for the high levels of inflation experienced during the 1970s.
Increases in the money supply
At the start of the 1970s, the UK left the gold standard due to the collapse of the Bretton-Woods system, turning the pound into a fiat currency. This prompted both expansionary fiscal and monetary policy by Anthony Barber, chancellor of the exchequer at the time, leading to the so-called ‘Barber Boom’ of 1971-73. Inflation was already at elevated levels of just over 6% at the start of the decade, due to easy money policies during the 1960s; further stimulus by the then chancellor only exacerbated the problem. In 1973, the government attempted to reduce the ever-increasing rate of inflation by temporarily enacting contractionary fiscal and monetary policy measures – an increase in interest rates coupled with reduced government spending.
However, due to the aforementioned oil shock hitting the British economy, this was quickly abandoned with the easy money inflationary policies soon returning. These initiatives were taken to boost aggregate demand to counteract a drop in real income (due to a shift in the relative price of oil), resulting in the depreciation of the pound, a decrease in international reserves, and unsurprisingly an increase in inflation. The sudden drop in the exchange rate that came with the depreciation, gave birth to the sterling crisis of 1976 – prompting an intervention by the IMF. They urged the government to pursue policies that would result in both a balanced budget and the decrease in the availability of credit – both of which had led to the excessive expansion of the money supply. This led to officials in the Bank of England paying closer attention to the theories laid out by Friedman and monetarists alike, who correctly described how inflation was a monetary phenomenon that could only be controlled by tightening the money supply.
A return to stability
Following the 1979 General Election, Margaret Thatcher’s Conservative party replaced the incumbent Labour administration. The former sought to heed the advice of the monetarists, with the Treasury implementing a deficit reduction plan by eliminating wasteful spending alongside raising taxes. The Bank of England similarly adopted contractionary policies by significantly reducing money growth. Altogether, these policies led to inflation returning to stable levels, with the inflation rate below 5% by 1983 – marking an end to the decade plagued by out of control price growth.