Stagflation is Coming (But It’s Not What You Think)
By Prof. Constantinos Charalambous, Provost, City Unity College Nicosia
Published on Gold News
The term ‘stagflation’ – the coexistence of rising inflation and unemployment – first became popular in the 1960s and ‘70s. Admittedly, such a symbiosis cannot last. If the government fights inflation with deflationary fiscal and monetary policies, unemployment will rise. Similarly, if it fights rising unemployment with expansionary fiscal and monetary policies, inflation will rise. The two variables are negatively related as indicated by the Philips curve. As such, stagflation is deemed as a shift of the Philips curve and is considered a short-term phenomenon, until corrective measures are taken.
The current state of the economy checks all the boxes. Inflation, check: Rising raw material prices are giving rise to production costs which are then passed on to the consumer in the form of higher retail prices. Unemployment, check: Due to higher production costs, labour is slowly but steadily phased out to maintain decent competitive prices. Now, I am not saying that businesses will start laying off workers by the hundreds or thousands, but the expectations of inflation and corrective measures that will follow alone cause them to be cautious with new hirings or providing incentives to existing labour to raise their productivity.
How did we get here? During the pandemic it was necessary for the state to keep the interest rate low to encourage spending. How do you boost the economy when everybody is sitting at home, spending only on necessities? But low interest rates lead to money creation. It is estimated that, by the beginning of 2021, the amount of money in the system had increased by 20%. When the lockdown ended, retail sales had increased by over 20% by May 2021. Excess demand from businesses for copper, steel and oil led to their prices rising by 67% in 2021 and another 20% in 2022. Add to the mix the renewed lockdowns in China and the war in Ukraine and you have a recipe for inflation.
The response by governments around the world was to increase interest rates, thus tightening their monetary policy. But, as noted above, tightening monetary policy will lead to unemployment. Simply put, it now costs more for companies to borrow from financial institutions, so it becomes more difficult for them to sustain their production numbers. As already noted, the rising prices of raw materials don’t particularly help either.
Monetary policy, however, is not an automatic mechanism. It will not reduce inflation overnight. On the contrary, inflation has a momentum which is guided by supply side factors. As such, the existence of inflation and rising unemployment give rise to stagflation.
Why did we get here? The short answer is expectations. Enhanced expectations. Economic thought cannot escape human nature, which seeks to provide for basic needs as portrayed by Maslow. Security is one of them. How can a household be financially secure? By saving in times of financial expansion and decreasing spending in times of financial turmoil. In either case, this comes at the expense of spending. A pandemic followed by a war with worldwide implications does not bode well for either the consumers or businesses. But it is important to understand that this is not the cause of stagflation or, at least, not the only cause.
Which brings me to the main argument of this article. Monetary policy and fiscal policy are all part of the world of Aggregate Demand (AD). Reduce AD, economists may argue, and you will lower inflation. Historically, these policies were the go-to plan when prices were getting out of control. In this case, however, the problem is not due to overspending or high AD. On the contrary, households and businesses will remain cautious until they see how this plays out. It is because of external shocks to the world economy, which have caused input prices to rise. So, in essence the problem is not demand but rather supply.
Admittedly, we cannot talk about Aggregate Demand and Aggregate Supply in isolation. After all, they are both forces of an integrated system where a variable might affect both forces, albeit to a different extent. This is where it gets interesting, though. Should you punish demand when the problem is supply? What are the corrective measures that can complement or even substitute AD side policies?
I suggest the following:
1) Reduce tax on raw materials. This will allow companies to keep prices in check and sustain production.
2) Encourage startups. With a large proportion of self-employed workers, new startups can have a positive impact on productivity, exercising downward pressure on the price level and upward pressure on employment.
3) Conduct a shift and share analysis to identify potential sectors in the regional economy that are developing so that finances are channelled to those sectors. It is of vital importance to understand that, as money becomes scarce because of deflationary monetary policy, the state needs to identify the correct way of channeling subsidies or financial incentives to the right sectors.
4) Public investment in education and training. Upgraded schools and training facilities are important as a means of investing in human capital. Human capital has gained a lot of momentum in the last decade because it can make or break an economy. Some may argue that this is a long-term solution but its positive impact will last for years to come.
