Flat White

Is high inflation back?

26 October 2021

4:25 PM

26 October 2021

4:25 PM

Inflation is clearly on the rise worldwide, running at over 5 per cent in the United States and over 3 per cent here and in Europe, all above central bank target levels.   

Does this mean we are set to experience high inflation, 1970s-style, again?   

To understand why higher inflation is more likely than not to take hold, it’s instructive to reflect on how macroeconomic ideas evolved when inflation surprised policymakers way back then. 

The Keynesian zeitgeist of the 1970s had no prescription for high inflation which appeared simultaneously with high unemployment. Nobel Prize winner Milton Friedman, more than any other economist, turned the intellectual tide against the prevailing Keynesian mindset and sparked an intense debate in macroeconomics. It ended with Friedman’s key propositions becoming standard university textbook theory to this day.   

As British Labour Prime Minister James Callaghan pronounced in 1977 that “We used to think we could spend our way out of recession. I tell you, in all candour, that that option no longer exists, and that if it ever did exist, it only worked by injecting bigger doses of inflation into the economy followed by higher levels of unemployment as the next step. That is the history of the past 20 years.” 

Friedman’s propositions were (i) that household consumption depended not just on current income but what was termed ‘permanent’, or long-term average income, (ii) that ‘natural’ factors prevented an economy reaching full employment in a literal sense, and (iii) that “inflation was always and everywhere a monetary phenomenon.”   


The first two of these implied that fiscal policy was not nearly as effective as a means of managing the economy as had been assumed, especially when taking the so-called reaction, implementation and action lags into account. The third proposition was why Friedman’s school of thought became known as Monetarism.   

Due to the weight of theoretical and empirical evidence supporting Monetarist precepts, more independent central banks around the world were subsequently assigned the job of keeping inflation low by manipulating the money supply and hence interest rates. Meanwhile, fiscal policy largely remained inert as a short-run macroeconomic stabilization instrument.   

In turn, that ushered in the so-called Great Moderation era from the 1980s to the GFC, with low inflation, solid economic growth and high employment levels. 

Things changed dramatically with the GFC.  Fiscal policy was used aggressively here and abroad in response to that crisis, even though it had not been deployed during the Asian financial crisis of the mid-1990s.  Fiscal policy has also been central to governments’ response to the COVID threat yet in a quite different way and on an even bigger scale.   

Meanwhile, central banks have massively expanded money supplies over this time via ‘quantitative easing’ and have effectively funded extra government spending to stoke aggregate demand, with the lessons of the 1970s seemingly forgotten.  

What then are the chances that economic history will repeat the 1970s experience?  Given the historical evidence on the link between money supply growth and inflation, they would have to be greater than 50:50.   

Already, near zero official interest rates have fueled unsustainable asset price inflation, reflected in high share and property prices.  Ordinary inflation is accelerating in the United States and Europe and over the past fifty years trend changes in overseas inflation have broadly coincided with trend changes in inflation here. 

Rising inflation will be a problem because, if unanticipated, it will cause further arbitrary redistribution of wealth between borrowers and savers in the economy. Hence, in the 1970s, the saying that ‘inflation was theft’ was popular as it conveyed the notion that inflation robbed wealth from savers earning negative interest in real terms.     

When it is high, inflation also tends to be more variable which creates additional uncertainty for business and complicates long term planning decisions.  In addition, there is the inconvenience and real cost to business of having to mark prices up very frequently (the so-called ‘menu cost’ of inflation). 

One reason inflation was hard to curb in the 1970s was that expected inflation remained persistently high because central banks lacked credibility, often failing to do what they said they would. Given the mounting inflationary pressures abroad and with consumers here expecting inflation next year of 4.4 per cent according to Melbourne Institute data, Reserve Bank credibility will be severely damaged if it continues to insist that interest rates will stay rock bottom until 2024 with the official rate at 0.1 per cent, come what may. And that there’s nothing to see here regarding ongoing asset price inflation.   

What finally put an end to the high inflation of earlier decades in Australia was the sharp recession in the early 1990s (the one we had to have according to then Treasurer Paul Keating), caused by the Reserve Bank acting too late and by too much. Pray tell we don’t ever see official interest rates having to rise anywhere near 17 per cent again. That would certainly kill inflation off should it get out of hand, but at horrendous cost to employment and national income.   

Tony Makin is a professor of economics at Griffith University and former IMF and federal Treasury economist 

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