Stagflation is an economic situation in which inflation and economic stagnation occur simultaneously and remain unchecked for a period of time.^[1] The portmanteau "stagflation" is generally attributed to British politician Iain Macleod, who coined the term in a speech to Parliament in 1965.^[2][3][4] The concept is notable partly because, in postwar macroeconomic theory, inflation and recession were regarded as mutually exclusive, and also because stagflation has generally proven to be difficult and costly to eradicate once it gets started.

Economists offer two principal explanations for why stagflation occurs. First, stagflation can result when an economy is slowed by an unfavorable supply shock, such as an increase in the price of oil in an oil importing country, which tends to raise prices at the same time that it slows the economy by making production less profitable.^[5][6][7] This type of stagflation presents a policy dilemma because most actions to assist with fighting inflation worsen economic stagnation and vice versa. Second, 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,^[8] and the government can cause stagnation by excessive regulation of goods markets and labor markets;^[9] together, these factors can cause stagflation. Both types of explanations are offered in analyses 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.^[10]

John Maynard Keynes wrote in The Economic Consequences of the Peace that governments printing money and using price controls were causing a combination of inflation and economic stagnation in Europe after World War I. Stagflation was also a very serious macroeconomic problem in the 1970s. In contrast to central bank responses to the oil price spike of the 1970s where similar policies were pursued on both sides of the Atlantic, the 21st century began with America going one way to fight recession and Europe going the other way to fight inflation.

Postwar Keynesian and monetarist views

Early Keynesianism and monetarism

Up to the 1960s many Keynesian economists ignored the possibility of stagflation, because historical experience suggested that high unemployment was typically associated with low inflation, and vice versa (this relationship is called the Phillips curve). The idea was that high demand for goods drives up prices, and also encourages firms to hire more; and likewise high employment raises demand. However, in the 1970s and 1980s, when stagflation occurred, it became obvious that the relationship between inflation and employment levels was not necessarily stable: that is, the Phillips relationship could shift. Macroeconomists became more skeptical of Keynesian theories, and the Keynesians themselves reconsidered their ideas in search of an explanation of stagflation.^[11]

The explanation for the shift of the Phillips curve was initially provided by the monetarist economist Milton Friedman, and also by Edmund Phelps. Both argued that when workers and firms begin to expect more inflation, the Phillips curve shifts up (meaning that more inflation occurs at any given level of unemployment). In particular, they suggested that if inflation lasted for several years, workers and firms would start to take it into account during wage negotiations, causing workers' wages and firms' costs to rise more quickly, thus further increasing inflation. While this idea was a severe criticism of early Keynesian theories, it was gradually accepted by the Neo-Keynesians.

Neo-Keynesianism

Contemporary Keynesian analyses^[12] argue that stagflation can be understood by distinguishing factors that affect aggregate demand from those that affect aggregate supply. While monetary and fiscal policy can be used to stabilize the economy in the face of aggregate demand fluctuations, they are not very useful in confronting aggregate supply fluctuations. In particular, an adverse shock to aggregate supply, such as an increase in oil prices, can give rise to stagflation.

Neo-Keynesian theory distinguished two distinct kinds of inflation: demand-pull (caused by shifts of the aggregate demand curve) and cost-push (caused by shifts of the aggregate supply curve). Stagflation, in this view, is caused by cost-push inflation. Cost-push inflation occurs when some force or condition increases the costs of production. This could be caused by government policies (such as taxes), or from purely external factors such as a shortage of natural resources or an act of war.

Supply theory

Fundamentals

Supply theories^[13] are based on the neo-Keynesian cost-push model and attribute stagflation to significant disruptions to the supply side of the supply-demand market equation, for example, when there is a sudden real or relative scarcity of key commodities, natural resources or natural capital needed to produce goods and services. Other factors may also cause supply problems, for example, social and political conditions such as policy changes, acts of war, restrictive socialist or nationalist control of production. In this view, stagflation is thought to occur when there is an adverse supply shock (for example, a sudden increase in the price of oil or a new tax) that causes a subsequent jump in the "cost" of goods and services (often at the wholesale level). In technical terms, this results in contraction or negative shift in an economy's aggregate supply curve.

In the resource scarcity scenario (Zinam 1982), stagflation results when economic growth is inhibited by a restricted supply of raw materials.^[14][15] That is, when the actual or relative supply of basic materials (fossil fuels (energy), minerals, agricultural land in production, timber, etc.) decreases and/or cannot be increased fast enough in response to rising or continuing demand. The resource shortage may be a real physical shortage or a relative scarcity due to factors such as taxes or bad monetary policy which have affected the "cost" or availability of raw materials. This is consistent with the cost-push inflation factors in neo-Keynesian theory (above). The way this plays out is that after supply shock occurs, the economy will first try to maintain momentum ? that is, consumers and businesses will begin paying higher prices in order to maintain their level of demand. The central bank may exacerbate this by increasing the money supply, by lowering interest rates for example, in an effort to combat a recession. The increased money supply props up the demand for goods and services, though demand would normally drop during a recession.

In the Keynesian model, higher prices will prompt increases in the supply of goods and services. However, during a supply shock (i.e. scarcity, "bottleneck" in resources, etc.), supplies don't respond as they normally would to these price pressures. So, inflation jumps and output drops, producing stagflation.

Explaining the 1970s stagflation

Following Richard Nixon's imposition of wage and price controls on August 15, 1971, two shocks were blamed for causing spiraling prices. The first was the failure of the Peruvian anchovy fishery in 1972. This was a major source of fertilizer for the world and resulted in a series of secondary shocks to agricultural production, particularly in Latin America.^[16] The second major shock was the 1973 oil crisis, when the Organization of Petroleum Exporting Countries (OPEC) constrained the worldwide supply of oil.^[17] Both resulted in actual or relative scarcity of raw materials. The price controls resulted in shortages at the point of purchase, causing, for example, queues of consumers at fueling stations.^[18]

Theoretical responses

Under this set of theories, the solution to stagflation is to restore the supply of materials. In the case of a physical scarcity, stagflation is mitigated either by finding a replacement for the missing resources or by developing ways to increase economic productivity and energy efficiency so that more output is produced with less input. For example, in the late 1970s and early 1980s, the scarcity of oil was relieved by increases in both energy efficiency and global oil production. This factor, along with adjustments in monetary policies, helped end stagflation.

If the resource scarcity is being caused by flawed market intervention (e.g., bad government), the solution is to eliminate the disrupting force on the market (e.g., better monetary policy, changes in tax laws).^[19]

Neo-classical views on stagflation

A purely neoclassical view^[20] of the macroeconomy rejects the idea that monetary policy can have real effects. Neoclassical macroeconomists argue that real economic quantities, like real output, employment, and unemployment, are determined by real factors only. Nominal factors like changes in the money supply only affect nominal variables like inflation. The neoclassical idea that nominal factors cannot have real effects is often called 'monetary neutrality'^[21] or also the 'classical dichotomy'.

Since the neoclassical viewpoint says that real phenomena like unemployment are essentially unrelated to nominal phenomena like inflation, a neoclassical economist would offer two separate explanations for 'stagnation' and 'inflation'. Neoclassical explanations of stagnation (low growth and high unemployment) include inefficient government regulations or high benefits for the unemployed that give people less incentive to look for jobs. Another neoclassical explanation of stagnation is given by real business cycle theory, in which any decrease in labour productivity makes it efficient to work less. The main neoclassical explanation of inflation is very simple: it happens when the monetary authorities increase the money supply too much.^[22]

In the neoclassical viewpoint, the real factors that determine output and unemployment affect the aggregate supply curve only. The nominal factors that determine inflation affect the aggregate demand curve only.^[23] When some adverse changes in real factors are shifting the aggregate supply curve left at the same time that unwise monetary policies are shifting the aggregate demand curve right, the result is stagflation.

Thus the main explanation for stagflation under a classical view of the economy is simply policy errors that affect both inflation and the labor market. Ironically, a very clear argument in favor of the classical explanation of stagflation was provided by Keynes himself. In 1919, John Maynard Keynes described the inflation and economic stagnation gripping Europe in his book The Economic Consequences of the Peace. Keynes wrote:

"Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some." [...]

"Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

Keynes explicitly pointed out the relationship between governments printing money and inflation.

"The inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent Governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance."

Keynes also pointed out how government price controls discourage production.

"The presumption of a spurious value for the currency, by the force of law expressed in the regulation of prices, contains in itself, however, the seeds of final economic decay, and soon dries up the sources of ultimate supply. If a man is compelled to exchange the fruits of his labors for paper which, as experience soon teaches him, he cannot use to purchase what he requires at a price comparable to that which he has received for his own products, he will keep his produce for himself, dispose of it to his friends and neighbors as a favor, or relax his efforts in producing it. A system of compelling the exchange of commodities at what is not their real relative value not only relaxes production, but leads finally to the waste and inefficiency of barter."

Keynes detailed the relationship between German government deficits and inflation.

"In Germany the total expenditure of the Empire, the Federal States, and the Communes in 1919-20 is estimated at 25 milliards of marks, of which not above 10 milliards are covered by previously existing taxation. This is without allowing anything for the payment of the indemnity. In Russia, Poland, Hungary, or Austria such a thing as a budget cannot be seriously considered to exist at all."

"Thus the menace of inflationism described above is not merely a product of the war, of which peace begins the cure. It is a continuing phenomenon of which the end is not yet in sight."

Keynesian in the short run, classical in the long run

While most economists believe that changes in money supply can have some real effects in the short run, neoclassical and neokeynesian economists tend to agree that there are no long run effects from changing the money supply. Therefore, even economists who consider themselves neokeynesians usually believe that in the long run, money is neutral. In other words, while 'neoclassical' and 'neokeynesian' models are often seen as competing points of view, they can also be seen as two descriptions appropriate for different time horizons. Many mainstream textbooks today treat the neokeynesian model as a more appropriate description of the economy in the short run, when prices are 'sticky', and treat the neoclassical model as a more appropriate description of the economy in the long run, when prices have sufficient time to adjust fully.

Therefore, while mainstream economists today might often attribute short periods of stagflation (not more than a few years) to adverse changes in supply, they would not accept this as an explanation of very prolonged stagflation. More prolonged stagflation would be explained as the effect of inappropriate government policies: excessive regulation of product markets and labor markets leading to long run stagnation, and excessive growth of the money supply leading to long run inflation.

Alternative views of stagflation

Theory of differential accumulation

Political economists J. Nitzan and S. Bichler have proposed an explanation of stagflation as part of a theory they call differential accumulation. According to this theory, periods of mergers and acquisitions can give rise to stagflation. This is because mergers decrease the number of competitors, increasing the market power of surviving firms. With greater market power, the survivors can raise prices and cut costs by decreasing their output. This enables them to lay off workers, and therefore unemployment rises together with prices.^[24]

Demand-pull stagflation theory

Demand-pull stagflation theory explores the idea that stagflation can result exclusively from monetary shocks without any concurrent supply shocks or negative shifts in economic output potential. Demand-pull theory describes a scenario where stagflation can occur following a period of monetary policy implementations that cause inflation. This theory was first proposed in 1999 by Eduardo Loyo of Harvard University's John F. Kennedy School of Government.^[25]

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 embedded 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.

Considerations for monetary policy during periods of stagflation

Stagflation becomes a dilemma for monetary policy when policies usually used to increase economic growth will further increase runaway inflation while policies used to fight inflation will further the decline of an already-declining economy.

An important monetary mechanism to increase economic growth is by lowering interest rates, which reduces the cost for consumers to buy products on credit and businesses to borrow to expand production. While this can increase economic activity, it can also result in increased inflation. The monetary mechanism to reduce inflation is by raising interest rates, which increases the cost for consumers to buy products on credit and businesses to borrow to expand production. While this can reduce inflation, it can also result in decreased economic activity.

Stagflation becomes a problem only when the impact of the further use of the principal monetary policy tool available to assist central bank direction of the domestic economy does more marginal harm than marginal good, if used. Ultimately, the central bank can either stimulate the economy or attempt to rein it in through the mechanism of adjusting the domestic interest rate, its primary tool.

A choice can be implemented that tends to improve growth, but does it ignite systemic inflation? A choice can be implemented that tends to fight inflation, but how badly does it impinge growth? During periods properly described as stagflation both problems co-exist. In modern times, it will be only after the central bank has used all possible tools to meet both goals, using the best quantitative measures it has at its disposal, for stagflation to occur. Major economic conditions of unusual proportion will have already created near-crises on both fronts before stagflation can set in again. Stagflation is the name of the dilemma that exists when the central bank has rendered itself powerless to fix either inflation or stagnation.

The problem for fiscal policy is far less clear. Both revenues and expenditures tend to rise with inflation, and with balanced budget politics, 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. One school of thought is 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. Whatever theory is employed, coordinating fiscal and monetary policy is not an easy task.

Stagflation in the 21st Century

An explanation of the round of stagflation which many economists see unfolding must include a reference to "911", the destruction of the World Trade Center by terrorists,as well as the response by central bankers worldwide, which was to lower interest rates to a noneconomic minimal rate in order to bolster business activity.

The prolonged maintenance of such a noneconomic low rate appears to have lulled lenders into a quiescence and brought about the relaxed standards and sense of euphoria underpinning what came to be known as subprime loans, Alt-A loans, and a resulting building boom fueled by soaring real estate prices. Soaring real estate prices and relaxed lending standards combined to induce underfunded investors to buy multiple properties with the full expectation that prices would continue to soar.

The next element came early in 2007 when the Peoples Republic of China put pressure on the United States of America to raise interest rates on government debt, with the threat that China would sell off its vast holdings of U.S. Treasuries if they did not.

The Federal Reserve (U.S.) responded with a series of increases in rates, leading to interest rate increases around the globe. Real estate sales in 2006 were sold heavily to speculator-investors and financed largely by variable rate mortgages. The mortgage product had been growing in popularity, and in 2006 nearly one-third of U.S. homes were sold to investors with little capital and often no downpayment. As the LIBOR climbed, mortgage delinquencies rose, leading to the so-called subprime mortgage crisis.

The demand for housing is inelastic. When more than a half-million homes went up for sale, homes built in reality to be sold to speculators not residents, buyers were in short supply. The result was an implosion in real estate prices.

Investors fleeing the financial sector found commodities to be a good storehouse of value, driving up commodity prices.

In response to the crisis, the U.S. Federal Reserve dropped interest rates drastically and dramatically, again and again. Since commodities trade in the world market and the U.S. dollar is simply another commodity, investors fled dollars and chased commodities, driving up the price of oil, metal and agricultural products.

The conflux of high oil prices, unsold houses and soaring commodity prices faced America, and the word recession began to be heard.

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 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.

Notes

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