Inflation fears rose briefly during 2018, as the increase in the Consumer Price Index (CPI) approached 3 percent. In 1980, three percent annual inflation would have set off celebrations. Our success in reducing inflation provides a lesson about policy making by elected officials.
To avoid confusion we should be clear
about the meaning of inflation. Americans often mean the cost of living when
they say inflation. Economists, by contrast, specifically mean an increase in
the overall price level.
A pure 5 percent inflation would be
exactly a 5 percent increase in every price. Salaries and wages are prices and
would be included. Inflation should not reduce the ability of households to buy
goods and services, as income and expenses both increase equally. Economists call
an increase in the price of gasoline or housing a change in relative prices,
not inflation, even though either raises living costs.
Housing costs more in New York or San
Francisco than in Alabama. That the cost of living in Manhattan is more than
double that in Montgomery matters for weighing job offers. Differences in
living costs, however, are also not inflation.
The CPI does not include wages and rises
even for relative price increases, yet still measures inflation pretty well. The
annual change in the CPI exceeded 10 percent in 1974 and 1979-1981, hitting
13.5 percent in 1980. By 1983, inflation was below 5 percent and has only
topped this level once since.
The U.S. has not been the only nation to
bring inflation under control. U.S. inflation fell from 8.5 to 1.7 percent over
1974-83 and 2008-17. Yet over these decades, inflation fell from 11.3 to 1.1
percent in France and from 16.7 to 1.1 percent in Italy and Spain. Even Latin
America has experienced progress; inflation fell from 33 to 4 percent in Mexico
and from 112 to 6 percent in Brazil.
International success argues against a uniquely American explanation for our decline in inflation. For instance, I might wish to credit Ronald Reagan for defeating inflation. While President Ronald Reagan undoubtedly deserves some credit, a “great person” story would require great leaders in many nations, which seems less likely.
During the 1970s, many blamed inflation
on rising world oil prices. A decline in oil supply would raise oil prices and
hike the CPI, but would be a relative price change, not inflation as defined by
economists. And significant oil price increase last decade did not produce
double digit inflation.
One economist who never wavered about the cause of inflation during the 1970s was Milton Friedman, who insisted that “inflation is everywhere and always a monetary phenomenon.” Governments and their central banks, like our Federal Reserve, inflate the money supply, driving up prices. Behind the focus on oil, the Federal Reserve did indeed fuel the 1970s inflation with money supply growth. With Paul Volcker as Federal Reserve Chair and Ronald Reagan in the White House, the brakes were put on the money creation and inflation fell accordingly. The economics profession now largely accepts that Professor Friedman was right on inflation.
Why then did so many nations cause
themselves the pain of inflation? And what has changed? Monetary economists have identified central
bank independence as a key. A central bank is like a bank for the nation’s
banking system, and generally controls the money supply. Politicians find easy
money and credit irresistible, particularly when running for reelection. If
politicians have too much control, they will inevitably inflate the money
The Federal Reserve has always had some political independence. When the Fed Chair and Governors want monetary stability, as Mr. Volcker and his successor Alan Greenspan did, they can often prevail over the President and Congress. Other nations increased their central banks’ independence, based on economists’ advice. The European Central Bank was modeled on Germany’s independent Bundesbank.
People are imperfect and face problems
of self-control. Our elected officials are human, and the potential to shift
blame in politics exacerbates self-control problems. The world’s success battling
inflation shows that elections alone do not always ensure wise economic policy.
Daniel Sutter is the Charles G. Koch Professor of Economics with the Manuel H. Johnson Center for Political Economy at Troy University and host of Econversations on TrojanVision. The opinions expressed in this column are the author’s and do not necessarily reflect the views of Troy University.