Stagflation: The Fatal Crux in Post-War Keynesianism Brought to The 2020s
Stagflation, a portmanteau of stagnation and inflation, synonymous with the early 1970s, a situation of high unemployment, slow economic growth and high inflation; namely the triad of economic deadly sins, is now a major concern amongst policymakers and those concerned with the economic health of our society.
Famously coined by Iain Macleod in a 1965 speech to Parliament, declaring: “We now have the worst of both worlds- not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of ‘stagflation situation.” The challenge of stagflation plagued governments in the 1970s and questioned the validity of post-war Keynesian economics, specifically the assertion that inflation and recession were regarded as mutually exclusive as described by the Phillips curve.
Post-war Keynesian economists ignored the possibility of stagflation, due to historical empirical evidence suggesting that high unemployment was associated with low inflation, and vice versa. However, when stagflation occurred it became obvious that the relationship between employment and inflation levels were not strictly inverse: namely, that the Phillips curve could shift.
Conventional wisdom at the time suggested that the causes of stagflation were cost-push factors. After Richard Nixon’s imposition of wage and price controls in 1971, the initial wave of cost-push shocks in commodities were blamed for increasing prices. The 1973 oil crisis transferred income to high-saving oil producers, with higher prices reducing importers’ real disposable income, hurting global demand and output. Countries such as the US and UK could no longer import oil from critical countries within the Middle East, and the sudden supply shock rose oil prices by 300%. The effects rippled throughout the 1970s, with countries forced to ration oil supplies which eventually lead to frequent power cuts and an enforced three-day working week. This, along with the National Union of Mineworkers calling national strikes that limited energy supplies, were considered to be the causes of the perennial inflation in the 1970s.
However, against the conventional wisdom, Milton Friedman argued: “inflation is always and everywhere a monetary phenomenon.” Friedman argued that inflation had very little to do with oil cartels, aggressive unions or evil businessmen. Rather, prices spiralled upwards because governments made the supply of money grow faster than the economy created real value. Or to put it simply: “Too much money chasing too few goods.” In the 1960s, policymakers believed that the inverse relationship between unemployment and inflation was stable. Monetary policy was used to increase overall demand for goods and services and keep unemployment low. However, as the overall money supply increased to increase demand, workers also expected their wages to rise accordingly with inflation. Initially, employers were willing to raise wages, but given the magnitude of inflation, inflation began to rise faster than wages. Not willing to supply labour for lower real wages, unemployment increased as inflation continued to rise.
Contrary to the “cost-push” explanation of inflation, pay and price increases did not drive inflation; they reflected it. Employees wanted nominal wages to keep up as the real value of currency declined. The wage and price control policies imposed also didn’t combat inflation, because all these policies treated the symptom rather than the cause.
Are we heading for stagflation?
With the unprecedented economic shock caused by Covid-19, many countries now face the threat of stagflation. And the signs that the UK economy could be heading for a repeat of 1970s stagflation are all present. Inflation has risen above central banks targets across most of the world, exceeding 3% in the UK and the euro area and 5% in America. The average unemployment rate in the UK is now 4.5 %, with Brexit and Covid having led to a depleted pool of migrant workers. This, along with the shortages of agricultural workers and lorry drivers is placing heavy pressure on global supply chains, during a time of high demand, making the upwards spiral of higher average prices even worse.
Moreover, the House of Lords recently warned that the Bank of England must show how it can end its £895bn QE programme given the threat of higher inflation and damage to the economy. Inflation will always be made worse if central banks cut interest rates and effectively print new money – as seen during the pandemic. More pounds chasing the same amount of goods and services will only force prices of food and fuel upwards.
Many now argue whether the current levels of inflation are transitory or here to stay. Few guessed the global economy would bounce back from Covid lockdowns with such vigour and vitality. As economies are beginning to slow from their rapid recoveries, the level of aggregate demand will be left uncomfortably high relative to the impaired supply situation, spelling an enduring inflation problem.
However, ultimately, we still don’t know if rising prices will become another “new normal” or if they’re just a temporary consequence of us emerging from a year of lockdowns and economic restrictions. What is certain, however, is the government must consider easing QE and rising interest rates incrementally in an attempt to cure the causes, not the consequences of inflation.
As Milton Friedman once said:” Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”