From the New York Times (October 13, 2021): “Wall Street is chattering about the chances of a return of an economic specter from the 1970s: the toxic mix of sluggish economic growth and high inflation that came to be known as stagflation…. the level of attention on stagflation is soaring. Last week, the volume of articles mentioning the term “stagflation” published by the financial news service Bloomberg hit a record.”
I know that, if a 1970s stagflation is coming, that would be really bad news. But I also know that mainstream economists, including those on Wall Street, badly misunderstand stagflation. This post uses the GEM Project’s powerful generalized-exchange theory – the earliest version of which was constructed and successfully used at the Federal Reserve during the 1970s stagflation decade — to adequately explain the phenomenon. Then we be better able to make sense of today’s Wall Street’s chatter.
What follows today summarizes useful facts about the previous stagflation episode. You cannot begin to figure out if stagflation is about to reemerge until you get your facts straight. The next two posts describe the relevant modeling and answers the question about whether stagflation is coming..
The stagflation decade began in the early 1970s and became the 20th century’s second most damaging stabilization crisis, behind only the 1930s depression. Like the Great Depression, it fundamentally altered how macroeconomics is done. Early Keynesians attempted, using their then-mainstream Neoclassical Synthesis, to contemporaneously model the broad market breakdown. But that effort was, in relatively short order, crushed.
Partly resulting from the professional disarray caused by stagflation, EK macro hegemony was challenged, and then replaced, by a reassertion of market-centric rational-behavior modeling. By the 1990s, the revolt had evolved into the modern New Keynesian consensus organized around friction-augmented general market equilibrium, i.e., the New Neoclassical Synthesis. The NK explanation of stagflation fundamentally differs from what was put forward by their EK predecessors. (See next week.)
Stagflation facts. An important, typically ignored combination of facts, beyond the simultaneity of high inflation and unemployment, provides insight into the stagflation decade. The evidence is organized into three interrelated groups: labor-adverse shifts in the terms of trade, dramatically increased inter-industry wage dispersion, and the concentration of higher unemployment among involuntary job losers. Robust explanation of the stagflation crisis must accommodate, not ignore, the important facts that accumulated during the prolonged episode of macro market failure.
Terms-of-trade shifts. There was, in the early 1970s, a powerful confluence of terms-of-trade shifts against labor. Contemporaneous analysis assigned an important causal role to those real disturbances in initiating the destructive stagflation macrodynamics:
- The quadrupling of oil prices, associated with the OPEC embargo, in 1973 was the largest single shock. By the end of the stagflation decade, the cartel had helped engineer more than a fifteen-fold price increase. During this period, energy costs directly accounted for a tenth of the total consumer price index.
- Food prices more than doubled in the early 1970s. The 1972 Russian crop failure put substantial pressure on world grain markets. Meanwhile, there was a mysterious collapse in the anchovy catch off Peru; and meat prices jumped as animal-feed (produced from grain or fishmeal) costs rose sharply.
- The over-valued dollar became unsustainable, and subsequent depreciations and higher import prices further pressured real wages. The gold window was closed in mid-1971 as a prelude to the Smithsonian agreement, which realigned rates of dollar exchange. The agreement was followed, in 1973, by two additional dollar devaluations.
As has been noted, almost all credible economists who contemporaneously worked on the stagflation problem assigned great significance to the terms-of-trade shifts. In post-crisis analysis, theorists began dismissing their relevance and, relatively quickly, that dismissal became mainstream.
Price-wage-price spiral. A virulent price-wage-price spiral was at the heart of stagflation mechanics. It had two phases. Initially, product prices associated with the terms-of-trade shift pushed up wages in a rational labor-pricing process familiar to readers of this Blog but out of the reach of market-centric theorists. Higher wages then pushed up product prices. Subsequently, the dynamics were reinforced by the more general interaction of wage catch-up interacting with cost-plus pricing. The sustained breadth and power of that nominal feedback – occurring while joblessness was quite high – was unheard of in the postwar United States and violated fundamental principles of mainstream macroeconomics. Any theorist seeking a policy-relevant explanation of the disruptive, costly decade cannot ignore the existence and implications of that spiral, beginning with its impact on interindustry wages.
Interindustry wage structure. The behavior of the interindustry wage structure turns out to be the key to solving the stagflation puzzle. After being relatively stable during the postwar period the wage structure blew apart in the 1970s. Wage dispersion (measured by the coefficient of variation) steadily rose and by the end of the decade was a remarkable 25% above its 1960s average.
My 1984 book on the stagflation crisis (The Price of Industrial Labor – hereafter POIL) is the most careful examination of that jump, which played a crucial role in the price-wage-price spiral and stagflation itself. POIL analysis establishes three critical facts about the blown-apart wage structure. First, about half of all nonfarm nonsupervisory workers were able to defend their real wages against the labor-adverse terms-of-trade shifts. The remainder of the work force took the hit. Second, the fortunate employees were located in large, capital-intensive establishments. Third, the primary cause of the altered wage-structure was the sharp jump in energy prices. There is no way that market-centric macro theory can accommodate that information; it was ignored then and is ignored now. (See next week.)
Nature of unemployment. In the stagflation recessions of 1974-75, 1980, and 1981-82, involuntary job loss was the overwhelming engine of rising unemployment. Job-losers incidence rose by 16.0, 7.4, and 11.2 points respectively during the three contractions, which is roughly in line with the 2007-09 experience when three-quarters of the increase in overall unemployment was attributable to the upsurge in forced job separation. Once again, mainstream market-centric macro theory could not then and cannot now accommodate that evidence, so it has been ignored. The sorry picture is one where so much critical information has been ignored that economists typically have no idea how stagflation dynamics work or whether it is about to reemerge.
Additional facts. Other, albeit less significant, political and economic shifts relevant to labor and product pricing around the stagflation period should be noted. Wage-price controls were imposed in the United States 1971, changing the time distribution of inflation. Global instability also aggravated by the spread of protectionist measures. In the U.S., there was a brief surcharge on imported autos, trigger prices on Japanese and European steel, and voluntary quotas imposed on the import of shoes, textiles, and television sets. Moreover, labor productivity gains decelerated significantly from the immediate postwar period. Average annual (nonfarm) productivity growth was 1.3% from 1973 to 1989, half the 2.6% annual 1950-1973 average.
Blog Type: Policy/Topical Saint Joseph, Michigan