annenberg media ♪ annenberg media ♪ in the early 1970s, battles raged in the middle east. and throughout the world, disastrous weather caused crop failures of immense proportions. why did these two events affect inflation and unemployment in the american economy?

u.s. society was besieged by the twin assaults of inflation and unemployment in the 1970s. why couldn't the government achieve significant success against the ravages of stagflation? in the late 1990s, the economy was booming. unemployment was at a 30-year low, and inflation was also at a 30-year low. did that mean inflation was dead? during the 1970s, the american dream threatened to become the american nightmare. for the first time, we were faced with skyrocketing prices and exploding unemployment. stagflation -- why couldn't we beat it? with economic analyst richard gill, we'll explore that question on this edition of "economics usa." i'm david schoumacher.

schoumacher: since the passage of the employment act in 1946, it has been accepted policy for the government to fight unemployment by stimulating total demand. often, inflation resulted. when that happened, the government shifted gears and clamped down on demand in order to decrease inflation. for five administrations, the government more or less successfully practiced the delicate art

of balancing off unemployment and inflation. the experience of the 1950s and 1960s indicated that when unemployment went up, inflation would, correspondingly, fall. by the time richard nixon was in office, though, this classic relationship was showing signs of strain. by 1972, inflation was at a level of 4% and unemployment was at 5 1/2%. a year later, unemployment was holding at 5%, but inflation had skyrocketed to 8 1/2%. why weren't the old predictable trade-offs working? what had happened to change the economic rules? nature, suddenly violent, rampaged over the entire globe. in 1972, there were crop failures worldwide.

what was the result? [ crowd shouting ] under the intense heat of worldwide demand, u.s. grain reserves nearly evaporated. within two years, reserves fell from 863 million bushels to 265 million bushels. the average price of all food in the united states rose 20%. this shock to the food supply caused an inflationary surge. but it was a different kind of inflation we'd previously experienced. what made it different? alan blinder, professor of economics at princeton university, comments. well, typically, the major cause of inflation is an excessively rapid growth of aggregate demand, of the demand for goods and services, a growth rate that outstrips the rate at which the economy's productive capacity is increasing. this is sometimes put in the phrase "too much money chasing too few goods." but there's another kind of inflation, often called cost-push or supply shock inflation,

that is caused not by demand growing very rapidly but by supply growing very slowly, or even, in some cases, contracting. schoumacher: and so, america was faced with this new kind of inflation, one based on supply, not demand. consumers were furious and protested vigorously. we want to boycott meat, we don't want to eat it, we don't want to fill up our freezers with it. we want to not eat it, and we don't want to buy it. i think we'll be effective... schoumacher: but all of this anger, this frustration, was merely a prelude for the storm to come. [ explosions ] on october 6, 1973, the middle east exploded in conflict. the arab nations retaliated against the u.s. support of israel with the most potent weapon in their arsenal -- an oil embargo.

america had come to rely on cheap and plentiful oil and had structured its economy on this basic resource. suddenly, oil was scarce and expensive. prices for gasoline soared 40% in just six months. prices on virtually everything shot upwd. inflation hit 10.8%, and the nation reeled from its second supply shock. i don't see why the president doesn't do something about it, it's like the gasoline and the meat and now this. i was shocked when i heard on the radio that now oil is going up, cooking oil is going up, beef is going up. there's just too many things that are going up. schoumacher: by the fall of 1974, prices were ballooning upwards at over 13% annually. in the past, inflation occurred during an expanding economy, marked by high employment. but this was different. the economy had slowed down,

unemployment was rising, yet there was still inflation. why? the inflation the economy was witnessing in the fall of 1974 was the legacy of the food price increases that had happened in '72 and '73 and more recently than that, the oil price increases that had happened in the closing months of '73 and the early months of 1974. these kinds of supply shocks, first of all, raised the prices of the products to which they applied, in a very obvious way. food prices went up and energy prices went up. beyond that, these agricultural and energy products -- and especially the energy products -- are inputs to other productive processes, so other manufacturers have to use these things to produce other goods, and therefore because they were suffering cost increases, the prices of these other manufactured goods went up. schoumacher: the american economy was like a great fighter that had been stunned by an unexpected one-two punch, the food and energy supply shocks. this economic combination created something new,

supply shock inflation and recession. people called it stagflation, and it was to hammer at the american economy for years to come. why did it so confound economists of the day? we put that question to economic analyst richard gill. in the old days, you used to be able to divide economists into two groups, those who worried about stagnation and those who worried about inflation. what the food and energy shocks of the early 1970s proved was that both were right. economics can be a bit unsettling that way. everybody's worries can come true. technically speaking, what was happening was a shift of focus from the demand side of the economy to the supply side. here we have aggregate supply and demand curves for the economy as a whole. we measure total output, gnp, along the horizontal axis, and the price level along the vertical axis. now, roughly speaking, we can think of stagnation

as occurring whenever the economy moves towards lower gnp. that is, to the left here, along the horizontal axis. but by contrast, inflation occurs when we move upwards here along the vertical, or price, axis. now, in the days before the supply shocks, people tended to focus on changes on the demand side only. if demand went up to here, for example, we'd get a new equilibrium of the economy with a higher price level. the change would be inflationary. but we wouldn't then have to worry about stagnation. gnp, you see, has also increased with this shift. but now look at what happens when you get an unfavorable shift in the supply curve. food and energy shortages drive up prices and businesses' costs of production. the supply curve shifts upward. and notice what happens. we have more inflation, as in the case of the demand shift,

but we now have a lowering of gnp. we have moved both up -- more inflation and, to the left, more stagnation. this is the world of stagflation. and unfortunately, when we tried to adjust to this world, we sometimes did things that made our problems even worse. in 1973, food shocks and oil shocks battered the economy, and stagflation settled over the land. was e federal government any better prepared to face the tough challenges ahead than business or labor had been? coming out of the 1960s, inflation was the nation's number-one economic problem. president nixon and his economic advisors grappled with this vexing puzzle unsuccessfully. finally, they instituted an extreme measure -- wage and price controls. but when the economy was shaken by the food and oil shocks, the wage and price program fell apart,

and inflation continued its upward spiral. for most of 1973, employment remained relatively high, and it was natural for government leaders and economists to think that t problem of inflation was due to excessive demand. why were the signs misleading? stanley fisher, professor of economics at the massachusetts institute of technology. at the end of 1973, it really wasn't clear what was happening in the economy. i think there were two main reasons for that. the first is that the data were actually bad. the early data on gnp in 1973 showed faster growth than we now know actually happened. the second reason is that unemployment was still very low at that time, under 5%. so that for both those reasons, it wasn't obvious that the economy was heading for a recession. the rise that we had in interest... schoumacher: so the federal reserve,

under the leadership of chairman arthur burns, sought to fight inflation by restricting the money supply. in late 1973, the fed raised the interest rates charged to member banks. chairman burns believed a restrictive monetary policy was necessary, not for weeks or months, but for years to come. the policy of monetary restraint pursued by the federal reserve has helped to cool the economy, by moderating the expansion of credit and disciplining inflationary psychology. schoumacher: but by the beginning of 1974, the economy stalled and inflation shot up to a staggering annual rate of 13.6%. why didn't the fed's actions halt the inflationary spiral? i don't think that the fed, or policymakers in general -- or economists, for that matter -- understood well how the oil price shock affected the economy. i think there was some view that oil prices would go up

without having much impact on the level of unemployment or the rate of growth of the economy. it's easy to see now that when you get a shock of that type, it really can push the inflation rate up for a period of a year, or two years even. but i don't think that's what people thought at the time was going to happen. schoumacher: as late as mid-1974, even as unemployment hit 6%, congress, business, and consumers were virtually united in the view that inflation was a worse problem than unemployment. between the food and the rent and the clothing and the cleaning and everything else, and you put it all together, you haven't got a dollar left. schoumacher: in an attempt to further cool the economy in the fall of 1974, the fed again raised the interest rate. at the same time, an economic summit conference was convened by the administration. the majority of economists present spoke out about the deepening recession

and wanted to stimulate the sagging economy. but president ford continued to call for a battle plan against inflation. ford: from this summit, we're going to start going up. but still, despite the signs of worsening stagflation, despite the message from the economic summit, neither president ford nor arthur burns, at the time, could bring themselves to alter the policy of fighting inflation above all else. in october, the president offered his anti-inflationary program to a joint session of congress. it relied on the old formulas -- a tight ceiling on federal spending and a tax surcharge. and for the public... it bears the single word "win." schoumacher: participation in a special campaign. i will call upon every american schoumacher: participation in to join incampaign. this massive mobilization

and stick with it until we do win as a nation and as a people. [ applause ] schoumacher: while government concentrated on fighting inflation, gnp continued to fall, unemployment continued to rise. why was it so difficult for the government to adapt to the signs of the developing recession? the first was the tremendous fear of inflation that was all over the country. it wasn't only in washington but all over the country, which really effectively paralyzed those arms of government policy that might fight recession. because those very same arms also tend to propel inflation. and so that was effectively eliminated by the fear of inflation. the second reason is that this unusual event -- the supply shock, the series of supply shocks that had happened in 1973 and into '74 -- was kind of a foreign event,

and people didn't really know how to think about it. there wasn't a conceptual framework. and lacking this conceptual framework, it was that much less clear what a policymaker ought to do about it. and these policymakers were not at all sure what to do about it. schoumacher: finally, soaring unemployment figures convinced the administration that a policy change was due. at the beginning of the year, president ford bowed to the inevitable. the new and disturbing element in the economic picture is our worsening recession and the unemployment that goes with it. we have made some progress in slowing the upward spiral of inflation and getting interest rates started down. but we have suffered sudden and serious setbacks in sales and unemployment. therefore, we must shift our emphasis from inflation to recession. schoumacher: in march, congress responded

to presidentord's call and passed a tax relief bill of almost $23 billion. and the fed, did it continue its restrictive monetary policies? at just about the same time that congress was passing the tax relief bill, the fed also changed course and increased the rate of growth of the money supply. and so, after months and years of struggle by men and women of vast knowledge and power, what was the outcome in the government's war against stagflation? was the beast finally overcome? for the rest of 1975, inflation would average over 9% and unemployment over 8%. at best, it was a holding action, and the dilemma of fighting both inflation and unemployment at the same time remained. we asked economic analyst richard gill why the government wasn't more successful. well, the reason the government was running into difficulty,

at least the reason that many economists would give, was that we were trying to deal with the problem too exclusively from the demand side. if we look back at our aggregate supply and demand curves again, we can see this problem very clearly. suppose we are not down here, but way up here, as we clearly were in the early and mid-1970s. prices are high, but gnp is prey far to the left. that is to say, unemployment is also quite high. now, if you decrease demand to fight inflaon, bringing prices down to here, you lowegnp to here, causing more unempyment. but if you increase demand to raise gnp to here, you're likely to cause prices to go up even higher, to here. neither policy is satisfactory, and shifting back and forth betweeeen the two ase d may be theery worst neither policy of all.sfactory,

now, not economists thenr w would agree with this particular analysis, but one thing is clear -- who had previously looked only at the demand side of the economic equation now began thinking that perhaps the supply side could alsose some attention. schoumacher: just as the stagflation of the 1970s saw weak growth and strong inflation, e periodf the 1990s stro growta phenomenonymt, ath hadotsetn,-- inhe uted statesfor ny deces over the yrs, the federal reserve came toe thatabove 2 1/2% a yeaot without inciting ilation. and yet in the 1990s, grt, ud all out waking the sleeiaf inatio low, whatas extraordiry about th1990s and yet in the 1990s, grt,

is that at thend of the long expansion -- expansion that'sow over -- the inflation tehend of the long expansion -- was asow as whent began. at is very uncracteristic of , because generally, when you have an economic expaio you're putting more essuconro, mo presse onhe labor for, and interest rates tend to , among other things, up, to bring thexpansion to an en didn't happen in the 1990s. why didn't it happen in the 1990s? spite all the economic dicators to the contrary?n a mafactor was e revotion iormation tecology. thdigitization of all inftion cread new compies new stri. in silicon valley alone, new comes were createdvery week. and its produco ing, was intellecal pperty.

a growing ba started among economis over whether the new ecomy had chged the rules. ladies and gentlemen, it'sy hono and deep prige intu the chairmanf fera, ladies and gentlemen, dr. anreensp it'sy hono and deep prige intu schoumacher:maalan gr. he dbtedheerlation coulbe adequately measuredinhy usg cuent techniques to tracericends over time. wh electricity was developed, th wasew economy. usg cuent techniques to tracewhen automobilese. became prevalent, that was a new economy now we have a new economy i think has conuted,c age. as those earli new economies contributed, to an increasein produ. ere was a time when economists thought thathen thunemployme re golow , ate would inevably have ination.- weound out in the 1990s that

thathen thunemployme re golow , ate would iwith very producticonomy, we don't necessarily get ination when unemployment drops. we don't necessarily schoumacher: prodtity was a key factor in keeping inflation down. but another ctor was the globalization of business. e inoducon of market foes, freetrade, and wispread deregulation meant that international played much largerole in our economyhan before. lcker: japan's been almostflak meant that international plrope's bn growgrole in our every swly before. til recently, particularly with a higlel ofnemploen so if you look at e world as a whole, while we were expanding, there was ready availabilityf goods. those citins have e option of buying from abroad. there was a loof emphasis on expen resaint. and that was particularly strong during the 1990s.

there was a great debate at the beginning of the clinton administration about how to deal with what was perceived as a relatively small recession, but nonetheless a recession, what to do. there were those who wanted to spend their way out, and others said no, let's have budgetary restraint. that will be better for the economy, that will keep interest rates down, it will tend to restrain inflationary pressures, and, in the long run, we'll be better off. and that was, i think fortunately, the approach that was adopted. and lo and behold, the economy did so well that we got some productivity increases, that revenues increased faster than expected, budget expenditures were held down, and for the first time in decades, we had budgetary surpluses. schoumacher: there was no inflation when it came to goods and services, t the was a sharp rise was this a problem?ocks. rivlin alan greenspan coid the term "irrional exubance,"

meaning that pple were buying stocks swe now know, of course, would cthat ty dn't. up and up. schoumacher: e fed played a key role in holding down inflatio in t 1990s, but after thteoratcks the opened the monetaryloodgas. the fearhat ople have of more rrorism and coulitead watoiginflation?acon, in a dowthat's t leastsn't worrof t worriesio because a down means peopleren, inpeople aren't demanding goods worrod seices,esio

becauthere's always a dangeeren, at we willrreact to events suchr d therefore there's nopwat wloyure on ices. and let the money supply drifup. especial whewe've d a lo period and let the money supply of very little ition, you gecompce and you startaking risks onhe oer side of equatio so i it would bevery foosh you gecompce and you startaking risks to say inflaon is dead. onhe oer side of equatio inflioisever dea going back to, i suppose, the dawnf civilization but certainly ck to the creation of money -- they had ilation in roman times. someeople think that inate to the downfall of the roman empire, but we certainly have ha periods in history ofecadesr evenenries but we certainly have ha of pce stabilityr declines, but in general ination has been a recurrent characteristic ofodern capilism

we asked ecomic analystnaris ination has been for his thoughts on inflation. duringheo-calledstan what"new economy boom," 1990s, the oductivity boom we iso look at and aggregate dema curs. the aggregate supply curve to move to the right faster iso look at and aggregate dema curs. than the athis allowedd cue. bothhe umployment rateaster iso look at and aggregate dema curs. the inflatiorate to to 30-year lows.y the experience of the la 1990s is exactly the opposite thof wt hand eay 19se 1970s90s when the aggregateupy cue moved theeft because of weakroductivity grow and supphoages withanthe inflion temrising si. any sertn abinflation being ad

st be ck uby tssumption thatroctivity growthwill reo unfortunately,s the expeence of, there is no guarantee thatroductivity growth unfortunately,s the expeence of, will contie to be robust. thus,thatlation wilberemainvigiy resuecteonce again. e classic busissycle has nocome to annd recessie and inflation could always rear its ugly head nehessthbusiness cycleof the990, dren more by technology and trade, d that could enable to grow sterhan bere without the danger of inflation.