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Stagflation June 23, 2009

Posted by presto21 in Economics.
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I was recently having a conversation with a friend when he asked me, “what is so bad about inflation?” Well the truth is we had at least one awful period of inflation in this county – the 1970’s.

Inflation is not such a bad thing if it can be kept to within 1-3% – the figure which today is almost universally aimed for by the central banks of developed countries. In fact it can be a good thing at those levels because it helps maintain fluidity in the credit markets. When inflation rises above that level however, it does have negative impacts. It discourages venture capital as well as complicating mortgages and other long-term loans because people can’t be assured that the long-term returns on their investments will hold up against inflation.

One of the most elementary propositions in economics is that people will not invest if they cannot keep the fruits of their investment. The effects on the engine of private sector growth and job creation, which require some degree of stability so that wages and prices can find an equilibrium, can be destructive.

Stagflation is an economic situation in which inflation and economic stagnation occur simultaneously and remain unchecked for a period of time. Stagflation presents a policy dilemma because most actions to assist with fighting inflation worsen economic stagnation and vice versa. Both stagnation and inflation can result from inappropriate macroeconomic policies. For example, central banks can cause inflation by permitting excessive growth of the money supply and the government can cause stagnation by excessive regulation of goods markets and labor markets; together, these factors can cause stagflation. Both types of explanations are offered in analysis of the global stagflation of the 1970s: it began with a huge rise in oil prices, but then continued as central banks used excessively stimulative monetary policy to counteract the resulting recession, causing a runaway wage-price spiral.

In macroeconomics, the price/wage spiral represents a vicious circle process in which different sides of the wage bargain try to keep up with inflation to protect real incomes. Thus, this process is one possible result of inflation. In the early 1970s, inflation had been much higher than in previous decades, getting above 6% briefly in 1970 and persisting above 4% in 1971. U.S. President Richard Nixon imposed price controls on August 15, 1971. This was a move widely applauded by the public and some number of (but by no means all) economists, especially Keynesian. The 90-day freeze was unprecedented in peacetime, but such drastic measures were thought necessary. Also motivating the controls, it should be noted that on the same date that the controls were imposed, 15 August 1971, Nixon also suspended the convertibility of the dollar into gold, which was the beginning of the end of the Bretton Woods System of international currency management established after World War II. It was quite well known at the time that this would likely lead to an immediate inflationary impulse (because the depreciation of the dollar that would follow would boost the demand for exports and increase the cost of imports). The controls aimed to stop that impulse. The fact that the election of 1972 was on the horizon likely contributed to both Nixon’s application of controls and his ending of the convertibility of the dollar.

The 90-day freeze became nearly 1,000 days of measures known as Phases One, Two, Three, and Four, ending in 1973. In these phases, the controls were applied almost entirely to the biggest corporations and labor unions, which were seen as having price-setting power. 93% of requested price increases were granted and seen as necessary to meet costs.With such monopoly power, some economists saw controls as possibly working effectively (though they are usually skeptical on the issue of controls). Because controls of this sort can calm inflationary expectations, this was seen as a serious blow against stagflation. The controls helped Nixon to re-election, but afterward were seen to be a total failure; meat disappeared from grocery store shelves and Americans protested wage controls that didn’t match up to inflation.

Finally, a man named Paul Volcker (whom some of you may recognize as a current economic adviser to President Obama) decided he was going to clamp down hard on inflation. As a talented economist he knew about the short-term pain his policy would bring to the economy. But he also believed that unless stringent fiscal discipline, a steady money supply and higher interest rates could be brought to bear against stagflation, it would continue indefinitely. Paul Volcker was a Democrat and was appointed Chairman of the Federal Reserve in August 1979 by President Jimmy Carter and reappointed in 1983 by President Ronald Reagan. Volcker’s Fed is widely credited with ending the United States’ stagflation crisis of the 1970s. Inflation, which peaked at 13.5% (insane) in 1981, was successfully lowered to 3.2% by 1983. The federal funds rate (AKA the interest rate), which had averaged 11.2% in 1979, was raised by Volcker to a peak of 20% in June 1981. The prime rate rose to 21.5% in ’81 as well. This was extremely unpopular at the time, but President Reagan stood by Volcker’s policies even as the economy convulsed. The recession worsened for a while, but by 1982 a strong recovery was underway. Unfortunately Reagan cut taxes so deeply while greatly expanding defense expenditures that he wound up running large deficits towards the end of his presidency (deficits George H. W. Bush would be left to deal with) and making it unclear whether he was ever really¬† committed to real fiscal discipline even though he consistently campaigned on it. But that’s another story…