Stagflation Again

The "Again" in the title above has two meanings.  First, the question is whether we may repeat the stagflation experience of the 1970s.  Will it happen again?  Second, my last blog posting was on stagflation, and, upon reflection, I need to try again.  I think it was correct (economically); but I got carried away by some issues of my student days.  Reminiscing took over, and I abandoned the KISS principle and became pedantic.  My apologies.  Let me do it again here in a more user-friendly manner.  But the serious reader might still do well to read the previous one first and treat this one as a summary review.

My main point is there are major differences between the 1970s and the current decade that make stagflation less likely now:

*The seeds of 1970s inflation were sown in the 1960s with the guns and butter (Vietnam and Great Society) approach of the Johnson Administration.  Inflation growth led to an ill-advised and counter-productive decision by President Nixon in 1971 to impose wage and price controls, which distorted prices and ultimately made matters worse.

*The decision to break the link between the dollar and gold in 1971, may or may not have been a beneficial move for the long run, but it probably did take a lid off suppressed inflation at the time. 

*The Arab oil embargo in 1973 was a supply restriction on a necessary commodity that both "pushed" some prices up, contributing to inflation, and weakened the economy generally because of reduced purchasing power for other goods and services.  This action alone contributed directly to both sides of stagflation, at a time when the U.S. economy was energy inefficient and vulnerable.

*In contrast, today's high oil prices are primarily demand driven, which, while it raises some prices and reduces purchasing power elsewhere, it also generates a different dynamic in the economy.  Think of supply and demand curves.  Given supply, higher demand increases both prices and output.  Lower supply increases prices but restricts output.  Hence, lines at the pumps.

*Another significant difference is in productivity growth, or growth in output per hour worked, which was much lower (by about half) in the 1970s than in the years since the mid-1990s.  Recent higher productivity growth has multiple benefits:  It allows higher wages without higher unit costs.  That means companies can pay higher wages without a profit squeeze, and the Fed has more leeway to "give growth a chance," i.e. allow faster output-income growth without triggering higher inflation.  Productivity growth raises the growth potential of the economy and increases the Fed's "speed limit."

[Footnote to the point above. Chairman Greenspan always emphasized that it wasn't higher productivity that benefited monetary policy, but an increase in the rate of productivity growth.  It had to be accelerating.  His emphasis here and elsewhere on the rate of change tempted me to nickname him "Mr.Second Derivative Man."]

*The Fed contributed its part to higher inflation in the 1970s because of faulty operating procedures.  FOMC members understood that "money is always and everywhere a monetary phenomenon" but they were trying to hit their money targets indirectly by hitting the Fed Funds target consistent with the desired money growth based on the econometric models.  The Fed Funds targets chosen weren't sufficient to slow money growth sufficiently to hold inflation down, as became evident when they changed to direct control of money growth in October 1979.  Another way to look at the error is that they thought the rising interest rates were a sign of monetary restraint when they were as much a sign of very strong underlying demand in the economy.  Presumably the FOMC is better now at distinguishing between the causes of a change in rates — supply or demand.

*With the strong demand and growing inflationary pressures from various sources in the late 1970s, monetary and fiscal restraint tended to raise unemployment more than curb inflation — at least that trade-off was less favorable then than it has been lately.  The major villain in the 1970s was insufficient downward price and wage flexibility, which makes rising unemployment too close a substitute for lower inflation. 

*As I just said, downward price and wage flexibility were relatively lacking in the 1970s:  Major industries had not yet been deregulated, including banking and finance, transportation, etc.  That was before the seminal event of President Reagan's firing of the air-traffic controllers, which shifted the balance of power between labor and management.  Wage increases greater than productivity growth, because of the monopoly power of unions and the government (minimum wage) are similar to an oil supply restriction in that the higher wages add to inflation while attempts to offset them with policy adds to unemployment.  So they got both.

This is my list.  It isn't complete, and I haven't proven all my assertions, but I think it gives some reassurance that stagflation is not necessarily in our near future because of huge differences in the economic environment.  But, then again, I could be wrong.