The idea that inflation & economic stagnation cannot occur at the same time was the traditional position of Keynes-inspired macro-economics before the 1970s stagflation.
Keynesian economists insist that inflation can only become a problem when the economy is in the vicinity of “full employment.”
For Keynes the gold standard was a problem because it forced central banks to implement deflationary policies that led to recessions.
Friedman’s explanation of 1970s stagflation
Friedman argued the best way to reduce unemployment was to get rid of the ‘socialist’ policies that kept wages too high, i.e. minimum wages & strong unions.
However, he also recognised that governments would be tempted to follow Keynesian stimulus policies that increase the rate of growth of the money supply.
He accepted that in the short run this could lead to increased output as workers were fooled by higher nominal wages are not actually higher real wages, but once they realise that inflation has eroded their wages they demand wage increases which the bosses cannot afford & so unemployment will return.
The stimulus only succeeds in creating inflation.
What did happen in the 1970s?
Fifty years ago the Bretton Woods dollar-gold exchange system collapsed.
This system was based on the convertibility of the U.S. dollar into gold at a fixed rate of one troy ounce of gold for every $35 presented to the U.S. Treasury.
While the dollar was backed by gold, the currencies of other countries were backed by U.S. dollars.
The dollar reserves of other imperialist countries began to grow at a faster rate than U.S. gold reserves as they began to run trade surpluses with the U.S. once their economies recovered after World War II.
The first real crisis of overproduction after World War II occurred in 1957-58.
The Fed. responded by quickly lowering interest rates, which provoked the first serious external gold drain that the U.S. had experienced since 1931.
To counter the gold drain, the Fed. was obliged to again raise interest rates, which caused the U.S. economy to fall back into recession in 1960-1961.
In response to this crisis, in 1962 the U.S. got the other imperialist central banks, especially the Bank of England, the Bank of France, and the West German central bank, to pool their gold reserves behind the U.S. dollar — much of which was stored for “safekeeping” in a vault under the Federal Reserve Bank of New York.
When the dollar price of gold rose on the free market above $35, these central banks would sell gold for U.S. dollars for $35.
When the dollar price of gold fell below $35, the central banks would purchase gold with U.S. dollars once again raising the dollar price of gold to $35.
But the “gold pool” could only buy time.
The basic problem was that the production of gold was not keeping pace with the rapid expansion of the number of commodities circulating on the world market.
The real problem that undermined the Bretton Woods system was that the market prices of most commodities were above their prices of production.
To equalize the demand for gold with its supply, interest rates had to rise, which they did.
To try & avoid another recession, or even depression, the link with gold was broken.
If there could be non-commodity money the post-war boom could be saved & the marginal theory of value would win out over Marx’s theory of value.
But if Marx was right the attempt would fail.
Unfortunately many socialist & communist parties supported the Keynesian reflationary policies.
In the 1970’s, in dollar terms holding gold was the most “profitable” investment.
As “investments” in gold bullion kept outperforming almost every other type of investment, demand for gold bullion kept climbing.
As a result the dollar price of gold rose.
Consequently the dollar prices of most commodities increases – inflation.
However, the price of labour power – the wage- lagged behind the rise in the dollar price of gold.
This did not prevent Keynesian economists from advising unions to practice “moderation” in their wage demands to “halt inflation.”
However, the capitalists kept attempting to raise dollar commodity prices in line with the sharply falling value of the dollar & the other currencies linked to it.
The inflation was not driven by wages but by currency devaluation.
Since prices were rising more rapidly than the quantity of U.S. dollars was increasing, interest rates rose to ever higher levels where the supply & demand for gold would be equalized.
Despite the continuation of “expansionary policies” by the central banks, the money market tended to tighten slowing down economic growth & increasing unemployment.
Unfortunately, Friedman’s claim that only “tight money policies” could end the relentless acceleration of inflation was correct (assuming the continuation of capitalist production).
Therefore, the Communist, Social Democratic, & trade union leaders who wrongly denied that tight money policies was the only way out of the inflation were doomed to lose the struggle of ideas to the reactionary Friedman and his “monetarist” supporters.
The result was that the working class was thrown back on all fronts across the globe.