Welcome to the 1970s
Published in Insights, The New Zealand Initiative’s newsletter, 25 March 2022
As the saying goes, everything in fashion eventually returns. And so it seems in the economy.
By now, we are not only aware of the cost-of-living crisis. We see its effects every day. Yesterday, the Initiative published a research note discussing the most important price changes.
The underlying reasons for those inflationary developments are less clear. To understand them, it is useful to recall what was happening in the 1970s.
Back then, the world encountered a new monster: stagflation.
Before the 1970s, economists believed that there could be periods of inflation when the economy grew, and periods of price stability when the economy stagnated.
What economists did not expect was for a stalling economy to also experience high inflation at the same time. And then came the 1970s oil crises.
The collapse in oil supply coincided with loose monetary policy and profligate government spending. It turned out these were the ingredients required to create recessions with price increases: stagflation.
Does that 1970s scenario remind you of something?
Like fifty years ago, the world economy is facing massive supply shocks. Current supply disruptions may be even more severe. Today’s crisis is not just around oil, and its effects occur in a much more interconnected world economy.
On the fiscal and monetary side, too, the vulnerabilities are greater than in the 1970s. Governments are bigger and more indebted. And especially after the GFC and the pandemic, central bank balance sheets are larger than ever before.
Supply shocks, public debt, and an overhang of monetary policy make a toxic cocktail. Add to that the risk of an escalation of the Ukraine war – or a Chinese invasion of Taiwan. And also consider the political and social divisions plus ageing populations in many developed economies.
Compared to the 1970s, the situation is much uglier and more dangerous today.
So, what does this mean?
Well, it means that this is not just a cost-of-living crisis. In fact, inflation is only one part of the underlying malaise of stagflation.Let’s hope it is only a stagnation and not a collapse in economic activity.
As politicians and central bankers experienced during the 1970s, fighting stagflation is challenging. Curbing inflation makes the economy contract, while trying to stimulate the economy will only lead to more price increases.
Perhaps the most urgent task is to realise that demand-side stimulus cannot fix supply shocks. Ultimately, it took policymakers most of the 1970s to finally realise that.
We can only hope it will not take us that long this time.