All about stagflation
Those of you who are old enough may have noticed some worrisome similarities between the economy of the 1970s and the economy today. If so, you're not alone--more than a few people are tossing the term "stagflation" around again. There are differences, but most of the differences work against us, and the similarities--including high oil prices--are a little scary.
Economic policy makers today have one big advantage over those of the 1970s--there is now a consensus about what causes inflation: growth in the money supply. (There's still some disagreement about what to call things, though, so let me define my terms: inflation is money becoming less valuable; rising prices are a symptom of inflation.)
Inflation, recession, and stagflation
The link between the money supply and inflation wasn't so clear back in the 1970s. It was common in those days to hear the cause of inflation as "too much money chasing too few goods," and to blame it on excessive government spending. The argument was that, when the government ran a deficit, it was taking borrowed money and spending it in the marketplace, bidding up the prices of things that consumers wanted to buy. Although it wasn't really intended as an experiment, during the 1980s, the US economy ran huge deficits, and during that period, the inflation rate fell steadily, pretty much disproving the deficit/inflation link.
With that key insight, the cause of the stagflation of the 1970s is pretty clear--the culprit was inflation. Once you let inflation get above 3% or 4%, the only way to bring it back down again is to severely cut the growth in the money supply. That inevitably leads to high interest rates, and almost always leads to a recession. However, if you don't bite the bullet and accept that recession, you still get the negative economic effects--a little less severe, perhaps, but extending out indefinitely into the future.
A bit of history
All though the 1970s (during the Nixon, Ford, and Carter administrations) the Fed would lurch between "stimulating" the economy, trying to head off a recession, and then "restraining" the economy, trying to keep inflation from getting out of control. But many policy makers thought that reducing government deficits was the real key. That meant that, whatever will there was to reduce inflation, it was always split between people who wanted to restrain the money supply and those who wanted to cut the deficit. Since neither idea was popular, neither one really got done.
Finally, in 1979, with the inflation rate about to smash through 10% and the value of the dollar plummeting against foreign currencies, Jimmy Carter replaced Fed chairman William Miller with Paul Volcker. Under Volcker, the Fed cut the rate of growth of the money supply sharply enough to drive interest rates to highs never seen before or since. (The 10-year treasury note peaked at over 15% in the early 1980s.)
At the same time that the Federal Reserve was driving interest rates to record highs, the government was also running record deficits. Under president Ronald Reagan, Congress cut taxes without cutting government spending.
So, that was our experiment. High interest rates, combined with high deficits, produced two recessions: a short one in the first half of 1980, and then a longer one that started a year later and ran to the end of 1982. But that was the end of stagflation for a generation.
The current situation
So, you see that there are some frightening similarities between the current situation and that in the 1970s. The inflation rate, although not yet approaching 10%, is high and rising. (And, significantly, the reported inflation rate obviously understates actual changes in the cost of living). At the same time, the Federal Reserve, trying to head off a recession, is cutting interest rates, allowing the money supply to grow at rates that ensure still higher inflation rates in the future.
There is also some similarity with the deficit, although just now the situation is worse. In 1979 we had just gone through three presidential terms during which government deficits were a constant issue--meaning that the deficit had largely been kept under control, and the deficit had been falling since 1975. Deficits are much larger this time, meaning that policy makers will have less leeway to do what worked last time--raise interest rates to high levels and then run a huge budget deficit to reduce the severity of the resulting recession.
A third similarity is high oil prices. The shape of the spike in oil prices in the late 1970s is very similar to oil prices right now. However, oil prices fell drastically in the early 1980s. That, together with the cost savings from the beginnings of globalization, played a large part in bringing prices under control in the 1980s. We don't know if oil prices will come down this time, although in a severe recession they probably will come down some. Very few people think they'll come back down to the $10 a barrel prices that we saw in the mid-1980s.
We know how to produce stagflation: lurch between raising interest rates to head off inflation and cutting interest rates when recession threatens. That'll get you there eventually. Throw in high oil prices, and it gets you there right away. Sadly, that seems to be the course we're on. We won't stay on it forever, though. Now, unlike in the 1970s, we know what causes inflation, and we know how to stop it. Sooner or later (hopefully sooner), the Federal Reserve will bring the coming period of stagflation to an end.
Stagflation may be the hardest economic condition for ordinary people to deal with. We know how to prepare for a recession and we know how to deal with inflation, but there just isn't much else that ordinary folks can do about stagflation except hunker down and wait for the recession that finally ends it.
Wise Bread, though, isn't a "hunker down" sort of place. Check out other, less depressing, pieces to get the tips and tactics for living well no matter what's going on in the economy.
Historical oil price information from Wikipedia.
Dates of service for Federal Reserve board members.