Saturday, January 30, 2016

The feat of Paul Volcker - a systemic view of the story of conquering US Inflation in the 1970's

The last surge in inflation the US went through, happenend during the 1970-1980 decade. This is the US inflation rate during the last 100 years:

How did the US control the inflation that had plagued it throughout most of the 1970's? An unlikely hero drove the inflation down in most unexpected ways, by looking at the system.

Today I came across this story which completely caught my attention as a beautiful example of systemic thinking. I am an avid Podcast listener during my commuting to and from work, and it continues to be a great source of insights. With System Dynamics permanently in my head, I am increasingly conditioned to hear the systemic effects in the stories that I hear, and I must accept that these episodes of system-realization are increasing. I find myself wondering continuously at all the systems around me I failed to see when I did not think in terms of systems.

If you want to listen to the podcast first, you can do this here. Thereafter you can go to the section in this blog where we analyze what happened. If you don't want to listen, read on.

1. Summary of the story

The basic facts of the story are the following.

US Inflation out of control

The US was in an inflationary crisis during most of the 1970's. Inflation reached as much as 10% annually, meaning that the quantity people could buy with the money they were earning , was less and less every month. This was partially caused by the uncontrolled printing of money by the Federal reserve. Why does this printing of money have this effect?

An island to understand the problem

Well, to quote the example in the podcast, imagine an island where there is 1000 coconuts and 1000 printed bills with which to buy them. Then each coconut would be worth 1 bill. Now imagine a plane flies over the island and drops another 1000 bills. How much would each coconut be worth now? by simple math, if there are still the same 1000 coconuts in the island and now there are 2000 bills in total, then each coconut would now be worth 2 bills instead of one. The "inflation" generated by these additional bills has then resulted in each bill being able to buy less coconut than before. A similar effect was happening in the US at that point in time.
This can create a vicious loop where as people can buy less with the money they have, and thus complain to the government, it leads to the government printing more money, which in turn decreases even more the purchasing capacity of the existing money. If not controlled, this can lead (and has led in many cases throughout history) to the collapse of a currency.

An unlikely hero proposes a solution

The President of the US at that time, Gerald Ford, wanted to get hold of the inflation, and appointed Paul Volcker in 1979 as chairman of the US Federal Reserve. He was convinced that it was the uncontrolled printing of money which was causing the problem, so he decided to stop printing money. According to his understanding this would then stop the existing money from loosing more of its value, and thus inflation would be controlled. It all seemed to work fine in theory. Only that when he did this, the inflation not only continued, but rose to higher levels, and stayed at those high levels for almost 2 years before coming down. There was something Volcker had overlooked.

Stuff in your head

What had happened then? Well, when the Federal reserve stopped printing more money, the effect that was sought did not come to be because the people did not believe inflation would go down,even though the government said this officially though the media. What was happening was that people, believing that the price of goods would continue to rise, preferred to buy goods now with the money they had. This led then to an increased demand of goods, which made the goods scarce, and therefore their price continued to rise. If only people had believed the Government that inflation would decrease through the measures they were taking, inflation would have stopped as planned. But it did not. Why? because of what people BELIEVED. Their expectations of inflation, drove that inflation.
There are many examples of this, where peoples expectations drive the phenomenon they are looking to avoid and which I will probably cover in another post, but it involves systemic effects in all cases. People's decisions had consequences far beyond the immediate effects, as in this case.

Eventually inflation subsided

It took almost 2 years for inflation to subside. During this time Paul Volcker stayed firm with his decision of not printing more bills, yet had to deal with unemployment not seen since the great depression and general public discontent. Once the inflation went down to low single digits, did the US kick start again,but having passed the trauma of unemployment on a mass scale, with consequences throughout the world.
It is important to note that the inflation in the US has since not risen to high levels again, and public opinion polls continue to show that the US population believes the Federal reserve will keep this under control. Seems like the self fulfilling prophecy, for the moment, is towards believing in the Federal reserve, not like in the 1970's.

2. Why did this happen?

The previous section stated the facts, and it could be similar to a doctor initially analyzing the symptoms of the patient: what were the sequence of events? so you have any rushes, pains, dizziness? However, in the same way, although making a good description of the problem, is not nearly good enough for finding its solution.We need to dig a bit deeper into how this problem comes about, this is, the structure of the system that leads to the unwanted behavior.

First, there are several feedback loops involved in this process These feedback loops result in the inevitable boosting of an unwanted behavior, just because of how the people and relationships present in the system.

Expected inflation Loop

A first feedback loop is the one concerning the expectation of inflation:
This representation is known as "Causal Loop Diagrams". Keep in mind the individual relationships between the components of this feedback loop, which we have named the "Self-fulfilling prophecy reinforcing feedback loop". It is read something like this:
  • "Expectation of Inflation" and "Preemptive purchasing are related because the story tells us that since the population expected prices to increase, they would buy goods sooner rather than later before the prices would be higher, not necessarily because they needed those goods at that point. These two are POSITIVELY related since, the more that people expected a rise in inflation, the more preemptive purchasing there would be. Look at the relationships within feedback loops here.
  • In the same way, the more preemptive purchasing there was in the market, the more scarcity there would be of goods (positive relationship)
  • the more scarcity there was of goods, the more the prices would in fact increase (positive relationship)
  • the more the prices would increase, the more the inflation rate would also increase
  • finally, the more the inflation rate would increase , the more the expectation of inflation increase would be confirmed and strengthened. 
This means that starting from an existing expectation of inflation, through the effect of hoarding among others, would mean an escalation of prices without bounds. This has happened in history. the old Weimar Republic suffered this in the 1920's, as did many other countries and societies throughout history.

Available paper money loop

Also there is the feedback loop concerning the printing of money salary and purchasing power of the money:

The story of this Feedback loop,which we have named the "Money Printing debacle" Reinforcing feedback loop", goes something like this:
  • An increasing inflation rate, due to complaints by the population according to the US inflation story, led to government printing more money to solve the issue (this is, until Paul Volckner came along). These two variables are then positively related: the higher the inflation rate, the more additional bills are printed.
  • Now according to the simplified coconut story, but just as true in a real, more complex economy, the printing of more bills leads to a decrease in the value of money, meaning that the same physical bill will be able to buy less and less due to the effect of there simply being more bills around. Therefore the "Additional printing" leads to a DECREASE in the value of money. Since these two related variables behave in opposite ways (when one increases the other one increases or vice-versa, these are said to be related in a NEGATIVE way (indicated with a negative sign in the causal loop diagramLook at the relationships within feedback loops here.
  • The less value money has, the more money it will be required (more physical bills) to purchase the same goods, and thus the prices will increase. These two variables "value of money" and "Increase in Prices" are NEGATIVELY related, when one increases, the other decreases or vice-versa.
  • Finally, when the price levels increase, the inflation rate increases as well.

Loop speed

It is important to note that the purchasing power of money (Value of Money) as reflected through the prices in the economy, is something that can adjust very quickly, and so it did in this story. However, the expectation of inflation is something that took a long time to adjust. Expectations are beliefs held throughout a group of people, and these normally take a long time to adjust, depending mainly on how quickly the "contagion for the new expectation" spreads throughout the population.

The loop named "Money printing debacle" has a greater speed than the slower "Self-fulfilled prophecy" loop.

Several models have been developed to explain how this "contagion" can take place. One that is relatively well known is the Bass Diffusion model, developed for the marketing industry in the 1950's. This model basically proposes that the contagion of ideas within a population can take place in two different ways, either through direct contact between people, or through the influence of advertising.

There are many things in our everyday systems that modify slowly, such as the example of the adjustment of expectations. Things that take along time to adjust are said to have a greater systemic inertia, as they are difficult to "move" and thus slow to change. Things that are difficult to "move" and which have been found to have big systemic inertia are, for example, cultural norms, habits and perceptions present in a community, as well as multiple types of expectations present in society and which invisibly, yet surely influence our lives, just as in the case of the "expectation of inflation" mentioned in the story here.

When a long and a short term loops coincide and act on the same problem (as it will normally be the case), it is a very normal thing to react first to the short term loops as their effects are apparent more quickly. This would however lead to a short term solution which would be deleterious in the long term, which is the appropriate time-span from which to search solutions to inflation.

It is thus remarkable that Volcker remained by his decision, somehow firmly believing in the long-term effects of his measures, no matter how tumultuous their effects where in the short term. eventually the expectation of inflation subsided, as the community slowly but surely realized that these measures were not a passing fancy, but rather where having the effects the Federal Reserve promised.

The future

Deducing from this story, a sensible question remains: how much longer will the current self fulfilled prophecy hold in the US, that the Federal Reserve is in control of inflation, until the effect of the trillions of dollars that have been printed without any backing, finally sinks in?

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