All about stagflation

by Philip Brewer on 24 February 2008 7 comments
Photo: Philip Brewer

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.

The future

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.

Statistics on inflation and deficits from FRED (Federal Reserve Economic Data) at the St. Louis Federal Reserve.

Historical oil price information from Wikipedia.

Dates of service for Federal Reserve board members.

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Joe

Few will argue that we are in for a recession, probably a long one (stagnation?). What is at issue is inflation vs deflation.

I believe deflation is the route we are headed not hyper inflation (>5%). Right now diddly squat for new money is being made and money is being destroyed very fast. If we destroy money faster than we create it, it becomes more scarce and therefore more valuable. Assuming demand for money remains the same, this results in delfation.

In a reserve system, debt is money. As debt is closed either by payed off or write off, that money is taken out of the money supply and therefore destroyed. Right now far more debts are being something-offed than are being originated. To add to this debts have been bought using more borrowed money. So as the original debt is payed off, all debts in the chain get payed off. This compounds the reduction in the money supply.

There are two trends that are emerging that indicate that this force will grow stronger. Both originate in apparent shifts in comumer attitude/behavior. First, debt is now viewed as a bad thing. This attitude is growing in numbers. Look at the growing popularitey of personal finance blogs offering advice on debt reduction. This will have the above mentioned affect on debt money.

Second, and related, with the reduction in using debt to purchase things comes a reduction in spending. This is where some of the recessionary force is comming from. As people spend less, buisness have less money and have no need to invest to grow. Look at the number of reatil chains that are reducing the number of stores they have. This trend will likely continue as consumers become more unsure in a recessionary environment.

Oil and commodoties will have to rise astronomicially to generate enough inflationary pressure to offset deflationary pressures and I dont think China and India can grow that fast. Especially considering a slowdown in the US will affect them too.

~joe

Philip Brewer's picture

That's a very good point. Back in the 1970s, the economy was not unwinding hundreds of billions of dollars of bad loans (and certainly not various securitized derivatives on bundles of bad loans) the way it is now. Those securities had been treated as assets. Now we have no idea what they're worth (except that we know that many are worth nothing).

Those assets were not money, but some of them were "money-like" and many of them, as assets of banks and other financial institutions, stood behind a lot of money.

We simply don't know how the collapse of all those imagined assets will affect the money supply. The Fed is obviously worried. They wouldn't be acting as they are, unless they were seriously afraid that the money supply was in danger of shrinking drastically as the imagined money vanishes from the economy.

The problem is, there's just no way to know how much money there is. The Fed tries to keep track, but so many things act as money part of the time. For example, a HELOC with a large amount of available credit is almost money--the homeowner could write a check for $10,000 at any time. But if that check doesn't get written, is the available credit "money" or not?

This makes a big difference when banks suddenly decide to cut credit limits, as they are now in places where home values have dropped. When the amount of HELOC available to homeowners drops by a billion dollars, has the money supply shrunk? If so, by how much? Probably so. Probably not by a billion dollars, but nobody knows whether it's a lot less or just a little less.

Personally, I'm still worried about inflation, and will stay worried about inflation at least until interest rates are above the inflation rate--but it may be that I'm being very short-sighted. My own attitudes are colored by my having come of age at the peak of the 1970s inflation. The people are the Fed are very clever. It's entirely possible that they're more clever than me. I kind of hope so, actually.

Guest's picture
Guest

We are in a recession? The truth is noone knows. Some very savy economists with amazing track records don't believe we are in a recession and do not think we are going there. Google Brian Westbury...

Oil is driving us into inflationary tizzy? I don't think so. By far the biggest) factor triggering stagflation in the late 70s was wage growth spiraling out of control that did not come with productivity improvements. That led to businesses laying people off as they simply could not afford them. Go back and look at the unemployment situation today vs say 1981. Two totally different worlds.

Is the fed going in the wrong direction today by easing rates and pumping up the money supply? I don't know about you, I'm seeing a 3% raise this year... Ask yourself this question, what impacts energy costs more, reduced demand as a result of markets making rational decisions to cut back on the use of oil or the USA tightening its money supply and driving up interest rates?

I agree with the previous caller that easing money supply should be equated with our economy taking on more debt -- thinking in terms of "printing money" is like saying debt is a bad thing. Debt can be a great thing if you have an opportunity to invest and generate a higher return than your carry costs.

The secret sauce to our great success in the last 20 years has been and continues to be the amazing productivity increases made by the american worker through applied technology. When we figure out ways to do our jobs more efficiently or create more value for our customers we get to the wonderful concept of sustainable growth. Does anyone believe we are at the end of the road? I look around my workplace and continue to be amazed at all the opportunity for improvement that is just sitting there waiting for me...

The budget deficit is pushing us into economic demise? There is a big flaw in your logic, you need to look at the debt burden as it relates to the size of the economy. Go back and make that adjustment before you talk about record deficits. I was studying economics back in the early 80s and thought the world would come to an end because of Reagan's hawkish military spending and tax cuts resulted in record deficits. Turned out everything worked out GREAT! Google larry kudlow for a more eloquent presentation than I could ever muster.

The dollar is a wreck, that is true. How does that affect me? I will not choose to go skiing in Canada this year, Colorado or Utah will get my money. No trips to Europe for me, I'll spend the summer vacation in the continental 48. That is the down side, expensive travel out of the country. For every ying there is a yang. Corporations that sell in the global market continue to blow the doors off in terms of growth (See Coke, Deere, etc) I'm a believer that if we continue to improve productivity over time the currency will go back to a more reasonable valuation. Who would of thunk it corporations are insourcing from India because the american worker is more productive and more reliable (plus the wage disparity is evaporating)

Last thought, people I respect really believe that the sub-prime mess is drying up liquidity, a bad thing if it is happening that might make you guys right after all. The problem isn't people are not willing to take on debt, the risk is that there will not be lenders willing to make loans. That is what the fed is addressing, watch out for another 50 or 75 basis point cut soon.

Philip Brewer's picture

It's true that we don't know yet if we're in a recession. Possibly we're not.  I'm not alone in worrying that we are.

Oil is definitely not driving us into an inflationary tizzy. (See above where inflation is caused by excessive growth in the money supply.) Rising oil prices do, though, lower our standard of living. Also, since rising oil prices tend to drive up many other prices (by raising costs), it becomes very hard to know whether what we're seeing is inflation (money becoming less valuable) or a declining standard of living (due to resource depletion). It's made even more complicated by the fact that rising oil prices actually drive some other prices down (because the people who used to buy those things can't afford them any more, because they're spending so much more money on fuel).

All told, the Fed has a tough job.

Guest's picture
Ginny

Back then, China and India didn't have booming economies with the resulting oil demand. It's pretty unlikely that oil will come down much, in my opinion.

Guest's picture
Inflation coming

Yes, you're right. If you have a look at the government statistics the Fed prints 10-20% more money each year. This means there is 10-20% more money in the system each year. Why don't consumer prices rise by that much then? Well once you print money you have no control where it goes.

Before 2000 you saw that money go into the stock market. After 2000 you saw that go into the property market. Now you're seeing it go into commodities. High commodity prices are only now starting to trickle into consumer prices. You could argue all these asset classes are relatively expensive. You could also say paper money has declined in value (You just can't print more property or shares).

I read some where the last time money supply was this high was before the 70s and 80s recessions. The Fed now has to choose between an inflationary recession (70s) or a dis-inflationary recession (80s). My guess is that we'll see a repeat of the 70s. The Fed always says they're looking at inflation but their actions speak otherwise. There are too many politicians/bankers barking for a return to easy money. I remember reading that Arthur Burns(70s Fed chairman) complained that he couldn't raise interest rates because that was politically unpalatable.

Guest's picture

Keep watching the global shift away from US Dollars as reserve currency. The US economy is now being propped up by central banks like the Federal Reserve and the European central banks to protect reserves but the bubbles are bursting everywhere. We no longer have a robust domestic manufacturing base so this one is going to approach the bad old days of the 1970s.
Hope I'm wrong but prepared for austere days ahead.