The economy is now in the midst of serious inflation unseen for over forty years. This condition could give way to a long, frustrating period of stagflation as occurred in the 1970’s. Those who were around in the developed world in those days got a good first-hand look at stagflation and what it can do to an economy. But what exactly is stagflation, and what could cause it to take place? Here are some of the theories that are thought to have brought out stagflation during that era.
Evolving Definition: In the 1970’s the concept of stagflation was so new to economic theory that an exact definition was at first hard to come by. There are two ways to look at it and both are similar in nature. The first one is a slowdown in economic growth combined with relatively high unemployment. The second one is inflation combined with a decline in economic output (or GPD). The term itself was first used by British politician Iain Macleod in the House of Commons back in the 1960’s. That discussion was about “inflation” on the one hand and “stagnation” on the other which created a “stagflation situation.”
The 1970’s Stagflation: Stagflation is truly a rare condition that may have only existed a few times in our history. It seems to occur with a combination of unusual events ganging up on each other. The most notable period of stagflation took place during the 1970’s, and it turned into a worldwide event for industrial nations. During the late 1960’s, inflation began to rise owing to the twin demand pull pressures of the Vietnam War and the war on poverty engineered by the Johnson Administration. Reaching into the early 1970’s, the Nixon Administration grappled with the never-ending Vietnam War, and inflation that was becoming more and more serious as it continued to rise unabated. As the war wound down, the Federal Reserve provided accommodative increases to the money supply in an effort to promote growth during a time that major industries were changing over from wartime production to postwar. Owing to an Arab-Israeli war in 1973, the Organization of Petroleum Exporting Countries issued an embargo against the western countries that supported Israel. This caused a huge price shock throughout the industrialized world as many, if not most, of those western countries were major importers of crude oil. The sudden increase in transportation costs exasperated supply chains already dealing with rising prices and increases in unemployment. The Gerald Ford Administration sought to fight inflation via a fiscal policy pullback, but that gave way in 1976 to the Jimmy Carter Administration that pushed fiscal policy forward again.
The Rise of Monetary Policy: During the throes of this stagflation, Milton Friedman, an economics professor at the University of Chicago, put forth the concept that monetarism was the tool needed to control inflation. The key to regulating inflation lay in regulating the money supply via Central Bank easing and tightening. The focus of policymakers followed this axiom in the latter 1970’s and the early 1980’s, as interest rates climbed as high as 20% for short term loans. Bank certificates of deposit were paying as much as 12-14% interest to savers, and home mortgages were managed by interest-only monthly payments and a massive balloon payment at a specific date. But inflation finally settled down, and the economy went on a nearly steady period of growth, punctuated by an occasional pullback, that lasted forty years until the Covid-19 Pandemic.
Redefinition of Inflation: The concept of inflation itself—declining purchasing power of the currency—has been fundamentally redefined owing to stagflation. Instead of being an economic ogre, it has become accepted by most economists and policymakers that some inflation will and should always exist in a healthy economy. The name of the game is to regulate and order the economic system toward an acceptable level of inflation that can still support a sound currency along with economic growth. In this day and age, an inflation rate of about 2% is preferred by some central banks including the Federal Reserve.
Conclusion: It takes nearly a perfect storm of events to create a period of stagflation. In all fairness, the condition is so rare that the remedy was not something that policymakers of the time had readily at their disposal.
Sources: Investopedia.com/terms/stagflation.
Wikipedia, stagflation.
Forbes.com/advisor/investing/stagflation