annenberg media ♪ ♪ . 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 govement 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 aboutthe 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 to join in 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, e 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 pretty 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 pocy is satisfactory

and shifting back and forth betweeeen e two ase d may be tery worst cy of all. now, notll economists then or w would agree with this particular analysis but one ing is clear -- a great many economists 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. schoumacr: just as the stagflation of the 1970s saw weak growth and stng inflation the periodthe 90s w the reverse stro growth, low unemploymt, d low inflatn, a phomenon th hadoteese inhe uted statesfor ny deces over the yrs the federal reservecame to assume that the economyld not expeenceloedrowth above 2 1/2% a y without citing ilation. and yet in the 1990sgrth was doue that

unemoyme was a 30-year low, d all wiout waking the sleeiaf inatio whatas extraordiry about th90s ishat at thend of theong expansion -- expansiothat'sow over --the inflation te was asow as whent began. at is veryncracteristicof expansions, cause generally, when you have an economic expaio you're putting more essuonroductive capaci mo presseon labor for anices tend too up aninterest ratestend to go up. and that tends among otr things to bringhe expansion to an en dn't happen in the 1990s. why didn't it happenin t 1990s? why didn't this happen? whatere the factors that kept inflation wn spite all the economic dicators to the contrary? a mafactor was e revotion ormationecology. thdigitization of all infon cread new compies new stri.

in silicon valley alone, new comeswere created every week. w economycomeo ing, and its produc was inteecal pperty. a growing batestarted among economis over whether the new economy had chged the rules. ladies and gentlemen it'sy hono and ep prigentroce to you thchairmanfthferal reserve d,dr. anreensp schoumr:maalan greenspthe rules had change hebted werlation couldequately measedinhe newcomy usg cut techniques to tracerices over time.wh electricias developed th wasew eco. when automobiles came prevalent thatas a new economy now we have a new economy that's electronic e. i think has conuted those earli new economies contributed, to an increasein pductivity. ere was a time when economists thought thathethunemployme regow 6%- or 5 1/2r 5, something ke tha--

ate wod inevab have ination. weound out in the 1990s that with very producconomy we don't necessarily get ination when unemployment drops. schoumac productity was a key factor in keeping inflation down. but another or was e globalization of business. e inoducon of market es freetrade, and wispread deregulation meant that internatial trade and instme played much largerole in our economy than bere. lcker: japan's been almost at on its back rope's bn growgvery swly until recently, particularly wi a higlel ofnemplo so if yook at e world as whole while we were expanding, there was ve ready availabilityf goods. when inflaon rises in coury ose citins have optionof buying from abroad.

there was a loof emphasis on een 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,

but the was a sharp rise t pricef stocks. was this a proem?rivlin: alan greenspan coid the term "irriol exuberance," meang that ppl were bing stocks without rega to the futureaings stecause ty thought that the stock market es would continueo go up and up. we now know,f course at ty dn't. scumache e fed played a key role in holding down inflatio in t 199 but aftethteoratcksof september 11t the feopened the monetaryloodgates. was that an overreacon and coulitead toiginflatio the fearhat op have of more rrorism has thrown the economy into dowur in aownturn, oneoesn't worry abouinflatio that's the least of torries because a down means peopleren't buyi peopleren't dending goods and seices

d therore there's no upwaressure on ices. there's always a dange at we willrreact to events such as septbe11. there'always aangerat wetpp anlet the money supply drifup. escial whewe've da lo period of very little ition you gecompce and you startaki risks onhe oeride of equatioso i it would be very fooshay inflaon is dead. inatiseverea we have a lot of human histo going cko, i suppose the dawnf civilization but certainly back to the creation of money -- they had ilation in roman times. someeople think thatinatiocontbute to the downfal of t roman empire, but we certainly have ha periods in history ofecadesr evenenries of pce stabilityr declines

but in general inatiohas been a current characteristic ofodern capilism. we asked ecomic analystnariman beaves for his thoughts on inflationin the 199 and beyond. one way to understan whatappened inhe late 1990s, duringheo-called "n economy boom," iso look at thaggregate supply and aggregate dema curs. the oductivity boom wed the aggregate supply curve toove to the right faster than the aggregate demand cue. this allowed bothhe umployment rate the inflion rate falsimultanusly to 3year lows. the experience of the la 1990s isctly the opposite of wt haenedn the 1970s and eay 19s when the aggregateupy cue mod the left because of weakroductivity grow and supphortag

this resulted intagflation with botthe unemployme re anthe inflion te rising simultasly. any sertn abouinflation being ad st be back u assumptio thatroctivity growthwill remain strong unfortunately, as the exrienceofhe 1970s showed us there is no guarantee thatroductivity growth will contie to be robust. thusthe fehas to remainvigint against t possibility thatlaon wilbe resurrecteonce again. e classic busissycle has comeo annd recession has nobeen banne and inflation could always rear its ugly head nehessbusiness cleof0sasiffe driven more bytechnology a trade d that could enable to grow sterhan bere without the danger of inflation. for "economics usa i'm david schoumacr.