Information about Stagflation

Stagflation, a portmanteau of the words stagnation and inflation, is a term in general use within modern macroeconomics used to describe a period of out-of-control price inflation combined with slow-to-no output growth, rising unemployment, and eventually recession. The term stagflation is generally attributed to United Kingdom Chancellor of the Exchequer, Iain MacLeod in a speech to parliament in 1965.^[1][2] "Stag" is drawn from the first syllable of "stagnation", a reference to a sluggish economy, while "flation" is drawn from the second and third syllables of "inflation"--a reference to an upward spiral in consumer prices. Economists associate the presence of both factors as unit costs increase because fixed costs are spread over smaller output.

Stagflation is a problem because the two principal tools for directing the economy, fiscal policy and monetary policy, offer only trade offs between growth and inflation. A central bank can either slow growth to reduce inflationary pressures, or it can allow general increases in price to occur in order to stimulate growth. Stagflation creates a dilemma in that efforts to correct stagnation only worsen inflation, and vice versa. The dilemma in monetary policy is instructive. The central bank can make one of two choices, each with negative outcomes. First, the bank can choose to stimulate the economy and create jobs by increasing the money supply (by purchasing government debt), but this risks boosting the pace of inflation. The other choice is to pursue a tight monetary policy (reducing government debt purchases in order to raise interest rates) to reduce inflation, at the risk of higher unemployment and slower output growth.

The problem for fiscal policy is far less clear. Both revenues and expenditures tend to rise with inflation, all else equal, while they fall as growth slows. Unless there is a differential impact on either revenues or spending due to stagflation, the impact of stagflation on the budget balance is not altogether clear. As a policy matter, there is one school of thought that the best policy mix is one in which government stimulates growth through increased spending or reduced taxes while the central bank fights inflation through higher interest rates. In reality coordinating fiscal and monetary policy is not an easy task.

Theories of stagflation

Neo-classical theory

In neo-classical economic theory, stagflation is rooted in the failure of the overall market to allocate goods and services efficiently. The root cause of this is generally thought to be excessive government regulation. The classic example of stagflation and its remedy occurred following the resignation of Richard Nixon. Price controls had been in effect for a number of years, but were released due to the range of dislocations that they had caused. The country was in a state of shock, the economy was stagnant, and inflation persisted. President Ford instigated the "WIN" policy - "Whip Inflation Now". All he did was wear and hand out "WIN" buttons for his economic staff to wear at a press conference. The plan was that the market would restore a balance in the allocation of goods and services, and over time, it did. Theoretically, the solution cannot be so simple. It should take changes in monetary policy to crush inflationary pressures, and a deregulation to force economic activity to more effectively reflect supply and demand. The monetary aspect of this "disinflationary" neo-classical policy was pursued in the USA by Paul Volcker starting in 1979, and late in the Carter Administration. Some elements of this policy were maintained in the Reagan Administration. Neo-classical theory also prescribes increasing consumption taxes, in order to encourage saving over spending.

Shock theory

One set of theories argue that stagflation occurs because of outside forces to an economy or "exogenous" factors. In this view stagflation is thought to occur when there is an adverse shock (a sudden increase, for example in the price of oil), in a country's aggregate supply curve. In the early Seventies the two shocks said to cause the spiraling prices which resulted in the Nixon era price control programs were the failure of the Peruvian anchovy catch, a major source of fertilizer for the world, and the success of the Organization of Petroleum Exporting Countries (OPEC).

Quality of money theories

Modern monetary economics assumes that a crucial role for central banks in maintaining stable prices is management of inflationary expectations. Thus central banks make every effort to appear not to pursue growth if a further stimulation of growth would fuel higher inflation. This theory rests on the fact that the overall marketplace is attuned to the possibility that when a central bank allows excessive inflation, higher long-term interest rates result, which lead to higher prices followed by higher wage demands in subsequent labor negotiations. Left unchecked, this is seen to bring round after round of greater inflation, which is known as the "inflationary spiral". Inflation can thus be seen to be imbedded in the self-fulfilling nature of inflationary expectations. One school of thought is that inflation targeting and other forms of limited central bank discretion are the best way to maintain low inflationary expectations. The Federal Reserve in the US has, however, managed to drive inflationary expectations to a quite low level while maintaining broad policy discretion. These theories are often combined with "quantity" theories of money supply, though not always.

Quantity theories of stagflation

Quantity theories of inflation, such as monetarism, argue that inflation is due to the money supply rather than demand and predict that inflation can occur with high unemployment if the government increases the money supply in a period of rising prices.

Classical Keynesianism and the Phillips curve

In the 1960s it was thought that the Phillips curve, which was associated with Keynesian economics suggested that stagflation is impossible because high unemployment lowers demand for goods and services which lowers prices. This results in low or no inflation. However, in the 1970s and 1980s, when actual stagflation occurred, it was realized that the relationship between inflation and employment levels was not a constant, but could be shifted, and that the Phillips relationship was better seen through payroll surveys (Current Employment Statistics) of employment rather than household surveys (Current Population Survey) ([1]).

Neo-Keynesianism

Neo-Keynesian theory developed a more detailed model of inflation which argued that there are two kinds of inflation--demand pull and cost push. Stagflation, in this view, is caused by cost push inflation, which could be the result of monetary policy, insufficient resiliency of the economy or from purely external factors. In this case the strategy for defeating stagflation is to cut the money supply, hoping to cut inflation to manageable levels, then increase the money supply to spur economic growth. This "disinflationary" Neo-Keynesian policy was pursued in the USA by Paul Volcker during the Carter Administration.

Differential accumulation

Differential accumulation theory sees stagflation (which oscillates inversely with periods where mergers and acquisitions is dominant) as a major strategy of dominant capital groups to beat the average and exceed the normal rate of return on investment. Stagflation, which appears as a crisis at the societal level, contributes significantly to differential accumulation at the disaggregate level, that is, of dominant capital groups accumulating faster than smaller businesses. Since the 20th century, the dominant capital group which has benefited from stagflation has been the "weapondollar-petrodollar coalition" during periods of Mid-east crises and rising oil prices. These periods have oscillated between periods of relative "peace" during which mergers and acquisitions have been the dominant strategy for beating the average.

Historical stagflation

Stagflation in the late Classical Keynesian Period (1968-1982)

Stagflation occurred in the economies of the United Kingdom in the 1960s and 1970s and the United States during the 1970s, most famously during the Carter Administration. The difficulty in fitting its existence within a Keynesian framework led to a greater acceptance of monetarist theories in the 1970s and 1980s. The pendulum has, to some extent, swung back in the other direction as monetarism has seemed to encounter increasing difficulty predicting the demand for money and the long period of low inflation and high employment during the Y2K/Dot-Com Bubble of the late 1990s and again during the 2004-2006 period, which temporarily drove oil prices high enough to measureably increase inflation during the first three quarters of 2006.

The monetarists would respond that inflation was remarkably stable during the dotcom boom and recession and that the oil price driven inflation was nothing more than the natural increase in price of one commodity rather than true inflation. The rise in oil prices was just that, a rise in oil prices. It had nothing to do with the value of the overall currency even if consumers lost effective currency as a result. The elimination of oil as a commodity would eliminate this "inflation".

Stagflation worries in the present

During 2006, certain economists believed that global stagflation might return when the price of oil was close to $80 a barrel, and the US Federal Reserve was increasing interest rates. Blogs promoting fears of stagflation began getting attention even before statements by Stephen Roach and Paul Krugman. They cite a cooling housing market combined with a failure to adjust monetary policy as potentially leading to higher than "comfort zone" inflation and slower growth.

The worries multiplied in 2007 . On February 27th China's reaction to its complex domestic policy binds triggered a shock to financial markets (DJIA down 5%)as well as a reminder of the danger China had raised in February 2005 when Chinese economist Fan Gang, director of the state-owned National Economic Research Institute in Beijing, recommended publicly [World Economic Forum, January, 2005] that China sell its hoard of U.S. Treasury debt into the world market because interest rates were too low. China is the second-largest holder of U.S. Treasury debt in the world (after Japan). Such an action would send U.S. interest rates soaring, according to most generally-accepted models of the global economy, since such a massive sale would immediately drive down bond values, thereby raising not only the effective interest rate on existing bonds but also the market into which new bonds were sold. These models show that U.S. interest rates would soar. The polico-economic indication from these models was that the U.S. Federal Reserve was already in the policy bind that would contribute to Stagflation.

Two days earlier (2-26-2007) U.S. Federal Reserve Chairman Alan Greenspan predicted a possible recession in the U.S. before the year 2007 was over, speaking via satellite link to a Hong Kong business group. Some took this to be an indication that his model also recognized that China's policy binds had created a U.S. policy bind which prevented anti-recessionary action by the U.S. Federal Reserve. Others postulated that the higher interest rates prevailing in the U.S. in 2007 were known by him to be the U.S. response that was implemented to forestall the possibility of China's massive bond sale. Still others voiced the conclusion reached after the Nixon-era price controls that high interest rates were in and of themselves inflationary, since the cost of money was factored into models for the unit cost of everything from the price of wheat to the cost of making a high-budget film in Hollywood, a microeconomic measure prevailing in some modern economic models.

At its May 2007 meeting the U.S. Federal Reserve (FOMC Minutes, May 9, 2007, U.S. Treasury Dept.) made the following policy statement: "In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information." The across-the-board reaction was that the widely anticipated July 2007 lowering of U.S. interest rates was no longer feasible, and the Fed's response confirmed to many who maintain a polico-economic models that U.S. economic policy was unfolding in a manner that confirmed that the policy bind which accompanies Stagflation was becoming more visibly present.

On May 11th former U.S. Federal Reserve Chairman Alan Greenspan redefined the odds on a U.S. recession during 2007 from "possible" to "1-in-3".

May ended with the widely publicized report that foreign holdings of U. S. Treasury debt maturing in the three-to-ten year range had reached the 80% level, sparking comparisons to 19th Century America when European lenders provided financing for building U.S. infrastructure projects such as railroads and canals. Today's worries leave U.S. domestic economic policy hostage to international economic factors flowing from spiraling U.S. trade deficits and government deficits.

The first two weeks of June 2007 brought reports that China's trade surplus for the previous month had exceeded $22 billion, which moved the United States Congress, the OECD and the IMF to forcefully describe China's trade and exchange rate policies as "unfair". Also in June China began to show a reluctance to increase its hoard of U.S. Treasury debt and is thought to be the Asian seller with daily offerings of 10-year Treasury notes in the overnight market. This action drove down values and thereby increased the interest yield from its long-established rate below 5.0% to the 5.1-5.2% range with peaks at 5.3%.

Despite these adverse signals and an oil price approaching $70 per barrel, there was sufficient optimism for investors to trigger the stock market to its largest three-day advance in 18 months on the occasion of the June 15th triple witching Friday.

Ultimately, the current worry had reached epic proportions in the prospect of global stagflation - a phenomena never before encountered.

Responses to stagflation

Stagflation undermined the dominant Keynesian consensus, and placed renewed emphasis on microeconomic behavior, particularly neo-classical economics with its attempt to root macroeconomics in microeconomic formalisms. The rise of conservative theories of economics, including monetarism, can be traced to the perceived failure of Keynesian policies to combat stagflation or even properly explain it.

Stagflation in the USA was defeated by the then Federal Reserve chairman, Paul Volcker, who sharply increased interest rates to reduce money supply from 1979-1983 in what was called a "disinflationary scenario." Starting in 1983, fiscal stimulus and money supply growth combined to create a sharp economic recovery which is in line with standard macro-economic models; however, there was a five-to-six-year jump in unemployment during the Volcker disinflation. It appears that Volcker trusted unemployment to self-correct and return to its natural rate within a reasonable period, which it did.

Supply-side economics emerged as a response to US stagflation in the 1970s. It largely attributed inflation to the ending of the Bretton Woods system in 1971 and the lack of a specific price reference in the subsequent monetary policies (Keynesian and Monetarism). Supply-side economics asserts that the contraction component of stagflation resulted from an inflation-induced rise in real tax rates (see bracket creep). In addition certain states in the USA had laws limiting nominal interest rates, which under high inflation resulted in negative real interest rates. In some places this caused a collapse in lending to business.

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