Is Stagflation Coming?

Is stagflation coming? No. (So much for on the one hand or the other.) The next macro crisis facing the country will be something else, as yet unknown. But we know today that the available evidence doesn’t come close to supporting predictions of an imminent  outbreak of stagflation. The chatter about that is much more indicative of Wall Street cluelessness about how stagflation works and, more generally, how labor and product prices are determined in highly specialized economies.

The argument. My confident “no” is rooted in two facts about today’s economy:

• The current state of the labor-market is badly inconsistent with stagflation, which is defined by the coexistence of high inflation and high unemployment. Throughout 2021, the jobless rate has been falling, not rising. It is heading toward the near-record low levels experienced before the onset of the pandemic in early 2020. The first pillar of stagflation is missing.
• Current interindustry wage-structure dynamics are also inconsistent with stagflation. The criticality of wage-structure dynamics in the 1970s crisis was featured in the post two weeks ago. Today, the most recent employment cost index (our best measure of wage behavior) shows that worker pay in relatively high-wage goods-producing industries, featuring manufacturing and construction, is increasing at half the rate of relatively low-wage service industries. The reduction of inter-industry wage dispersion has been especially driven by robust gains in retail trade and hospitality/leisure sectors, which have been experiencing labor shortages. Readers of this blog know that increasing dispersion is a necessary condition of stagflation.

Moreover, shifts in the terms of trade against labor occurring today aren’t nearly big enough to support a powerful price-wage-price spiral that is needed to align today with the 1970s experience. A wonkish fact that is also relevant here is another consequential implication of GEM intra-firm modeling that makes the Workplace Exchange Relation an endogenous outcome of optimizing employer-employee interaction. That process is demonstrably capable of learning.  After the wage structure blew apart in the 1970s debacle, much higher labor costs in iconic LEV industries helped set the stage for the 1980’s downsizing crisis that produced massive permanent good-job loss and destruction of shareholder equity. That outcome greatly damaged both labor and management. LEV firms have since been rationally weaning workers away from expecting lock-step movement with price inflation. That effort is illustrated by the common framing of periodic general wage increases as resulting from productivity gains as well as the sharply decreased reliance on cost-of-living escalators.

The role of expectations. Why do so many economists continue to get labor and product pricing wrong. The most important reason is their belief in an outsized role for expectations in both. Recall last week’s analysis, in which Eugene Farmer (2010b, p.60) summarized the durable mainstream friction-augmented general-market-equilibrium (FGME) explanation of the stagnation decade: “During the 1970s, the U.S. economy experienced high inflation and high unemployment at the same time and the data did not lie anywhere near the [original Keynesian] Phillips curve…. The Phillips curve broke down because firms and workers began to increase wages and prices in an inflationary spiral. Wages went up because workers believed that prices would rise. Prices went up because higher wages were passed on to consumers.” Macro textbooks today widely accept that the engine of the 1970s stagflation was workers’ anticipations of inflation being unanchored by the central bank. Modern theorists agree that the root cause of the simultaneous wage-price spiral and high unemployment was a less-than-credible monetary-authority commitment to low, stable price inflation. That New Keynesian consensus is simply wrong. It does not come close to aligning with critical evidence. (See last week.) Its policymaking advice is reckless. Its economics are embarrassing.

The Wall Street chatter motivating this three-part series on stagflation is rooted in the flimsy un-anchored-inflation-expectations explanation for the stagflation decade. That story is consistent with the market-centric general-equilibrium framework that the macro academy insists is finished theory. It does not matter that its implications for stagflation analysis are inconsistent with both relevant evidence and rational behavior; what matters is that it does not challenge “finished” theory. Adding a second workplace venue of rational exchange, despite its extraordinary incremental power to explain what actually goes on in highly specialized economies, is not worth the cost of upsetting the established market-centric order. The academy’s revealed preference is to be wrong about a lot of important stuff.

Blog Type: Policy/Topical Chicago, Illinois