Stagflation and Volcker

The stagflation of the 1970s -- simultaneous high inflation and high unemployment -- confounded the prevailing Keynesian framework, which predicted a stable trade-off between the two. In the standard Phillips curve relationship, low unemployment produced upward wage pressure and hence inflation, while high unemployment reduced it. The 1970s produced both, apparently refuting the framework and opening space for the monetarist and supply-side doctrines that would reshape economic policy for the following four decades.

The inflation of the 1970s had multiple causes. The oil shocks of 1973 and 1979, which quadrupled and then doubled oil prices, were supply shocks that raised costs throughout the economy. The 1971 end of Bretton Woods removed the external discipline on US monetary expansion. Federal Reserve policy under chairs Arthur Burns and G. William Miller had accommodated wage-price spirals rather than restraining them, partly from political pressure and partly from genuine uncertainty about how to respond to supply-side inflation without causing unemployment.

Paul Volcker, appointed Fed chairman by Jimmy Carter in August 1979, made the deliberate choice to end inflation regardless of the unemployment cost. He raised the federal funds rate to a peak of 20% in June 1981 -- producing the most severe recession since the Depression. Unemployment reached 10.8% in November 1982. The business failures, farm foreclosures, and personal bankruptcies of the Volcker recession were the most direct consequence of the most intentionally painful monetary policy in American history.

My own belief is that we are in a serious recession... It will be an act of considerable political courage to maintain the kind of policies that are needed.Paul Volcker, testimony to Congress, February 1982

Volcker succeeded. Inflation, which had reached 13.5% in 1980, fell to 3.2% by 1983. The success had distributional consequences that commentators at the time were largely reluctant to name. High unemployment weakened labor's bargaining power, ending the wage-price dynamic that had sustained inflation. The collapse of union membership that followed the PATCO strike of 1981 -- Ronald Reagan's dismissal of 11,000 striking air traffic controllers -- accelerated this process. Wages in the private sector barely grew in real terms for the next decade; the income share of capital rose substantially.

Volcker's recession also destroyed much of the domestic manufacturing base that had employed the American working class. High interest rates attracted foreign capital, driving up the dollar's value and making American exports uncompetitive. The industrial Midwest, which had provided well-paid unionized employment for generations, began the deindustrialization that would continue for three decades. The communities that lost their industrial base did not recover. The stagflation crisis and its resolution marked the end of the postwar settlement and the beginning of the neoliberal era.