Back to the supply-side future

Published in The New Zealand Herald (Auckland), 9 June 2022

There are many fashion treasures from the past that keep coming back. Long flowered dresses, cut-up jeans, or bell-bottom pants: fashion is cyclical.

With economic policy, it’s the same.

So maybe it is not that surprising to hear the word ‘stagflation’ again these days – a term from the 1970s. It describes the unpleasant experience of having both economic stagnation and rapid price increases at the same time. Many economies may well have to go through that again in the coming years.

Stagflation is a blast from the past, but we should also remember what followed. Not just in New Zealand.

In the 1970s, many governments realised that their old recipes of Keynesian stimulus spending, economic planning and regulation did not work. They failed to generate genuine economic growth needed to overcome the stagflationary crisis.

Many countries were in deep trouble. In the US, inflation reached over 14 per cent at its peak. In Britain, the economy nearly collapsed when energy had to be rationed and strikes paralysed the country. The final reckoning for both Australia and New Zealand came in the early 1980s when both countries had become uncompetitive and got close to defaulting on their foreign currency obligations.

In some ways, our economic circumstances today are comparable. It is not just that we are recording price increases of a magnitude not seen in decades. Our economies are also in a position in which no amount of economic stimulus will make them grow much stronger but will fuel further inflation.

When you are in stagflationary territory, that is the predicament you face. The kind of fiscal stimulus or monetary stimulus that had previously kept you going is now toxic and counterproductive. Instead, policy needs to simultaneously bring inflation under control and grow the economy by improving its productivity.

We can see how this played out in the past.

In the 1980s, the US was one of the worst inflation-affected economies. Their annual price increases were rapid, and the expectation of further price increases had become embedded. Americans had given up hope of stability, which only fuelled further price increases. It was a vicious cycle.

Federal Reserve chair Paul Volcker almost single-handedly broke that cycle. He raised interest rates so high that the US economy was plunged into a severe recession. That crushed inflation expectations, and the economy finally recovered to achieve both price stability and economic growth. President Reagan was not pleased with Volcker’s therapy, but he accepted it.

Considering the Federal funds rate reached 20 per cent back then, we might not need the extreme ‘tough love’ of the Volcker years today. It is important to remember, though, that tight monetary policy is the only way to combat inflation. We cannot just wait for inflation to go away by itself. Without decisive action from central banks, this will not happen.

When central banks squeeze the economy in this way, politicians are always tempted to cushion the blow. However, if they try, they will only make matters worse. The whole point of monetary tightening is to let steam out of the economy. Politicians, therefore, must refrain from counteracting their central banks. That is what “monetary policy needs mates” means.

Rather, governments should make their economies more competitive, more productive, and more flexible. This is the only way they can expand – and this growth on the supply side will also help to stabilise the price level.

It is basic economics that inflation is a sign of too much money chasing too few goods. So, to get inflation under control, you can tighten the money supply, or you can produce more goods – or, ideally, you do both.

In a stagflation world, growing the economic pie without stimulus becomes the political challenge of the day. And that is precisely what governments in the late 1970s and early 1980s eventually realised.

After the stagflationary crisis, there followed an era of ‘supply-side economics’. Or, if you prefer to give it the names of politicians, it was the birth of Thatcherism, Reagonomics and indeed Rogernomics. This generally free-market approach was all about restoring productive capacity. It was characterised by privatisation, deregulation and trade liberalisation.

The combination of tighter monetary policy and supply-side oriented economic policy freed economies from the grip of stagflation. It created the foundation for the economic expansion of the 1980s and 1990s, and it was also a factor in establishing a period of generally solid growth, low inflation and progress (“the great moderation”) which lasted until the early 2000s.

None of this is to deny that much hardship accompanied these reforms. Unsurprisingly, many regulatory mistakes were made over that time, some of which later culminated in the Global Financial Crisis of 2008. And, of course, there were other global developments at play which helped in the recovery from the 1970s stagflation.

Still, if we are looking for policy inspiration in the face of today’s stagflation crisis, it is right there. The 1970s global stagflation crisis was overcome by genuine, supply-side oriented reforms and we should aim to do the same today.

Deregulation, privatisation, lower taxes, free trade, and openness to trade and investment may have fallen out of fashion recently. We need to bring them back into fashion to cope with our many economic challenges.

If not under this Government, then hopefully under the next.

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