The media will be filled this morning with discussions of the budget. Political commentary will focus on how the programs announced in the budget will impact the major parties and influence next year’s election. Economists will weigh in on the upcoming tax cuts and spending on the battle against inflation. My own opinion will add little to the debate.

Instead, I want to tell a story. We turn to history not because it is a crystal ball but because it holds clues to what may happen and the trade-offs we make as a society.

Nixon, Burns and Volker

The 1970s was a decade of high inflation in the US and globally with an average inflation rate of 6.8% per year in the US. That is double the long-run historical average. And while it is easy to look back to the past and paint a period of time with a broad brush, we lose perspective if we zoom too far out.

The early 1970s was a great period for investors. The market was surging. Despite all the societal turmoil the 1960s were good for business. It wasn’t until 1973 that underlying issues rose to the surface. The headline event was the Arab oil embargo which quadrupled crude oil prices. Prices sat at this elevated level throughout the decade before the Iranian Revolution in 1979 caused them to jump again.

It was the oil shock that acted as the initial trigger for higher inflation. Yet there were underlying structural economic conditions that contributed to the level and stubbornness of inflation. The cost of the Vietnam War caused budget deficits to increase in the US. This was combined with significant spending on social programs and an expansionary monetary policy that provided kindling to the inflation conflagration. However, we need to rewind back to 1960 to get a fuller picture of why inflation got out of control.

In 1960 Richard Nixon was running for president against John F. Kennedy. As the Vice-President for 8 years under President Eisenhower, Nixon was running on the track record of the administration. In March 1960 Nixon received a call from an economist with a warning that unemployment was likely going to rise prior to the election in November. As a loyal Republican the economist had some recommendations to help the economy. The economist was Arthur Burns.

Nixon lost the election. Not a man to shrug off a defeat Nixon obsessed over who and what was to blame. Nixon decided one culprit was the rise in unemployment which had occurred just as Burns had predicted.

Fast forward to 1970. Nixon had finally won the White House after being declared politically dead after losing the election for Governor of California. He famously finished his press conference after the loss by declaring “you don’t have Nixon to kick around anymore.” He had clawed his way back to the pinnacle of power and was going to do everything possible to hang onto it.

Watergate is the most famous of Nixon’s actions to win the 1972 election. But Nixon remembered the economic lessons from 1960. And he remembered the man who had provided the prescient warning. In 1970 Arthur Burns took office as Charman of the Federal Reserve.

The US economy had come out of a recession in 1970 but unemployment kept rising as often happens even after economic growth returns. And Nixon wasn’t going to take any chances. Not exactly a stickler for the rules Nixon infringed upon the traditional independence of the Federal Reserve to pressure Burns.

Their conversations were recorded on the infamous White House tapping system. It was clear what Nixon wanted Burns to do. According to Nixon aide William Safire the administration also orchestrated a series of leaks to apply additional pressure. One leak indicated the administration was going to expand the Federal Reserve Board so Nixon could appoint more members. Another leak outlined efforts to expand political control of the central bank. And then there was a leak that Burns was trying to get his salary raised when he had actually proposed to lower it. A little character assassination as the icing on the cake.

Even though inflation was starting to rise the near-term political problem was unemployment and any impact on the upcoming election. This was Nixon’s focus and Burns caved to the pressure. Between 1970 and 1972 the Fed funds rate dropped along with US treasury yields. The money supply increased, the economy surged and unemployment dropped. And Nixon won the election in a landslide.

In 1973 after that triumphant election year for Nixon US inflation hit 9.6%. In 1974 it reached 11.8%. Inflation wasn’t brought under control until the early 1980s after Fed Chair Paul Volker crushed the US economy with interest rate hikes.  

The verdict of history has not been kind to Arthur Burns. Paul Volker has been hailed as a hero despite implementing a series of policies that led to unemployment climbing to over 10% in the early 1980s. This action eventually brought inflation under control and was politically palatable as Reagon had just entered office and was simply cleaning up “the others guy’s” mess. He knew he had a long runway until the next election.

As painful as that era was inflation was finally brought under control and the economy eventually exhibited strong growth in the 1980s.

Inflation is painful. So is bringing it under control.

The problem with inflation is that politically the cure can be worse than the disease. When future UK Prime Minister John Major was Chancellor of the Exchequer, he said of his inflation policy “if it isn’t hurting, it isn’t working.” Unfortunately for elected officials the people it hurts also vote.

And this is the problem with inflation. Higher prices cause genuine pain for people. Especially the most vulnerable members of society as they are forced to make trade-offs that nobody in a wealthy country like Australia should have to make. The desire to help people that are suffering is the most noble of causes for a politician. Relieving the symptoms without making the disease of inflation worse is one of the most challenging problems for elected officials. I don’t envy the position that Jim Chalmers is in. I hope his plan works. History suggests I should be worried it won’t.

Nixon is an easy man to disparage. And his methods may have been abhorrent. But his motivations and focus on the next election were not unique. There is always going to be temptation to overly focus on the symptoms of inflation and infringe upon the independence of central banks. We all want to keep our jobs. Politicians are no different.

As I said I will leave the political commentary and the possible economic ramifications of the budget for others. Our concern at Morningstar is how people can manage their own budget and reach their financial goals. It is hard to save money in the face of rising prices. But if you have the means to put away a portion of the upcoming tax cuts it may make sense in the face of an uncertain economic future.

Many people will be tempted by the higher yields available through bonds. Yet historically while all types of investments have suffered in inflationary environments shares have performed better. Companies can respond to higher inflation by raising prices. The nominal yields on fixed rate bonds suffer in real terms with inflation. Ashely Owens has written about the historic returns on different assets class in the face of inflation. It may be a timely read for all investors.