09/01/23, 08:50 A playbook from the 1980s for dealing with inflation | The Economist

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A playbook from the 1980s for dealing with inflation

Do today’s politicians have the stomach?

Dec 1st 2022

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A cross the rich world consumer prices are rising by 10% year on year, the highest rate since 1983. That
year holds a special place in the history books. It was the final year, after many, in which annual inflation
was in double figures. Thereafter it moved downwards, paving the way for the low inflation of the 1990s.

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Today’s central bankers hope to repeat the trick and thus enter monetary policy’s hall of fame alongside the
giants of the 1980s. Paul Volcker, who led the Federal Reserve from 1979-87, is the biggest giant of all. But
Gerald Bouey in Canada, Carlo Azeglio Ciampi in Italy and Karl Otto Pöhl in Germany—who memorably
compared inflation to toothpaste (“once it’s out, you can hardly get it back in again”)—also presided over
disinflation in that decade.

Central bankers hope their job will not be too hard. The Fed’s projections suggest that by 2024 inflation will be
close to target, at the price of just a small rise in unemployment. The current period of high inflation is
relatively short, so the hope is that expectations of price pressure are not entrenched. Others say that price
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rises are in large part driven by supply-side disruptions, which should soon fade. Yet over time, the
inflationary surge appears to be broadening almost everywhere. In many places expectations are starting to
look stubbornly high.

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So the experience of the 1980s may become instructive. And once you dig into the history, the decade holds
three tough lessons for today’s policymakers. First, inflation can take a long time to come down. Second,
defeating inflation requires the participation not just of central bankers, but other policymakers too. And
third, it will come with huge trade-offs. The question is whether today’s policymakers can navigate these
challenges.

Take the path of disinflation first. In the 1980s it was a slog. Italy saw success faster than most. Under Ciampi
the central bank moved from the treasury’s plaything to a quasi-independent institution: inflation fell from
22% in 1980 to 4% by 1986. But that still meant five long years where prices rose by more than 10%. Even if the
rich world today reduces inflation as fast as Italy did, its average inflation rate would not come down to 2%
before late 2025.

In any case most countries had more trouble than Italy. In 1980-81 rich-world inflation fell, but progress came
to a halt in 1982-83. Then in 1987-88 there was another inflationary spike, fuelled by energy costs. In some
countries inflation jumped around. In early 1984, with inflation at 3.5%, New Zealand’s wonks thought they
had slain the monster. By mid-1985, however, it exceeded 16%. We estimate that in only 53% of months in the
1980s did inflation in the average rich country decline relative to the previous month. Disinflation was
happening, but often it did not feel that way.

The second lesson of the 1980s is that central bankers can only do so much. “Inflation was not conquered in
the 1980s by monetary policy alone,” argues John Cochrane of Stanford University in a new paper. Some say
that the liberalising reforms of the 1980s helped in the fight, increasing competition and thereby lowering
prices. imf research has found that labour- and product-market reforms can, under certain conditions,
reduce prices. These reforms, though, probably took some time to kick in.

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Economists can make a stronger case for the role of fiscal policy in the anti-inflation fight. In the 1980s
policymakers across the world recognised, as they had failed to do in the 1970s, that loose fiscal policy could
add fuel to the inflationary fire. They held back on spending even as households’ real incomes declined. Mr
Cochrane points out that America’s primary budget deficits (ie, excluding interest payments) were
“unremarkable, especially given the severe recessions of 1980 and 1981-82”.

Governments elsewhere were harder-nosed. Japan reduced its primary deficit from 3.2% of gdp in 1980 to a
surplus by 1985. Denmark experienced a tough period of austerity. Even France kept a firm lid on borrowing. A
growing number of economists today are urging policymakers to learn these lessons. In a new piece Tobias
Adrian and Vitor Gaspar of the imf argue that “[f]iscal responsibility...demonstrates that policymakers are
aligned against inflation.” They reckon a given fiscal tightening can reduce core inflation by almost as much
as a dose of monetary austerity.

The third lesson of the 1980s is that disinflation is painful. The world economy did not benefit from a “soft
landing”, where inflation falls without provoking recession. Average unemployment across the rich world
doubled in the five years after 1979. Some parts of the economy cratered. Home construction, for instance, fell
by a fifth in 1980-82.

Unsurprisingly, therefore, there was anger. A carpenter sent Volcker a plank of wood in the post—a symbol
that lumber was unneeded since no one was buying houses. In Canada car-workers shut down highways.
Policymakers nonetheless stayed the course, showing the public that they were deadly serious about getting
inflation under control.

It was acceptable in the 80s

Do policymakers today have the stomach for the fight? Coming so soon after the fiscally austere 2010s, many
are reluctant to tighten the tax-and-spending screws once again. Indeed many politicians have gone the other
way, and now seem uncomfortable with the notion that anyone should lose out from anything, ever. They are
offering hundreds of billions’ dollars-worth of deficit-financed fiscal support that will fuel inflation, whether
by subsidising energy bills (in Europe), offering “cost-of-living payments” (in Australia and New Zealand) or
forgiving student debt (in America).

Policymakers are thus ignoring the fundamental lesson of the 1980s. Fighting inflation is hard. It requires all
hands on deck, and immense courage over a long period of time. It is also, unfortunately, almost inevitable
that some groups lose out, if only in the short term. As politicians run scared, the 2020s risk earning a special
place in the history books, too—for failing to tame inflation. 7

Read more from Free Exchange, our column on economics:

Weather is again determining economic outcomes (Nov 24th)
Only a revived economy can save China’s property industry (Nov 17th)
Interest rates have risen sharply. But is monetary policy truly tight? (Nov 10th)

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This article appeared in the Finance & economics section of the print edition under the headline "I’ll do things for you"

Finance & economics

December 3rd 2022

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