Deepening stagflation: Out of the frying pan into the fire

Anis Chowdhury and Jomo Kwame Sundaram

SYDNEY and KUALA LUMPUR: The world is sailing into a perfect storm as key leaders seem intent on threatening more war, albeit while proclaiming the noblest of intentions. By doing so, they block international cooperation to create conditions for sustainable peace and shared prosperity for all.

Monetarist counter-revolution

The 1970s saw Milton Friedman disciples’ monetarist counter revolution blaming stagflation on ostensibly Keynesian economic policies. In 1974, Nixon replacement President Gerald Ford declared inflation “public enemy number one” and US “determination to whip inflation”.

Monetarists wanted tighter monetary policies to fight inflation. Curbing rising prices was deemed urgent, even though it would increase joblessness. They advocated abandoning expansionary fiscal measures for more growth and jobs.

But US Federal Reserve Bank chair Arthur Burns still considered ensuring full employment his top priority. For Burns, addressing inflation ‘head-on’ – as urged by his detractors – was too costly for the economy and people’s wellbeing.

Nevertheless, the monetarist ascendance was confirmed when the 1946 Employment Act was replaced. The successor 1978 Full Employment and Balanced Growth Act is better known as the Humphrey-Hawkins Act for its sponsors, including the Democrats’ 1968 presidential nominee.

In early 1980, Burns’ Fed chair successor, Paul Volcker insisted, “[M]y basic philosophy is over time we have no choice but to deal with the inflationary situation because over time inflation and the unemployment rate go together.… Isn’t that the lesson of the 1970s?”

Thus, ‘fight inflation first’ became the clarion call in 1980. This was the pretext for sharply raising US interest rates, while claiming that reducing inflation would somehow eventually create many more jobs. The UK and many other industrial countries followed, deepening recessions and raising unemployment.

By post-1950s’ Western standards, the 1980s saw very high unemployment. Unemployment in rich developed OECD countries averaged 7.3% during 1980-89, compared to just under 5% during 1974-79, and under 3% during the 1960s.

Debt crises, lost decades

The sharp US interest rate spike triggered debt crises in Poland, Latin America and elsewhere in the early 1980s. Earlier, US commercial banks had enjoyed windfall gains following the two oil price spikes in the 1970s.

The US government had long provided concessional low interest rate loans to allies to secure support during the Cold War. Flush with deposits from Organization of Petroleum Exporting Countries (OPEC) members in the 1970s, they pushed loans to borrowing governments, many in Latin America.

With the interest rate spikes, borrowing countries suddenly faced liquidity crises, also creating systemic risks for their US and UK bankers. Successive US Treasury Secretaries, James Baker and Nicholas Brady, came up with various debt restructuring schemes to contain the problem, with the latter adopted.

Meanwhile, International Monetary Fund (IMF) and World Bank financial support was tied to short-term stabilization programmes and medium-term liberalizing reforms, packaged as structural adjustment programmes (SAPs) with explicit policy conditionalities.

The liquidity crises were due to the sudden sharp interest rate increases. But instead, these were portrayed as solvency crises stemming from weak ‘economic fundamentals’, blamed on ‘over regulation’ and protectionism.

Although African countries were generally not able to borrow as much, they too faced problems as commodity prices collapsed with the growth slowdowns. Many were forced to seek financial support from the IMF and World Bank, and thus obliged to implement SAPs as well.

The liberalizing and deregulating SAP reforms were supposed to usher in rapid growth. Instead, however, both Latin America and Sub-Saharan Africa experienced “lost decades of development”.

Stagflation in Europe

Stagflation in our times is expected to be initially most severe in Europe. This has been caricatured as fighting for Ukraine until ‘the last European’ as it bears the brunt of NATO imposed sanctions on Russia. Besides oil and gas, they will pay more for imported wheat, fertilizers and other Russian exports.

But other economic trends will likely make things worse. First, some rich economies – particularly the UK and the US – are weaker now, having lost much of their manufacturing edge. Others have been experiencing declines in productivity growth since the mid-1970s.

Second, low wages – due to labour market deregulation and ‘off-shoring’, i.e., relocating production abroad – have meant less productive activities have survived. Very low interest rates – due to ‘unconventional’ monetary policies since the 2008-09 global financial crisis – have allowed unviable ‘zombie’ enterprises to stay alive.

Third, the declining labour income share has increased income inequalities, lowering aggregate demand. But demand has been sustained by rising household debt. Low, if not negative real interest rates have also encouraged more corporate debt, but with less used for productive new investments.

Fourth, the pandemic has raised all types of debt – household, corporate and government – to record levels. Fifth, countries, especially smaller ones, are now far more internationally integrated – via trade and finance – than in the 1970s.

Therefore, small interest rate increases can have devastatingly large impacts on household, corporate and government finances. Advanced countries are thus likely to see severe economic contractions and rising unemployment.

Meanwhile, more racism and intolerance in recent decades show little sign of receding. Worse, these are likely to worsen as political elites compete in the ethno-populist league to blame Others for their problems. The recent European decision to privilege Ukrainian refugees is a poignant reminder of what is in store.

But impacts on developing countries are likely to be far worse due to capital outflows, declining development finance and aid, as well as slowing world trade after decades of globalization. Increasing inequality since the 1980s and declining growth since 2014 – now worsened by the pandemic – will not help.

Thus, instead of striving to ensure sustainable peace, necessary to improve conditions for all, the world seems set for sustained conflict. This has involved easy resort to sanctions, namely war by economic siege, hurting all. We all thus risk the prospect of mutual destruction instead of shared prosperity for all.

Related IPS commentaries

War or Peace, Barbarism or Hope: War threatens world with stagflation. 29 Mar. 2022. https://www.ipsnews.net/2022/03/war-peace-barbarism-hope/

Stagflation Threat: Be Pragmatic, Not Dogmatic. 22 Mar. 2022. https://www.ipsnews.net/2022/03/stagflation-threat-pragmatic-not-dogmatic/

Ukraine Incursion, World Stagflation. 15 Mar. 2022. https://www.ipsnews.net/2022/03/ukraine-incursion-world-stagflation/

Financialization at Heart of Economic Malaise. 22 Feb. 2022. https://www.ipsnews.net/2022/02/financialization-heart-economic-malaise/

Coronavirus Exposes Global Economic Vulnerability. 4 Mar. 2020. https://www.ipsnews.net/2020/03/coronavirus-exposes-global-economic-vulnerability/

War or peace, barbarism or hope

Anis Chowdhury and Jomo Kwame Sundaram

SYDNEY and KUALA LUMPUR: 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?

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.

1970s’ stagflation

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.

Related IPS commentaries

Ukraine Incursion, World Stagflation. 14 Mar. 2022. https://www.ipsnews.net/2022/03/ukraine-incursion-world-stagflation/

Stagflation Threat: Be Pragmatic, Not Dogmatic. 22 Mar. 2022. https://www.ipsnews.net/2022/03/stagflation-threat-pragmatic-not-dogmatic/

Stagflation threat: Be pragmatic, not dogmatic

Anis Chowdhury and Jomo Kwame Sundaram

SYDNEY and KUALA LUMPUR: “If your only tool is a hammer, every problem looks like a nail”. Still haunted by the clever preaching of monetarist guru Milton Friedman’s ghost, all too many monetary authorities address every inflationary threat or sign they see by raising interest rates.

Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” still defines the orthodoxy. Despite changed circumstances in the world today, for Friedmanites, inflation must be curbed by monetary tightening, especially interest rate hikes.

No central banker consensus

The threat of higher inflation has risen with Russia’s Ukraine incursion and the punitive Western ‘sanctions from hell’ in response. International Monetary Fund (IMF) Managing Director Kristalina Georgieva warns wide-ranging sanctions on Russia will worsen inflation.

European Central Bank (ECB) President Christine Lagarde fears, “The Russia-Ukraine war will have a material impact on economic activity and inflation”. US Treasury Secretary Janet Yellen has also acknowledged the new threat.

She recognizes tighter monetary policy could be contractionary, but expresses confidence in the Federal Reserve’s ability to balance that. Meanwhile, US Federal Reserve chair Jerome Powell has pledged to be “careful”.

Terming Russia’s invasion “a game changer”, with unpredictable consequences, he stressed readiness to move more aggressively if needed. On 16 March, the Fed raised its benchmark short-term interest rate while signalling up to six more rate hikes this year.

But other central bankers do not agree on how best to respond. Bank of Japan Governor Kuroda has ruled out tightening monetary policy. He recently noted, “It’s inappropriate to deal with [cost-push inflation] by scaling back stimulus or tightening monetary policy”. For Kuroda, an interest rate hike is inappropriate to deal with inflation due to surging fuel and food prices.

Friedman’s disciples at some central banks began tightening monetary policy from mid-2021. The Reserve Bank of New Zealand, the first to adopt strict inflation targeting in 1989, raised interest rates in August for the second time in two months.

The Bank of England (BOE) raised interest rates for the first time in more than three years in December. Going further, Norway’s central bank doubled its policy rate on the same day.

Anticipating interest rate rises in the US and under pressure from financial markets, central banks in some emerging market and developing economies (EMDEs) – such as Brazil, Russia and Mexico – began raising policy interest rates after inflation warning bells went off in mid-2021. Indonesia and South Africa joined the bandwagon in January 2022.

Ukraine effect

With inflation surging after the Ukraine incursion, the Bank of Canada doubled its key rate on 2 March – its first increase since October 2018.

The ECB has a more hawkish stance, dropping its more cautious earlier language. Its governing council has reiterated an old pledge to “take whatever action is needed” to pursue price stability and safeguard financial stability.

Following the US Fed’s move, the BOE raised its interest rate the next day. A month before, in February, the BOE Chief Economist was against raising interest rates, favouring a more nuanced approach.

However, instead of kneejerk interest rate responses, Reserve Bank of Australia’s Governor Philip Lowe is “prepared to be patient” while monitoring developments.

EMDE central bankers have also responded differently. Brazil has raised its benchmark interest rate after the Fed, and signalled more increases could follow this year. But Indonesia has been more circumspect.

Interest rate not inflation cure-all

The interest rate is a blunt policy tool. It does not differentiate between activities facing rising demand and those experiencing supply disruptions. Thus, interest rate hikes adversely impact investments in sectors facing supply bottlenecks needing more investment.

In short, the interest rate is indiscriminate. But the prevailing policy orthodoxy of the past four decades does not differentiate among causes of inflation, prescribing higher interest rates as the miracle ‘cure-all’.

This monetarist policy orthodoxy does not even recognize multiple causes or sources of inflation. Most observers believe that current inflationary pressures are due to both demand and supply factors.

Some sectors may be experiencing surging demand while others are facing supply disruptions and rising production costs. All this has now been exacerbated by the Ukraine crisis and the ensuing sanctions interrupting supplies.

Old lessons forgotten

Well over half a century ago, the UN’s World Economic Survey 1956 warned, “A single economic policy seems no more likely to overcome all sources of imbalance which produce rising prices and wages than is a single medicine likely to cure all diseases which produce a fever”.

Addressing ‘cost-push’ inflation using measures designed for ‘demand-pull’ phenomena is not only inappropriate, but also damaging. It can increase unemployment significantly without dampening inflation, warned the UN’s World Economic Survey 1955 as Friedman’s anti-Keynesian arguments were emerging.

Interest rates do not discriminate between credit for consumer and investment spending. In efforts to dampen demand sufficiently, interest rates are raised sharply. Such monetary tightening can do much lasting economic damage.

Declining or lower investment is harmful for the progress needed for sustainable development, requiring innovation and productivity growth. After all, improved technologies typically require new machines and tools.

No one ‘one size fits all’

Dealing with ‘stagflation’ – economic stagnation with inflation – caused by multiple factors requires both fiscal and monetary policies working together complementarily. They also need particular tools and regulatory measures for specific purposes.

Monetary authorities should also create government fiscal space by financing unanticipated urgent needs and long-term sustainable development projects, e.g., for renewable energy.

Governments need to first provide some immediate cost of living relief to defuse unrest as food and fuel prices surge. This can be done with measures that may include food vouchers, suspending some taxes on key consumer products.

In the medium- to long-term, governments can expand subsidized public provisioning of healthcare, transport, housing, education and childcare to offset rising living costs. Such public provisioning – increasing the “social wage” – diffuses wage demands, preventing wage-price spirals.

Such policy initiatives brought down inflation in Australia during the 1980s without causing large-scale unemployment. This contrasted with the deep recessions in the UK and USA then due to high interest rates.

Get correct medicine

But to do so, governments need more fiscal space. Hence, tax reforms are critical. Progressive tax reforms – such as introducing wealth taxes and raising marginal tax rates for high income earners – also mitigate inequality. Governments also need to align their short- and long-term fiscal policy frameworks.

Monetary authorities need to apply a combination of tools, such as reserve requirements for commercial bank deposits, more credit, including differential interest rate facilities, and more inclusive financing.

For example, central banks should restrict credit growth in ‘overheated’ sectors, while expanding affordable credit for those facing supply bottlenecks. Central banks also need to curb credit growth likely to be used for speculation.

Governments also need regulatory measures to prevent unscrupulous monopolies or cartels trying to manipulate markets and create artificial shortages. Regulatory measures are also needed to check commodity futures and other speculation. These increase food and fuel price rises and other problems.

Relying exclusively on the interest rate hammer is an article of monetarist faith, not macroeconomic wisdom. Pragmatic policymakers have demonstrated much ingenuity in designing more appropriate macroeconomic policy responses – not only against inflation, but worse, the stagflation now threatening the world.

Related IPS commentaries

Ukraine Incursion, World Stagflation. 14 March 2022. https://www.ipsnews.net/2022/03/Ukraine-incursion-world-stagflation/

Inflation Targeting Constrains Development. 8 March 2022. https://www.ipsnews.net/2022/03/inflation-targeting-constrains-development/

Inflation Targeting Voodoo. 1 March 2022. https://www.ipsnews.net/2022/03/inflation-targeting-voodoo/

Resist Inflation Phobia Coup. 8 February 2022. https://www.ipsnews.net/2022/02/resist-inflation-phobia-coup/

Inflation Paranoia Threatens Recovery. 1 February 2022. https://www.ipsnews.net/2022/02/inflation-paranoia-threatens-recovery/