For many on Wall Street, talk of stagflation sends shivers down the spine, bringing back bad memories of the s. It's no accident the '70s was the decade to give birth to gritty films like "Taxi Driver" and aggressive music like punk rock. The economies and societies of the developed world were convulsed by the perfect storm of high unemployment and rocketing prices that decade.
It was a shock after two decades of relative calm and prosperity after World War II, when governments actively managed their economies to try to keep unemployment low. After the deflation of the s and the Great Depression , they were happy to tolerate price rises if it meant the jobs market was healthy. The US and global economies went through a recession as oil prices surged and Richard Nixon changed the rules of international finance by unpegging the dollar from gold , which had been the bedrock of the financial system since the end of World War II.
Despite slowing growth, inflation spiralled out of control, with price rises in the US soaring into double digits by the end of the decade. The oil-price shock, high levels of government spending, and unions pushing up wages were all blamed.
The resulting stagflation was a nightmare for households and businesses, and smashed the old way of thinking about economics. It ultimately led to a new set of ideas gaining influence, with governments and central banks particularly in the US and UK inspired by the economist Milton Friedman to slash government intervention and focus on controlling inflation.
The new system helped bring back growth but laid the foundations for a new set of problems, primarily soaring inequality and the crisis in housing and finance.
The return of stagflation threatens to turn the post-pandemic period into a mass firefighting exercise. US stocks plunged in September and have had a rocky October as investors worry that inflation could stay high — eating away at their investments — even as growth cools.
Yet there are hopeful signs. Analysts point out that economies around the world are still set to chalk up better growth rates in and than they've seen in years. And unemployment rates in advanced economies have stayed relatively low. Even so, markets are jittery and the stagflation debate will stick around. Economists and traders will be digging through each data release for any whiff of slowing growth or persistent price rises — and praying that there's no return to the s.
In this article, we'll examine stagflation in the U. Those that argue that unemployment and inflation are inversely related believe that, when the economy slows, unemployment rises, but inflation falls. Therefore, to promote economic growth, a country's central bank could increase the money supply to drive up demand and prices without stoking fears about inflation.
Beliefs about inflation and unemployment were based on the Keynesian school of economic thought, named after twentieth-century British economist John Maynard Keynes. According to this theory, the growth in the money supply can increase employment and promote economic growth. In the s, Keynesian economists had to reconsider their ideas, as industrialized countries around the globe entered into a period of stagflation.
Stagflation is defined as slow economic growth occurring simultaneously with high rates of inflation. When people think of the U. That price level would not be exceeded for 28 years. Indeed, inflation was high by U. Unemployment was also high, and growth uneven; the economy was in recession from December to November , and again from November to March The prevailing belief as promulgated by the media has been that high levels of inflation were the result of an oil supply shock and the resulting increase in the price of gasoline, which drove the prices of everything else higher.
This is known as cost-push inflation. According to the Keynesian economic theories prevalent at the time, inflation should have had an inverse relationship with unemployment, and a positive relationship with economic growth.
Rising oil prices should have contributed to economic growth. In reality, the s was an era of rising prices and rising unemployment; the periods of poor economic growth could all be explained as the result of the cost-push inflation of high oil prices.
This was not inline with Keynesian economic theory. A now well-founded principle of economics is that excess liquidity in the money supply can lead to price inflation ; monetary policy was expansive during the s, which could help explain the rampant inflation at the time.
Milton Friedman was an American economist who won a Nobel Prize in for his work on consumption, monetary history, and theory, and for his demonstration of the complexity of stabilization policy. In a speech, the chair of the Federal Reserve, Ben Bernanke , said:. Milton Friedman did not believe in cost-push inflation. He believed that "inflation is always and everywhere a monetary phenomenon. To get the economically devastating effects of inflation under control in the s, the Federal Reserve should have followed a constrictive monetary policy.
This finally happened in when Federal Reserve Chair Paul Volcker put the monetarist theory into practice. This drove interest rates to double-digit levels, reduced inflation, and sent the economy into a recession.
In a speech, Ben Bernanke said about the s, "the Fed's credibility as an inflation fighter was lost and inflation expectations began to rise. The severity of the recession, the worst of the postwar period, clearly illustrates the danger of letting inflation get out of control.
This recession was so exceptionally deep precisely because of the monetary policies of the preceding 15 years, which had unanchored inflation expectations and squandered the Fed's credibility. Because inflation and inflation expectations remained stubbornly high when the Fed tightened, the impact of rising interest rates was felt primarily on output and employment rather than on prices, which continued to rise.
Disinflation is a temporary slowdown in inflation, while deflation is the opposite of inflation and represents a decrease in prices throughout an economy. One indication of the loss of credibility suffered by the Fed was the behavior of long-term nominal interest rates.
For example, the yield on year Treasuries peaked at This was almost two years after Volcker's Fed announced its disinflationary program in October , suggesting that long-term inflation expectations were still in the double digits. Milton Friedman eventually gave credibility back to the Federal Reserve. The job of a central banker is challenging, to say the least. Economic theory and practice have improved greatly, thanks to economists like Milton Friedman, but challenges continuously arise.
At some point, this boom will culminate in a Minsky moment a sudden loss of confidence , and tighter monetary policies will trigger a bust and crash. But in the meantime, the same loose policies that are feeding asset bubbles will continue to drive consumer price inflation, creating the conditions for stagflation whenever the next negative supply shocks arrive.
Such shocks could follow from renewed protectionism; demographic ageing in advanced and emerging economies; immigration restrictions in advanced economies; the reshoring of manufacturing to high-cost regions; or the Balkanisation of global supply chains.
More broadly, the Sino-American decoupling threatens to fragment the global economy at a time when climate change and the Covid pandemic are pushing national governments toward deeper self-reliance.
Add to this the impact on production of increasingly frequent cyber-attacks on critical infrastructure, and the social and political backlash against inequality, and the recipe for macroeconomic disruption is complete.
Making matters worse, central banks have effectively lost their independence because they have been given little choice but to monetise massive fiscal deficits to forestall a debt crisis. With both public and private debts having soared, they are in a debt trap. As inflation rises over the next few years, central banks will face a dilemma. If they start phasing out unconventional policies and raising policy rates to fight inflation, they will risk triggering a massive debt crisis and severe recession; but if they maintain a loose monetary policy, they will risk double-digit inflation — and deep stagflation when the next negative supply shocks emerge.
But even in the second scenario, policymakers would not be able to prevent a debt crisis. While nominal government fixed-rate debt in advanced economies can be partly wiped out by unexpected inflation as happened in the s , emerging-market debts denominated in foreign currency would not be. Many of these governments would need to default and restructure their debts.
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