12 - The Political Economy of Inflation

Summary

Macroeconomic miscalculations by policymakers cannot alone account for the decade and a half of high inflation following 1965. The desire of the political system to use inflation as a tax was a major factor. Friedman (1975, 149) explained: “From time immemorial, the major source of inflation has been the sovereign's attempt to acquire resources. … Inflation has been irresistibly attractive to sovereigns because it is a hidden tax that at first appears painless or even pleasant, and above all because it is a tax that can be imposed without specific legislation. It is truly taxation without representation.”

The political environment within which the Fed operated changed radically after the November 3, 1964, election. The election provided the mandate and the congressional votes to undertake a broad expansion of income redistribution programs. In the election, Democrats had campaigned for a national medical care program (Medicare) and a strong Social Security program. Republicans had campaigned for Social Security coverage limited to the needy elderly and financed out of general revenues. The elections gave the Democrats a 295–140 majority in the House and a net increase of 42 northern Democrats. The conservative coalition of Republicans and Southern Democrats that had blocked social legislation crumbled. In 1965, the Vietnam War defense buildup began. The political system demanded a rapidly growing economy that would generate continuous increases in revenue. For the Fed, that concern translated into pressure for “low” interest rates.