Is a return to 1970s-style inflation on the cards?

The globe in the 1970s

Inflation surged across the globe in the 1970s, in an event that is now called ‘The Great Inflation’. In the US, annual inflation peaked in 1980 at 13.6%, having averaged 7.9% in the 10 years up to the end of that year. Inflation was less intense in Germany than the US but was still high, at an average of 5.1% over the 10 years to the end of 1980.

What exactly drove this surge in inflation in the 1970s is still a matter for debate: like most other major economic events of the 20th century, such as the Great Depression in the 1930s, there is still no consensus among economists. What’s more, the debate is at times ideologically driven.

The traditional theories

There are two main theories for the causes of the Great Inflation. The first is that it was caused by cost-push inflation resulting from the oil shocks of 1973 and 1979. The second is that it was caused by the monetary and fiscal largesse of the 1970s: The US’s deficit ballooned to fund its war in Vietnam and was not really cut back subsequently, while the Federal Reserve was rather complacent and kept interest rates too low.

Some neo-Keynesians later suggested that another contributory factor was that high inflation expectations had started to become entrenched among households, leading to inflation becoming self-perpetuating and explaining the breakage of the traditional ‘Phillips curve’, which links inflation to the unemployment rate. Indeed, the conundrum for Keynesians was that while the unemployment rate was high, inflation remained high too, going against their models.

Some international macroeconomists trying to explain 1970s inflation place more emphasis on the global monetary disorder that resulted after President Nixon de-pegged the US dollar from gold in 1971.

Other economists – ourselves included – prefer to have a more holistic approach. This includes looking at the microeconomic structure of developed economies and big-picture factors like demographics and the role of global trade, as well of trade unions. Considering such factors could also help us ascertain whether we are embarked on a similar period of high inflation today, bearing in mind the similarities between now and then—a big commodity price shock and big fiscal deficits following the pandemic.

Demographics were different in the 1970s to now

Demographics were undergoing a major shift in the 1970s as the Baby Boomer generation reached prime consumption age, i.e. above 20 years. In the US, consumption of durable goods such as fridges and cars surged as the active population (those aged between 15 and 64) grew by a historic 2.8% per year in the 10 years to 1980.

This is very different to the current period, with the growth of the active population in the US averaging just 0.2% per year in the 10 years to 2021, according to OECD data. In the 1970s, one could argue that inflation resulted from a genuine gap between surging consumption and production struggling to keep up. Households rushed to buy consumer goods, leading to the sharp increase in prices. However, there is a debate now among economists about whether ageing populations, and in particular a wave of fresh retirees eager to spend their nest eggs, could sometimes spark higher inflation (see ‘The end of 40 years of disinflation’ in Horizon 2022).

Different economic structures

Economies in the 1970s were much more rigid and closed than they are now. Trade unions were also much stronger back then and arguably played an important role in helping perpetuate high inflation in the 1970s through wage indexation and strong bargaining power. Even though there are currently renewed demands for a return to price indexation in the US, unions have less clout now, and the manufacturing sector where they were strongest has shrunk. Work arrangements have also changed, with many workers being ‘contractors’ instead of ‘employees’. The role of tech platforms has grown considerably, leading to the emergence of the so-called ‘gig economy’.

In addition, economies are now much more open to global trade than in the 1970s, which means that workers face much stiffer competition from elsewhere. That said, there is increased debate about whether we are entering a period of ‘de-globalisation’.

A shift to services spending

As consumers have become richer, there has also been a shift away from consuming goods to consuming services. The focus is increasingly on ‘experiences’ rather than possessing durable goods. Travel, leisure and entertainment now account for a much bigger proportion of consumer spending and suggest the current commodity price shock may not be as damaging as in the 1970s.

Economies are also much less fuel intensive than they were back then, although the rapid push to decarbonise economies may arguably introduce new costs and send energy bills much higher.

Lessons to be learned

The bottom line is that the structure of economies and patterns of work have changed over the past 50 years and populations have aged, so it may be too easy to see a replay of the 1970s through only the prisms of the energy shock and loose policy. However, policymakers may have forgotten in recent years that, as in the 1970s, very loose fiscal policy may still be a major driver of inflation. Modern Monetary Theory, which gained prominence during the pandemic as it advocated a loose link between the fiscal stance and inflation, has faced a massive reality check in 2022. While it may not prove as persistent as in the 1970s, inflation could still stay high if governments do not adapt their policy mixes. The future of globalisation may also hold the key for the inflation outlook in developed economies.