Are we going back to the seventies? That was the question hanging over the International Monetary Fund’s annual meeting this week. Its keyword is ‘stagflation’, the contraction of economic stagnation and inflation, as it occurred at the time and drove policy makers to despair.
Formally, to the best of our knowledge, the term was carefully avoided. In the hundreds of pages of research published by the IMF over the course of this week, the word does not appear once, as far as I can tell.
Outside of that, however, the s-word did fall. Inflation has been rising in recent months, and there are concerns about the momentum of the economic recovery after the pandemic. There is a heated debate about how dangerous the combination of rising prices and declining economic momentum is. Olivier Blanchard, one of the most authoritative economists of our time, joined the discussion loud and clear on Thursday: “I think the use of ‘stagflation’ is wrong,” he tweeted.
Something like that carries weight. But why is stagflation such a fear gegner for investors and policy makers? This has to do with traumas that are now a distant past for many investors. So put on your wide-leg pants and step into the purple-orange seating area of the seventies.
Yom Kippur War
Oil traded in the 1960s at a price of between $1.50 and $2 a barrel, and had become more expensive by the early 1970s.
With the Yom Kippur War between Israel and its Arab neighbors in 1973, OPEC, the club of mainly Arab oil exporting countries, took advantage of its increased market power and increased the price of oil four times from $3 a barrel to $12. dollar, and briefly ceased deliveries to Israel’s most loyal allies: the United States, but also the Netherlands, which played a crucial role in international oil logistics with the port of Rotterdam.
That was a huge shock in a world accustomed to cheap oil, using 2.5 times as much oil per unit of gross domestic product than is now usual. The result was screeching inflation, which peaked at 10 percent in the Netherlands in 1975, but rose much higher in many other countries. At the same time, the energy crisis caused a recession and supply problems in the business community. Inflation and stagnation suddenly went together. And nobody was used to that.
Contrary to previous forecasts, the IMF predicts that high inflation in the US could last until mid-2022. That is dangerous
If inflation stays high long enough, it will creep into the expectations of people and companies. Unions at the time pushed up their wage demands, and prices and wages began to chase each other in a spiral. Policymakers faced an impossible task: should interest rates go up to curb inflation, or stay low to give the economy a chance? And should fiscal policy be cautious or expansive?
There has been considerable delay, especially in the US, where the central bank has remained inert for too long. But there was also delay in Europe. If the interest rate is not raised, but inflation does rise, a negative ‘real’ – inflation-adjusted – interest rate will automatically arise. And it did wonders for house prices at the time. In the Netherlands it rose by almost 30 percent in 1976 and by 40 percent in 1977.
It was Paul Volcker, the then newly appointed central banker in the US, who cut the Gordian knot of stagflation. After a second oil crisis in 1979, when the oil price doubled and inflation rose even further, Volcker doubled the US interest rate to 20 percent. Inflation fell from a peak of 15 percent in 1980 to 3 percent in 1983.
The Fed set the interest rate at 20 percent in 1979: inflation fell but there was a severe recession and the housing market collapsed, also in the Netherlands
But at the cost of the worst recession since World War II, skyrocketing unemployment and a housing market crash. Certainly also in the Netherlands: house prices almost halved. And it would take until 1993 for the peak of 1978 to be reached again. Klaas Knot, the president of De Nederlandsche Bank, said earlier this year that this period in his youth helped shape him as an economist.
Lesson from the pit: you do not want stagflation, because then there is no good choice to make. Hence the fierceness of the current debate. The stakes are high. Home prices are skyrocketing across the West – including now due to years of negative interest rates and negative real interest rates. Stock prices are at their peak. A lot of household wealth is in houses and shares, and can be vulnerable. And the economy is just recovering from the pandemic recession.
Stag vs. flation
The current debate can be divided into the parts that make up the word ‘stagflation’: the ‘stag’ and the ‘flation’. To start with the first one, Gita Gopinath, the IMF’s chief economist rightly said this week that the economic recession during the pandemic was so atypical that the recovery is too.
The economy was expected to get off to a flying start in the late spring and summer. The so-called purchasing managers index, a survey of corporate purchasing managers, rose to record highs almost everywhere.
The optimism was enormous. But in the course of the summer, delivery problems also appeared. This is to be expected in an economy in which demand is suddenly allowed to explode again: at first it is difficult for companies to keep up. There was already a shortage of computer chips, for example because everyone started working from home and bought new stuff. This was followed by, for example, a shortage of wood, rising commodity prices, especially energy. The chip shortage remains acute: a company such as VDL, which makes cars, suffers a lot from it in the Netherlands.
In addition, waves of corona measures are still disrupting international supply chains. From Chinese ports that are being paralyzed to problems at ports on the American west coast. In the meantime, containers are still in the wrong place, causing additional capacity problems. And it’s too early to say how companies are holding up now that generous government support has ended during the pandemic.
The second half of the word ‘stagflation’ is also unclear. Not that higher inflation is not already there: the United States announced this week that inflation rose to 5.4 percent last month. But it is also high in Germany: 4.1 percent – although there are also one-off reasons for this, in the form of an abolished reduction in VAT. High gas prices play an important role, especially in Europe.
The debate here is mainly about the duration of high inflation: how temporary is the current peak, and will inflation calm down later? Contrary to previous forecasts, the IMF forecast this week that high inflation in the US could last until mid-next year. That becomes dangerous: because, as in the 1970s, inflation expectations among the public also start to rise, then the high inflation can last longer.
Economists at ING pointed this week to the rise in energy prices in 2008, just before the collapse of the Lehman Bank ushered in the credit crisis. Although energy prices subsequently collapsed, a year later the consumer price for energy was still 12 percent higher. Inflation can prove stubborn.
But there are many uncertainties. Unemployment is low, there are many vacancies, but in many countries not everyone is back on the labor market yet. If many people still report there, this could remove the upward pressure on wages. And that is also good to keep the production of business going.
Conversely, the International Energy Agency (IEA) warned this week that high energy prices could not only boost inflation, but also threaten the economic recovery. The latter could mainly be due to power outages caused by insufficient fuel.
This has been the case in China for some time. The recovery from the pandemic, the IEA says, is too dependent on fossil fuels and is thus “unsustainable”. For example, much is still unclear about the interaction between growth and inflation in the current phase of the recovery.
The IMF itself therefore gives a very cautious and hybrid advice: as a government, be careful with austerity measures, so as not to decelerate the economy. Invest in things that increase productivity in the long run. And, as central banks, don’t curb monetary policy too quickly. Reduce the purchase of government bonds a bit, and be careful with interest rate hikes.
That all sounds very responsible and prudent. But it also shows that the real diagnosis of the current state of the global economy has not yet been made. The stagflation as we know it from the 1970s is not very likely. But normal times, those are not for the time being.
IMF: The genie of the Seventies is still in the bottle
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