Yves here. The odds of stagflation already looked high before the immediate effects of war (shutdown of Black Sea shipping hurting wheat and fertilizer transport) plus the sanctions row, both formal sanctions and self sanctioning. As we’ve said repeatedly, higher energy prices cycle through to all products.
Stagflation hurts investment two ways. The first is that high interest rates mean lower net present values when you discount future cash flows. The result is only projects with near-term, high paybacks look good. The other is that businesses become uncertain of their results because items on their balance sheet inflate at different rates. When investors start worrying about FIFO versus LIFO accounting for inventories, you know inflation is a problem.
And even though everyone but owners of hard assets suffer, the ones who are hit worst are the poor, both the less well off in rich countries and substantial parts of the population in emerging economies.
By Anis Chowdhury, Adjunct Professor at Western Sydney University and University of New South Wales (Australia), who held senior United Nations positions in New York and Bangkok and Jomo Kwame Sundaram, a former economics professor, who was United Nations Assistant Secretary-General for Economic Development, and received the Wassily Leontief Prize for Advancing the Frontiers of Economic Thought. Originally published at Jomo Kwame Sundaram’s website
The spectre of ‘stagflation’ threatens the world once again. This time, the risk is the direct consequence of political provocations and war, and not simply due to inexorable economic forces.
Stagflation is a composite word implying inflation with stagnation. Stagnation refers to weak, ‘near zero’ growth, inevitably worsening unemployment. Inflation refers to price increases – not high prices, as often implied.
The term ‘stagflation’ was supposedly first used in 1965 by Iain Macleod, then UK Conservative Party economic spokesperson. He later became Chancellor of the Exchequer, or finance minister, in 1970 for little over a month, the shortest tenure in modern times.
In 1965, he told the UK Parliament that amid “swiftly rising” incomes and “completely stagnant” production, “we now have the worst of both worlds. We have a sort of stagflation situation”.
The term caught on in the 1970s, when high inflation and unemployment ended an economic era dubbed the ‘Golden Age of capitalism’ describing the post-World War Two (WW2) boom.
Normally, in a recession, the inflation rate – i.e., the overall rate at which prices increase – falls. As unemployment rises, wages come under pressure, consumers and businesses spend less, reducing demand for goods and services, slowing price rises.
Similarly, when the economy booms, the labour market tightens, pushing up wages, in turn passed on to consumers via increasing prices. Thus, inflation rises and unemployment falls during a boom.
However, stagflation poses a dilemma for central banks. Normally, when economies stall, central banks try to stimulate growth by cutting interest rates, encouraging more borrowing, and thus spending.
But that could also fuel further price rises and higher inflation. On the other hand, if they raise interest rates to check inflation, growth may slow even more, further worsening unemployment.
The growth of world trade after WW2 increased demand for the US dollar, the de facto world currency under the 1944 Bretton Woods (BW) international monetary agreement. The US financed much post-WW2 reconstruction to broaden its ‘Free World’ sphere of influence as the Cold War began.
Following post-WW2 reconstruction, demand for the greenback was met by greater US imports paid for with US dollars. As foreign central banks increasingly accumulated dollar reserves, flows were reversed in the 1960s, with net resources into rather than out of the US.
During the 1960s, US economic growth was increasingly sustained by government military and social expenditure. Spending increased for both ‘defence’, especially the Vietnam War, and social programmes, e.g., President Lyndon B. Johnson’s ‘war on poverty’ and ‘Great Society’.
As LBJ was reluctant to acknowledge the rising costs of the Vietnam War, it was difficult to raise taxes to pay for his ‘swords and ploughshares’ spending. Instead, spending was financed by government debt, from selling US Treasury bonds. Thus, the world financed US government spending, including the war.
By January 1967, Johnson was under pressure to cut the growing budget deficit. But it took a year and a half for the US Congress to pass his new budget with tax increases. When finally passed in mid-1968, US federal debt had grown even more as spending for both ‘guns and butter’ did not decline.
US monetary policy was obligingly expansionary. Unsurprisingly, inflation shot up from 1.1% during 1960-64 to 4.3% in 1965-70. Higher inflation also eroded US competitiveness, further worsening its balance of payments deficit.
Inflation also undermined US ability to honour its BW commitment to maintain full convertibility to gold at US$35 per ounce. This obligation did not go unnoticed by foreign governments and currency speculators.
As inflation rose in the late 1960s, US dollars were increasingly converted to gold. In August 1971, US President Richard M. Nixon ended the exchange of dollars for gold by foreign central banks, effectively violating its BW commitment.
A last-ditch attempt to salvage the international monetary system – through the short-lived Smithsonian Agreement – failed soon after. By 1973, the post-WW2 BW international monetary arrangements were effectively done with.
Commodity Supply Disruptions
Oil exporting, European and other countries which held reserves in US dollars suddenly found their assets worth much less. With Venezuela, the Middle East-led Organization of Petroleum Exporting Countries (OPEC) reacted by dropping their earlier willingness to keep oil prices low.
In October 1973, ‘nationalist’ Saudi monarch Faisal embargoed oil exports to nations supporting Israel soon after President Anwar Sadat’s attempted reprisal following Egypt’s defeat by Israel in 1970. The oil price almost quadrupled – from US$3 to nearly US$12 per barrel when the embargo ended in March 1974.
This steep oil price rise was paralleled by great increases in other commodity prices during 1973-74. Besides petroleum, other primary commodity prices more than doubled between mid-1972 and mid-1974. Meanwhile, the prices of some commodities – such as sugar and urea – rose more than five-fold.
Commodity supply shocks and higher commodity prices increased production costs, consumer prices and unemployment. As rising consumer prices triggered demands for higher wages, these in turn increased consumer prices. Thus, wage-price spirals accelerated price increases and inflation.
The 1979 Iranian revolution triggered a second oil price shock. The resulting ‘great inflation’ saw US prices rise over 14% in 1980. In the UK – then deemed the ‘sick man of Europe’ – inflation averaged 12% a year during 1973-75, peaking at 24% in 1975, while inflation in West Germany and Switzerland exceeded 5%.
In the 1960s, unemployment in the seven major industrial countries – Canada, France, West Germany, Italy, Japan, the UK and the US – rarely exceeded 3.25%. But in the 1970s, the unemployment rate never fell below that. By mid-1982, it rose to 8%, exacerbated by interest rate hikes, ostensibly to fight inflation.
The 1970s’ growth slowdowns – with rising unemployment and inflation – in major industrial economies caught many economists off-guard. Economic thinking then presumed inflation and unemployment were alternatives.
The Phillips Curve implied low unemployment came at the cost of higher inflation, and vice versa. This crude and static caricature of Keynesian economics enabled a major assault on its influence. The assault on development economics was collateral damage in this ‘counter-revolution’.
Peace Is Our Best Option
In October 2021, the International Monetary Fund, the European Central Bank, the US Fed and other such institutions believed the factors driving inflation were transitory. None of these authorities saw an urgent need for interest rate hikes.
But in the last month, the war in Ukraine and sanctions against Russia have driven up the prices of commodities such as wheat and oil. This will exacerbate rising inflation in much of the developed world. The threat of stagflation is undoubtedly more real now than six months ago.
By October 2021, Google searches for ‘stagflation’ hit their highest level since 2008. Mention of stagflation in online news stories surged to more than 4,000 weekly by mid-March, up from slightly more than 200 at the start of the year.
This time, ‘stagflation’ is the direct consequence of political choices, especially for war, not unavoidable economic trends. Developing countries are fast learning where they really stand in this unequal world of endless war, e.g., from the European treatment of Ukrainian refugees.
Peace is therefore imperative. The alternative is the barbarism of conflict among big powers in which most of us have no vested interests. Instead, our shared hope lies in ensuring peace, to focus instead on the common challenges facing humanity.