Like many studies of the period, they emphasize the role of inflation expectations, which became increasingly less anchored as a result of external shocks and policy errors. External commodity shocks such as the OPEC oil shocks caused inflation expectations to rise. This in itself is not that different from the inflation shock of 2022. Yet in the 1970s, the then government made matters worse by implementing fiscal policies that focused on preserving jobs and promising higher wages to workers to compensate them for the commodity inflation shock.
There is a crucial difference with today, where wages in the US or Britain are not experiencing the same upward pressure as in the 1970s, thanks in no small part to the fact that unions are much weaker today than they were then.
However, the White House in the US is once again embarking on a fiscal policy that increases budget deficits. In Britain, this budget deficit in the 1970s was the result of higher government spending on wages and other fiscal stimulus measures. In the US today, this comes from tax cuts that should stimulate consumer demand.
In Britain, this fiscal stimulus increased inflationary pressures in the United Kingdom, while the Bank of England remained stagnant and unsure how to deal with economic developments and the government’s fiscal measures. This uncertainty was understandable to some extent, as it had only recently entered a world of flexible exchange rates after the end of Bretton Woods.
The conventional wisdom at the time was that the British economy could afford the large deficits because it would soon start receiving revenues from the sale of oil from the North Sea, which was then being developed. And Britain’s international imbalances would resolve themselves thanks to a devaluation of the British pound. Inflation would only be temporary and transitory, they thought.
Ultimately, that wasn’t the case, and the Bank of England’s inaction made the situation worse, as it kept interest rates well below the level suggested by a simple Taylor rule (not that they had any idea of something like the Taylor rule at the time).
Policy rates in Britain versus the Taylor rule
Source: Bordo et al. (2022)
The chart below shows the different contributions to UK inflation during the period of high inflation. Note that the initial rise in inflation in the early 1970s was due to cost inflation (gray bars). But these inflationary pressures were then exacerbated by government measures to boost aggregate supply (brown bars) and monetary policy that remained too accommodative (orange bars).
Decomposing British inflation in the 1970s
Source: Bordo et al. (2022)
Looking at the current situation in the US, we also had a cost-increasing inflation shock in 2022 and 2023 that we are still processing (remember, we never went back to 2% inflation in the US). Now the US government is trying to create a supply shock by cutting taxes (while simultaneously creating another cost-increasing inflation shock through tariffs). And it puts pressure on the Fed to keep interest rates artificially low to further stimulate demand.
And guess what: it could work very well in 2026. It could create a nice sugar rush with stronger growth and consumer demand. But Britain’s history in the 1970s tells us where this could lead in 2027 or 2028.
To quote from A newer article by the same authors: “Our empirical evidence suggests that fiscal policy was at the heart of many of Britain’s problems during the Great Inflation. Unlike most of British history, it was not used to stabilize public finances. Instead, it was used to keep unemployment low and increase growth, to subsidize the losers of the terms of trade shocks and to secure deals with the unions.”
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