The Seeds of the Great Inflation Are Sown by the Fateful Phillips Curve

Keynesian policies led, however, according to one prominent economist, to “the greatest failure of American macroeconomic policy in the post-war period.” The Great Inflation was the defining macroeconomic event of the second half of the twentieth century and continues to have significant repercussions.

Over the nearly two decades it lasted, the global monetary system established during World War II was abandoned, there were four economic recessions, two severe energy shortages, and the unprecedented peacetime implementation of wage and price controls. But that failure also brought a transformative change in macroeconomic theory and, ultimately, the rules that today guide the monetary policies of the Federal Reserve and other central banks around the world. If the Great Inflation was a consequence of a great failure of American macroeconomic policy, its conquest should be counted as a triumph.

The basis of the policy was the belief that permanently lower rates of unemployment could be provided if modestly higher rates of inflation were tolerated. The idea that the “Phillips curve” represented a longer-term trade-off between unemployment, which was very damaging to economic well-being, and inflation, which was sometimes thought of as more of an inconvenience, was an attractive assumption for policymakers who hoped to forcefully pursue the dictates of the Employment Act.

The stability of the Phillips curve was a fateful assumption, however; one that economists Edmund Phelps (1967) and Milton Friedman (1968) warned against, arguing that the trade-off between lower unemployment and more inflation that policymakers believed they could make would likely be a false bargain, requiring ever higher inflation to maintain.

Chasing the Phillips curve in pursuit of lower unemployment could not have occurred if the policies of the Federal Reserve were well-anchored. And in the 1960s, the U.S. dollar was anchored, if tenuously, to gold through the Bretton Woods agreement. The story of the Great Inflation is in part also about the collapse of the Bretton Woods system and the separation of the U.S. dollar from its last link to gold.

Among the flaws of the Bretton Woods system was the attempt to maintain fixed parity between global currencies. Many nations, it turned out, were also pursuing monetary policies that promised to march up the Phillips curve for a more favorable unemployment–inflation nexus. As the world’s reserve currency, the U.S. dollar had an additional problem. As global trade grew, so too did the demand for U.S. dollar reserves.

For a time, the demand for U.S. dollars was satisfied by an increasing balance of payments shortfall, and foreign central banks accumulated more and more dollar reserves. Eventually, the supply of dollar reserves held abroad exceeded the U.S. stock of gold, implying that the United States could not maintain complete convertibility at the existing price of gold—a fact that would not go unnoticed by foreign governments and currency speculators.

As inflation drifted higher during the latter half of the 1960s, U.S. dollars were increasingly converted to gold, and in the summer of 1971, President Nixon halted the exchange of dollars for gold by foreign central banks. The post-war global monetary system was finished. With the last link to gold severed, most of the world’s currencies, including the U.S. dollar, were now unanchored. Except during periods of global crisis, this was the first time in history that most of the monies of the industrialized world were on an irredeemable paper money standard.

Our Economy Fights Another War, on Several Fronts

The late 1960s and the early 1970s were a turbulent time for the U.S. economy. President Johnson’s Great Society legislation brought about major spending programs across a broad array of social initiatives at a time when the U.S. fiscal situation was already being strained by the Vietnam War.

To that tension was added the repeated energy crises that increased oil costs and sapped U.S. growth. The first crisis was an Arab oil embargo that began in October 1973 and lasted about five months. During this period, crude oil prices quadrupled to a plateau that held until the Iranian revolution brought a second energy crisis in 1979. The second crisis tripled the cost of oil.

From the perspective of the central bank, the inflation being caused by the rising price of oil was largely beyond the control of monetary policy. But the rise in unemployment that was occurring in response to the jump in oil prices was not. Motivated by a mandate to create full employment with little or no anchor for the management of reserves, the Federal Reserve accommodated large and rising fiscal imbalances and leaned against the headwinds produced by energy costs. These policies accelerated the expansion of the money supply and raised overall prices without reducing unemployment.

Looking back at the information policymakers had in hand during the period leading up to and during the Great Inflation, economist Athanasios Orphanides has shown that the real-time estimate of potential output was significantly overstated, and the estimate of the rate of unemployment consistent with full employment was significantly understated. Thus, the effect of flawed policy was compounded by flawed data. The stable trade-off between inflation and unemployment that policymakers had hoped to exploit did not exist.

Federal Reserve Chairman Volcker Toughs It Out

But once in the position of having unacceptably high inflation and high unemployment, policymakers faced a dilemma. Fighting high unemployment would almost certainly drive inflation higher still, while fighting inflation would just as certainly cause unemployment to spike even higher. In 1979, Paul Volcker, formerly the president of the Federal Reserve Bank of New York, became chairman of the Federal Reserve Board. When he took office in August, year-over-year inflation was running above 11 percent, and national joblessness was just a shade under 6 percent.

Fighting inflation was now seen as necessary to achieve both objectives of the dual mandate, even if it temporarily caused a disruption to economic activity and, for a time, a higher rate of joblessness. In early 1980, Volcker said, “[M]y basic philosophy is over time we have no choice but to deal with the inflationary situation because over time inflation and the unemployment rate go together.… Isn’t that the lesson of the 1970s?”

Volcker believed that fighting mounting inflation should be the primary concern for the Fed: “In terms of economic stability in the future, [inflation] is what is likely to give us the most problems and create the biggest recession” (FOMC transcript 1979, 16). He also believed that the Fed faced a credibility problem when it came to keeping inflation in check. During the previous decade, the Fed had demonstrated that it did not place much emphasis on maintaining low inflation, and public expectation of such continued behavior would make it increasingly difficult for the Fed to bring inflation down. “[F]ailure to carry through now in the fight on inflation will only make any subsequent effort more difficult,” he remarked.

Over time, greater control of reserve and money growth, while less than perfect, produced a desired slowing in inflation. This tighter reserve management was augmented by the introduction of credit controls in early 1980 with the Monetary Control Act. Over the course of 1980, interest rates spiked, fell briefly, and then spiked again. Lending activity fell, unemployment rose, and the economy entered a brief recession between January and July. Inflation fell but was still high even as the economy recovered in the second half of 1980.

But the Volcker Fed continued to press the fight against high inflation with a combination of higher interest rates and even slower reserve growth. The economy entered recession again in July 1981, and this proved to be more severe and protracted, lasting until November 1982. Unemployment peaked at nearly 11 percent, the highest level experienced since the Great Depression, but inflation continued to move lower and by recession’s end, year-over-year inflation was back under 5 percent. In time, as the Fed’s commitment to low inflation gained credibility, unemployment retreated, and the economy entered a period of sustained growth and stability. The Great Inflation was over.

Securitization Solves a Genuine Problem, and Turns the World Upside Down

To understand the phenomenon called securitization that has had such profound impact on the world and the boardroom as we know it, we need to again look back. In 1970, the first money market fund was established as a mutual fund, creating what was seen to be a safe place to earn interest outside of a bank. As interest rates rose in the era of high inflation, money moved rapidly out of banks and into the new money market accounts. Concerned about deposit flight from thrift institutions, then a protected species given their special role in making home mortgage loans due to the belief that home ownership promoted stability, Congress allowed the first interest bearing deposit accounts to be offered by thrifts and savings banks in the late 1970s.

To help the thrifts who now had to pay depositors high interest but could afford neither to sell their current low coupon fixed rate loans nor fund new ones at high rates, Congress allowed them to write off sale-related losses as “goodwill” over a long period of time to preserve the impression they were solvent. In doing so, however, Congress all but wrote the death knell for the thrift industry. With the huge new influx of secondary product sold to the Street by the thrifts, the secondary mortgage market per se finally took off in the early 1980s. Ironically, the thrift industry, no longer uniquely useful, was quickly made irrelevant.

Suddenly, the Street’s bond trading floors, historically sleepy backwaters controlled by a tight knit group of local guys who maintained discipline through tried and true, often unwritten, rules, became places where huge amounts of money could be made due to the volatility of interest rates.

Not Your Daddy’s Trading Floor

Trading in mortgages became the hottest game in town, as the analytical complexities of valuing mortgages could be used to advantage by a savvy trader dealing with less sophisticated sellers and buyers. Pools could be purchased from the thrift institution assuming one rate of prepayment and sold at a radically different assumed prepayment rate. They were making a killing, as no one was in position to know what a realistic price actually was. Traders were in heaven, and they seemed to have, as delightfully and accurately detailed in Michael Lewis’s book Liars Poker, protected positions. They were seen as kings.

In a powerful example of the shifting of the trader from employee concerned about protecting his employer’s balance sheet, earning his keep through building the enterprise, to the direct pursuit of personal benefit, one legendary trader managed to get himself into a loss position of $25 million. Let’s call him Richie. He is alleged to have told the head of fixed income trading that the loss left him unmotivated, and he was thinking of leaving the job. In deep alarm, as he did not know how to get out of the loss position, the boss asked what could be done.

After some thought, Richie responded that he needed an incentive to get him going. He proposed that if he cut the loss in half, he would receive $1 million. If he got the position to flat before year end, he needed $2 million. Anything above zero would need to include payment to Richie of half the profits. The boss took the deal, Richie traded back to the plus side, and everyone was happy. Kind of.

Trading floors attracted MBAs drawn by the earning potential, and rocket scientists by the great puzzle of valuing pools in which each mortgage included 360 possible prepayment dates, and each pool of mortgage backed securities traded included thousands of mortgages. Option valuation thinking bloomed, and the MBAs, the quant jockey rocket scientist Ph.D.’s, the long-time traders from the neighborhood, and the gamblers who arrived from Las Vegas struggled to learn new vocabularies. Almost overnight, the old hand signals to traders disappeared, along with the once strictly upheld convention that a trader’s word was his bond.

As an aside, when Adolph Berle’s widow, a long-time family friend, asked me what I did when I was starting the derivatives function at Drexel Burnham in 1984, words failed me and I told her I was an anthropologist on Wall Street. Some time later, at dinner at her Gramercy Park brownstone (always a black-tie affair that started at 8:00 pm and ended at 10:00), she introduced me to my dinner companions as an anthropologist on Wall Street and asked me to offer some of my observations. Who was in attendance? Henry Kissinger and Arthur Schlesinger.

Interest Rate Arbitrage Comes of Age with the Swap Market

Moving along, in another response to inflation related volatility, the swap (derivatives) markets were born, allowing borrowers and issuers to separate principal repayment risk from interest rate or currency risk. A simple contract entered into by two or more counterparties, the swap contract was private and invisible, free of any regulatory involvement.

The swap contract allowed a borrower who could borrow in one market at attractive fixed rates but preferred floating rate payments to agree to make floating rate payments to another borrower, who preferred fixed rate payments but could not access such financing directly but had attractively priced floating rate cost of funds. The contract therefore called for the second borrower to make fixed rate payments. The contract netted the payments, so the parties paid the resulting differences to each other periodically. The principal repayment was not involved. At the outset, the broker in the middle received a several month mandate by telex to source the counter party and took a hefty, risk free fee for putting them together.

It was a very secretive market at the outset in the early 1980s, and only a few dealers participated. As volume grew, these dealers started to inventory attractive swaps by becoming the counter party themselves, hedging the position in the government bond market, and then laying off the other side of the trade as counter parties were found. I was a participant in this process, which initially was quite home grown, and developed for the most part out of finance departments, not trading areas. One Monday morning, we in the swap group discovered that all of our hedges were gone. Upon investigation, it was discovered that the government bond traders in London, responsible for the positions while U.S. markets were closed, had not recognized our bonds as hedges, and sold them in the face of attractive bids.

In another anecdote showing the shift in culture from enterprise balance sheet to individual, I joined Drexel Burnham from Bankers Trust Company, hired to start the interest rate swap function under the guidance of an academic sort of guy who had previously traded in futures, not very successfully, if memory serves. I could not figure out why in the first year of our operation he consistently wanted to overprice our trades, which seemed to me shortsighted as it would reduce much needed deal flow and repeat business.

At the end of the year, the light dawned. He had made a deal pursuant to which he personally received 35% of the discounted value of the income from the swap transactions. I imagine he knew that his superiors, once they understood the arcane world he had refused to explain clearly to them, would never renew that deal, so he did as many swaps as he could at high spreads during that one year. He also, I later learned, changed my initials on the trade blotters so it looked as if I was much less productive than I was, so that, once he had learned everything he could from me, he could easily terminate my employment.

That ploy did not work, and he left for greener pastures. He developed a joint venture with a AAA rated insurance company with whom he cut an even better deal. The insurance company provided the AAA rating and the money to pay for office space far from headquarters, and he provided the intellectual capital needed to create a swap business. He was to be compensated on the basis of 50% of the discounted value of the profits, aka the swap spread.

On paper this may look benign, or at least not unfair. In fact, though, since the swap profit or spread is collected over the life of the swap contract, this was a disastrous deal for the insurance company, who was required to pay that compensation in current cash, cash it had not yet collected. Of course, he wrote as many swaps as he could, and offered longer swaps than anyone else in the market. And that insurance company would pay the price, over and over again, until the music finally stopped in 2008.

The swap market continued to develop and be used in an ever-increasing range of situations, from currency swaps to swaps on hurricane risk to credit default swaps and beyond. Once a very quiet market, the interest rate swap curve joined the other reference curves for all traders; while at inception it solved genuine problems for genuine customers, its replication as a model for transferring all kinds of risk became overpowering.