Guns, Butter, and the Slow Rot

In January 1965, consumer prices were rising at 1.1% per year. The economy was strong. Unemployment was falling toward 4%. The Kennedy tax cuts were flowing through the economy. And on the surface, the postwar consensus on price stability seemed intact. The CPI had averaged below 2% for the entire decade since the Korean War. America had learned to expect stable prices.

By February 1970, inflation stood at 6.4%. It hadn't arrived in a single month of panic buying or a dramatic policy change. It had crept in, percentage point by percentage point, over five years of fiscal excess and monetary hesitation. And unlike the episodes of 1946 and 1951, this inflation would not burn itself out. It would persist, mutate, and eventually metastasize into the worst sustained inflation in American history.

This is the story of how a nation lost control of its price level — not through a single blunder, but through a series of reasonable-seeming decisions that compounded into catastrophe.

The proximate cause was the oldest in economics: a government trying to spend on two things at once without paying for either.

In March 1965, the first U.S. combat troops landed at Da Nang. By year's end, 184,000 American soldiers were in Vietnam, and the defense budget was climbing sharply. Simultaneously, President Johnson was building his Great Society — Medicare, Medicaid, the War on Poverty, federal education funding, and dozens of other programs. It was the most ambitious expansion of domestic spending since the New Deal.

Johnson's economic advisors, led by the Council of Economic Advisers, warned him that financing both commitments without a tax increase would overheat the economy. Johnson refused. A tax hike would force Congress to confront the cost of the war, which Johnson had deliberately obscured. So the spending continued, financed largely by deficits.

The CPI responded on schedule. It rose from 1.1% in January 1965 to 1.9% by December, then crossed 3% by mid-1966. The acceleration was gentle — tenths of a percent each month — but the direction was unmistakable.

Fed Chairman William McChesney Martin saw what was happening. In 1966, he pushed the Fed Funds rate from 4.42% in January to 5.76% by November — a significant tightening. The credit markets seized up. The housing sector collapsed as mortgage rates soared. It was called the "Credit Crunch of 1966," and it scared everyone.

Then the Fed flinched.

By April 1967, the Fed Funds rate was back to 4.05%. The tightening was reversed before it had time to work. CPI, which had briefly paused at 2.5%, began climbing again. It crossed 3% by late 1967 and 4% by mid-1968. The first opportunity to kill the inflation while it was still manageable — while it was still a 3% problem rather than a 6% problem — was lost.

This is the moment that separates Episode 3 from Episodes 1 and 2. In 1948, no one needed to act because supply recovered on its own. In 1951, the Accord and price controls broke the panic. But in 1966-67, the Fed had the tools, used them briefly, got scared by the side effects, and quit. It was the monetary policy equivalent of starting antibiotics and stopping halfway through the course.

By 1969, with CPI running above 5%, the new Nixon administration and the Fed finally committed to serious tightening. The Fed Funds rate was pushed to extraordinary levels — reaching 9.19% in August 1969. This was the most aggressive monetary tightening since the Fed gained independence in 1951.

It induced a recession. Industrial production peaked in September 1969 and declined for over a year. Unemployment, which had been a historically tight 3.4% through most of 1968-69, began climbing in early 1970. By December, it had reached 6.1%.

But inflation barely moved.

This was America's first encounter with what economists would later call stagflation — the simultaneous presence of rising unemployment and persistent inflation. The 1969-70 recession pushed unemployment from 3.4% to 6.1%, costing millions of jobs. Yet CPI barely dipped below 5.5%. The Phillips Curve tradeoff that had guided postwar economics — lower unemployment means higher inflation, and vice versa — appeared to be breaking down.

The reason was that inflation expectations had shifted. After five years of steadily rising prices, workers demanded higher wages not because they saw prices rising today, but because they expected them to rise tomorrow. Businesses raised prices not because costs were surging, but because they assumed their competitors would. The inflation had moved from the goods market into the psychology of the economy.

Facing a 1972 re-election campaign with unemployment above 6% and inflation still at 4.4%, Richard Nixon chose the politically irresistible option. On August 15, 1971, in a televised Sunday evening address, he announced three bombshells simultaneously.

First, he imposed a 90-day freeze on all wages and prices — the most dramatic peacetime intervention in the American economy since the New Deal. Second, he imposed a 10% surcharge on all imports. And third, he suspended the convertibility of the dollar into gold, effectively ending the Bretton Woods system that had governed international finance since 1944.

The price controls worked — superficially. CPI fell from 4.4% in August 1971 to 3.3% by December, and continued declining into 1972. Nixon won re-election in a landslide. The economy boomed. Unemployment fell.

But the controls didn't kill the inflation. They buried it alive.

When the controls were lifted in 1973, prices exploded with an intensity that would have been unimaginable in 1965. That explosion — compounded by the OPEC oil embargo — is the subject of Episode 4. But the seeds were planted here, in the slow erosion of 1965-71, when inflation crept from 1% to 6% and every institution responsible for stopping it either couldn't, wouldn't, or quit too early.

Gradual inflation is harder to fight than sudden inflation. The post-WWII and Korean War episodes were sharp — prices surged and then fell. But the Great Inflation started with a gentle drift from 1% to 2% to 3%. At no single point did it feel urgent enough to justify the pain of aggressive tightening. By the time it reached 5-6%, expectations had shifted and the inflation had become self-sustaining. The lesson for today: treat a persistent drift upward with as much alarm as a sharp spike.

A central bank that flinches loses credibility. The Fed's 1966-67 reversal was the original sin of the Great Inflation. Martin raised rates, it worked, the side effects scared Congress, and the Fed backed down. Every subsequent Fed chair inherits this lesson: if you tighten and then reverse because of political pressure or market tantrums, you teach the economy that you're not serious. Inflation expectations will adjust accordingly.

Price controls don't cure inflation — they postpone and amplify it. Nixon's 1971 freeze suppressed the CPI reading while doing nothing about the underlying monetary and fiscal excess. When the controls came off, prices caught up with a vengeance. This lesson has been confirmed repeatedly: price controls can suppress symptoms temporarily, but the disease continues to spread beneath the surface.