The 1970s brought a new kind of economic crisis. Instead of a sudden crash, many economies suffered years of high inflation combined with weak growth and rising unemployment, a painful mix called stagflation. Oil price shocks were at the centre of it. In Part 6 of Great Financial Crises, we look at how it happened and how it was finally defeated.
The backdrop: inflation was already rising
According to the Federal Reserve's history essays, US inflation was only about 1% a year in 1964. Over the following decade it crept higher, driven by government spending, loose monetary policy and the belief that a bit more inflation could buy lower unemployment.
In August 1971, President Richard Nixon ended the convertibility of the dollar into gold for foreign central banks, effectively ending the Bretton Woods system of fixed exchange rates. He also introduced wage and price controls in phases between 1971 and 1974. These controls held prices down temporarily but created shortages and distortions. By mid-1973, wholesale prices of industrial goods were already rising more than 10% a year.
The first oil shock (1973 to 1974)
On 19 October 1973, during the Yom Kippur War, Arab members of the oil producers' group OAPEC announced an oil embargo against the United States and other countries that supported Israel. The embargo was lifted in March 1974, but the price increase stuck.
According to the Fed's history essay, the price of oil rose from $2.90 a barrel to $11.65 by January 1974, nearly quadrupling. Petrol shortages led to long queues at service stations. Some states rationed fuel by odd and even number plates, and some stations limited sales per customer.
Because energy is used in almost everything, higher oil prices pushed up costs across the economy. At the same time, consumers had less to spend on other goods. Many advanced economies entered recession in 1974 to 1975 while inflation stayed high.
Why stagflation was so confusing
Economists in the 1960s commonly believed there was a stable trade-off between inflation and unemployment, known as the Phillips curve: higher inflation would come with lower unemployment, and vice versa. Stagflation broke this pattern. Both inflation and unemployment rose together.
Policymakers were caught in a dilemma. Easing policy to support jobs risked worsening inflation, while tightening to fight inflation risked deepening the recession. For much of the 1970s, they leaned towards supporting growth, and inflation expectations became entrenched. Workers demanded higher wages to keep up with prices, and firms raised prices to cover costs.
The second oil shock (1979)
The Iranian Revolution in 1979 disrupted oil supplies again. According to the Fed's essay on the Great Inflation, the 1979 oil crisis tripled the cost of oil. US inflation surged, reaching around 14.5% in 1980. Gold, once fixed at $35 an ounce, rose to around $455 by the end of the 1970s according to the Fed essay, and spiked even higher in early 1980.
Volcker's cure
In August 1979, President Jimmy Carter appointed Paul Volcker as chair of the Federal Reserve. Inflation was above 11% and unemployment just under 6%. In October 1979, the Fed changed its approach, targeting the growth of bank reserves and money rather than interest rates, and allowing rates to rise as high as needed. Short-term interest rates rose to extraordinary levels, peaking at around 20% in the early 1980s.
The cure was painful:
- A short recession from January to July 1980.
- A deeper recession from July 1981 to November 1982, when unemployment peaked near 11%.
- Farmers, homebuilders and indebted countries were hit hard by high interest rates (see Part 7).
But it worked. By the end of the 1982 recession, inflation was back under 5%, and it averaged about 3.5% in the second half of the 1980s. The episode established the principle that central banks must keep inflation under control, even at a short-term cost.
Impact on investors
- Stocks: US shares performed poorly in real terms in the 1970s, as inflation eroded earnings and high interest rates lowered valuations.
- Bonds: rising inflation and interest rates caused heavy losses for bondholders.
- Commodities and gold: generally performed well as inflation hedges.
- The 1980s rebound: once inflation fell, both stocks and bonds began long bull markets.
Echoes today
When inflation surged again in 2021 and 2022 after the pandemic and energy price spikes following Russia's invasion of Ukraine, policymakers often referred to the 1970s. Central banks raised interest rates rapidly, partly to avoid the 1970s mistake of letting high inflation become entrenched.
Lessons for investors today
- Inflation is a real risk. It can erode the value of cash and bonds for years.
- Energy shocks spread widely. Oil prices affect transport, food, manufacturing and consumer spending.
- Central bank credibility matters. Once people expect high inflation, it becomes much harder to stop.
- Diversify across asset types, including assets that can hold up when inflation rises.
In Part 7, we see how high interest rates helped trigger a debt crisis across Latin America.
Sources
Great Financial Crises: the full series
- Part 1: Tulip Mania (1637)
- Part 2: The Mississippi and South Sea Bubbles (1720)
- Part 3: The Panic of 1907
- Part 4: The Wall Street Crash and Great Depression
- Part 5: Weimar Hyperinflation (1923)
- Part 6: The 1970s Oil Shocks and Stagflation (you are here)
- Part 7: The Latin American Debt Crisis (1982)
- Part 8: Black Monday (1987)
- Part 9: Japan's Bubble and Lost Decades
- Part 10: The Savings and Loan Crisis
- Part 11: The Mexican Peso Crisis (1994)
- Part 12: The Asian Financial Crisis (1997)
- Part 13: Russia's Default and LTCM (1998)
- Part 14: The Dot-Com Bubble (2000)
- Part 15: Argentina's Collapse (2001)
- Part 16: The Global Financial Crisis (2008)
- Part 17: Iceland's Banking Collapse (2008)
- Part 18: The Eurozone Debt Crisis
- Part 19: The Covid Crash (2020)
- Part 20: The 2023 Banking Turmoil
This series is for education only and is not investment advice. Figures are taken from the sources listed and other commonly cited historical records, and may vary slightly between sources.
