Locating the Turning Point

Edward Yardeni has a line that is similar to the thrust of the argument here, viz., "war causes inflation and peace causes deflation." Using this approach, one might think, and Yardeni suggests, that the turning point from inflation to deflation would have occurred about 1990 when the Berlin Wall fell -- when the Cold War ended. Yardeni argues that the world hasn't worked that way simply because central banks have been quick to loosen monetary policy to prevent deflation since 1990. But it's not, in my opinion, war and peace, per se, that cause inflation and deflation -- it's the monetary policy during war in contrast to the monetary policy after war that produces fundamentally different price paths (viz., those observed by Kondratieff).

Page 5 of Yardeni's pdf paper, Deflation: the Good, the Bad and the Ugly, shows a history of US prices with inflation during wars and deflation thereafter except after WWII. Prices declined to roughly their pre-war levels after the War of 1812, the Civil War and WWI. But something happened after WWII and the Viet Nam War. After WWII, the price level did not drop, but the rate of inflation sharply declined. After the Viet Nam War, neither the price level nor the inflation rate dropped -- it took another seven years from the end of the war until 1980 before the Fed got sufficient control of monetary policy that the post-Viet Nam inflation was turned around. By this time inflation had a momentum and expectations were hard to break -- it took the recession of 1981-82 to break the strong inflationary psychology and then another decade of ups and downs to bring it under control.

If we are to explore similarities between long deflationary waves of the past that began after wars and a post-Viet Nam deflationary wave, we need, I argue, to identify the turning point with the policy shift that began to effectively terminate the inflation from the preceding war. The Viet Nam War signaled the end of Bretton Woods and the attachment to gold. Following the end of the Viet Nam War the US did not return to gold and it took a number of years for policy makers to fully realize that interest rates were low, not high. It was only after the notion of real interest rates firmly penetrated the highest levels of policy that money was tightened sufficiently to break the back of inflation.

The post Viet Nam inflation that looks most like the 1920-21 recession after WWI is the 1982 recession, not the 74-75 recession induced by the increase in energy prices. The 1920-21 recession was induced by tight money whereas the 1974-75 recession (and the stagflation that followed) was accompanied by loose money. The turning point, I argue, is not in 1974 as most longwave advocates would have it, nor would I look the fall of the Berlin Wall as Yardeni does. I look for the fundamental shift in monetary policy that is most akin to the turn in monetary policy at the end of the Civil War in 1865 and at the end of WWI in 1920. And that policy shift occurred with the October '79 revolution in monetary policy.