What Explains The "Stagflation" of the 1970's?

In discussions of the current Bear market, economists have mentioned the decade of the 1970s-during the period 1969-1980, the US stock market went to sleep-share prices hardly moved.There was lttle interest in stocks, and brokers didn’t make a lot of money. What caused the stagnation?
Was it the entry of large numbers of “baby boomers”, graduating from college, entering the labor market? Or was it the big price increases for oil, which also made Detroit’s investments in big cars worthless?
What do most economists assign as the cause of the 1970’s bear market?
Are we in similar territory today?

I’m taking a course on American Economic History right now, so I think I can answer your questions. Inflation can be caused by “overheating,” that is, when aggregate demand in an economy is so strong that the ability of the economy to supply cannot keep up. As a result, average prices rise. Now this demand can come from several places, including consumption, investment (in infrastructure, factories, houses, etc.), exports, or government spending. In the late '60s we had two huge expansions of government spending - Vietnam and the War on Poverty under LBJ. The war increased defense expenditures 14% and transfers (ie handouts) 16%. Supply was unable to keep up, one reason being the extremely high top marginal tax rates at this time. The top tax bracket was 90%, whereas it is now somewhere 35-40%, and this probably had a stunting effect on productivity.

By 1969, there was clearly an inflationary gap driven by government fiscal policy; the economy was stretched beyond full employment resulting in inflation. Now while a little inflation is normal, the problem with inflation is when inflationary expectations set in; that is, people develop an assumption that prices will rise, say, 10% a year. This sets up a vicious cycle: manufacturers cannot stop raising prices because the prices of their inputs keep rising, and employees (a major “input”) demand higher nominal wages to keep up with inflation. Inflationary expectations take several years to build up but then are difficult to stop.

The normal way to stop inflation is a recession, since workers can’t demand higher wages when their cohorts are getting laid off, thus collapsing the cycle. However the Fed had a record of expanding the money supply to get out of a recession, and did so in 1971 (among other things, that’s what we’re doing right now.) Thus the recession did nto stop inflationary expectations since people expected that the Fed would increase Ms to avoid a spike in unemployment. On top of all this, the OPEC oil shock of 1973 meant that the price of crude went from $3-$12, thus feeding inflation further as the price of stuff that uses oil rose. The fall of the Shah had a similar effect.

Now what did this mean for businesses? Inflation has its own set of costs, as it distorts business decisions as everyone tries to keep up with new prices. It also had an effect in that the Fed can fight inflation or recession, but not both. The reason is that the Fed controls the money supply, and the way it fights recessions is by increasing the money supply (among other effects, this stimulates lending and hiring). In a period of high inflation though, that just makes inflation worse. So the Fed was unable during this decade to fight any recessions that came along.

It is also true that industry had a share of the blame. The aftermath of WWII destroyed the infrastructure of most industrialized countries, and much of the prosperity of the '50s was due to the fact that the US ended up a with a huge share of the world’s manufacturing capacity. This made everyone happy, but it made companies complacent too. Auto and steel factories did not invest in newer technology, and unions, seeing that businesses were profitable, negotiated lucrative long-term work agreements. This meant that when Japan came back online, these industries were caught with their pants down, hamstrung by institutional lethargy and union guarantees, a situation that persists to this day.

What finally collapsed this cycle was that the Fed decided to take a hard line on inflation, holding down the money supply whatever the cost. The cost was several years of recession in 1979-1982, which finally got people back to a non-inflationary mindset.

So, to recap, inflation happens when aggregate demand gets ahead of aggregate supply. In the 1970s case, social spending and Vietnam increased the government’s demand greatly, while supply was unable to catch up, partly because of the incentives of high marginal tax rates.

Are we headed there again? Well we certainly are not in an inflationary cycle right now, in fact some economists are worried about deflation, which has its own set of bad effects. We are, however, massively expanding the money supply both through the Fed and by setting up new government expenditures (stimulus packages.) The former is mechanistically easy to reverse, the Fed has the tools at its disposal to take back the money it’s pumping in right now - that’s if it has the political will to do so and risk jeopardizing a recovery. The fiscal stuff (what Congress works on) is harder to pull back, for the simple reason that once people get on the teat of the government, it’s well-nigh impossible to wean them off. Obama’s tried to make some of the spending temporary (thus you hear about “shovel-ready” projects, which we hope will be one-off expenditures). But his social agenda includes propping up welfare (which he did via a clause in the stimulus package) and reforming healthcare. These will have a big price tag, which is not only bad for our debt but threatens to push us into stagflation territory if it’s not properly timed.

So right now we don’t have to worry about stagflation, we have a different set of problems. But it’s something to keep an eye on as we come out of this recession, it’s very possible that we will overshoot into inflationary territory.

A fast run-up in prices of a commodity is part of the equation - in the case of the 1970’s, it was the price of oil. Oil is a core commodity, and its price is reflected in the prices of an array of goods as transportation and manufacturing costs go up. So you get inflation, coupled with a reduction in economic growth.

Other similar price shocks can occur through regulation - tariffs on products drive up prices and lower economic output. Wage laws and regulations drive up prices and lower output. Attempts to stop the inflation through price controls tends to lower productivity and make the problem worse.

The other cause of stagflation is fiscal policy. If the Fed raises the money supply, you get inflation. If the increase in the money supply doesn’t translate into additional growth, you get stagflation.

In the 1970’s, all three happened. After the oil shock of 1973, the economy started to turn down while inflation increased. Government policy compounded the problem - the federal reserve loosened the money supply, adding to the inflation. The Nixon, Ford, and Carter governments attempted various forms of price controls to stem inflation, which instead simply hurt economic growth.

One of the more famous speeches of the time was Gerald Ford’s “Whip Inflation Now” speech, in which he proposed a 10-point plan for solving the problem. Text and video of the speech can be seen here: Ford - Whip Inflation Now Speech.

That speech is utterly daft, and it shows how wrong governments can go in trying to analyze and ‘fix’ the economy. Most of his 10-point items had nothing to do with the current inflation, many of his ideas were counter-productive, and all of them contributed to the productivity-destroying chaos of the time.

There are some scary parallels in that speech to what is going on today. Among the topics discussed:

  • Ending reliance on foreign oil
  • Demanding auto fuel efficiency be increased by 40%
  • Expanding the money supply
  • Regulating businesses
  • New public service jobs to hire 170,000 people
  • Tax cuts for lower and middle class Americans
  • Propping up the housing market
  • A ‘community improvement corps’ of semi-paid volunteers

Yet another grand government plan, scientifically planned to solve the problem - and utterly wrong-headed. The result was a deepening of the problem, and Ford losing to Carter in the next election.

At first, Carter continued many of the same wrong-headed policies. But in the second half of his term, he appointed Paul Volcker to the Fed. Volcker moved away from the Keynesian demand-side policies of previous administrations and accepted the monetarist theory of inflation, formulated mainly by Milton Friedman who said that the only thing that matters in the long term is money supply. So Volcker began shrinking the money supply. Carter began a program of de-regulation, starting with airlines and trucking. The short-term effect was more economic contraction, but that was the price that needed to be paid to restore fiscal balance. Reagan accelerated these policies. He retained Volcker, and gave him a free hand to impose whatever interest rates he felt necessary without pressure. The result of that was a recession, but coming out of the recession the fundamentals of the economy had been restored and the stage was set for the longest economic expansion in U.S. history.

The lessons seem pretty clear to me, and the Obama administration is following more along the paths of Nixon and Ford - re-regulation, punishing businesses, expanding the money supply, creating government jobs programs, etc.

And, it was Stagflation that really struck a blow to Keynesians, because Keynes’s theories did not allow for stagflation. Keynes believed that inflation could only happen in periods of full employment. By the end of the 1970’s, Keynes was almost wholly discarded by the economic community. His resurrection in the 2000’s is utterly baffling to me, except that among left-wing economists the pull of Keynes is strong because his theories can be used to justify widespread interventions in the market. So Keynesianism died, only to be revived as ‘neo-Keynesianism’, which changed a few details to allow for things like stagflation while retaining the rest. Now we’re all supposed to believe that it’s self-evident that Keynes was right and that Friedman and the Austrians and others have been disproved, which isn’t even remotely the case.

But here we are again. Keynes gets another kick at the cat: Keynesianism is back in full force, and we’re trying to buy our way out of a recession with huge borrowing, while simultaneously punishing the supply side through higher taxes while stimulating the demand side with tax cuts on the poor and middle class. To me, that’s a straightforward recipe for stagflation. It doesn’t have to happen that way, but it will unless the government is aggressive about shrinking the supply of money once the economy starts to pick up. Unfortunately, I think that will be extraordinarily difficult to do. The political pressure to keep the loose money supply will be strong.

I hope that if there’s another round of stagflation it will put the final nail in the Keynesian coffin and people will eventually realize that wealth does not equal money, and that you can’t borrow your way out of a crisis caused by borrowing, and that you can’t regulate your way to prosperity.

Okay, it’s a dim hope.

I agree. I often wonder why it always seems to happen this way.

You would think that understanding the way to create jobs and wealth would be pretty straightforward: Sound money, adherence to the rule of law, free trade, and an low-burden investment climate that is fair, straightforward and doesn’t change quickly at the whim of politicians. Instead we tend to get the opposite.

I think it’s because during times of economic stress,

  1. The majority of the voters want elected officials to ‘do something’, usually something that is proactive, visible and requires passage of new legislation.

  2. The majority of the voters want a villain to punish, and politicians are glad to find one that’s handy… to deflect blame from themselves

  3. A sharp switch from loose money to tight money invariably causes discomfort and squeals from the consumer economy

I would add a 4th, which I discussed in the Libertarian/Fringe thread a while back. And is also clearly evident from the recent FDR/Depression thread, even though the SDMB is probably not a perfect sampling of the American voter.

And that is I see a disturbing trend where more and more of the American voting public doesn’t really understand where jobs, wealth and increased living standards come from. They think jobs come from the government. They think the government creates wealth. They subscribe to fixed-pie thinking (what classic economists would call the ‘lump of labor’ fallacy) and believe it’s only a matter of shifting the size of the pieces around. Then everything will be OK.

What’s worse, career politicians in Washington often have no idea either. They are all either lawyers or have worked for the government their entire adult lives.

Obama’s language during his campaign, during the debates, during the Joe-The-Plumber episode, and even during his time in office also suggests he believes the government creates wealth. Or perhaps more charitably, he’s unclear how it gets created…but he’s going to make damn sure it’s spread around fairly and properly.

How would he know any different? He’s been a law professor, a ‘community activist’, and a politician. That’s it.

Has he ever had to make an investment decision on a new plant? Or weigh the pros and cons of outsourcing, considering the punitive tax burden the government puts on the hiring and paying of employees in this country? Or try and settle the debt of someone who owes him money, only to realize he has to ship off a 1099 to the debtor for the forgiven amount, which has the potential to scuttle the whole thing? Or dealt with frivolous workmen’s compensation claims?

Of course not. He’s never done any of these things. That’s why when he says things like how the new foreign tax rules will ‘create jobs here in America’ serious businessmen roll their eyes and groan. He has absolutely no idea what he’s talking about. And what’s worse, most of the people in Congress are in the same boat.

Wouldn’t it be great if instead a President said ‘You know what? I will do something. I’ll do as much as possible, as fast as possible, to get out of the way of the people who actually create jobs and wealth in this country. They’ll know what to do if I make their life easier. That’s what I can do to help.’

Naaaa. It’ll never happen.

Well, if you want lower regulation, lower taxes, lower govt spending, and on and on, it helps if you don’t have 8 years of a Republican president who thoroughly discredits those ideas in the eyes of the public.

If all those ideas were so great, why are we in TheWorstEconomicSlowdownSinceTheGreatDepression? What caused the housing bubble, the stock crash, the accounting scandals, the automaker bankruptcies, the oil price spikes, and so on that have landed us in the mess we’re in now?

And before you answer, I know you’re going to say wrongheaded Keynesian ideas and socialism, and so on. Right. But if conservatives support that sort of thing just as much as the liberals, then where does that leave the public? Vote for big-spending big-goverment Bush and McCain, or vote for big-spending big government Obama? Give them a choice between a Keynsian and a Keynsian and they’ll choose a Keynsian.

The problem is that Bush screwed the pooch too. He’s a HORRIBLE example, since on matters of fiscal policy he acted more Keynesian than anything else. His policies were confused and his efforts at deregulation were spotty at best. On trade he was all over the place. If, as IdahoMauleMan says, Obama is unclear how wealth is created, Bush was totally clueless.

Because you are assuming Bush to have been an economic conservative and to have implemented the policies and ideals Sam was talking about…and you’d be about as wrong as you could be. Bush was like Nixon and Ford.


Who said anything about 8 years of a Republican president?

I see you checked box number 2 on my list above. Thanks for the feedback.

While it is often stated that Keynesian theory can't explain stagflation can't explain stagflation that isn't quite correct. For example in a simple AS/AD diagram a negative aggregate supply shock will produce both a rise in the price level and a decline in output. It is probably true to say that the 70's discredited the simple Phillips curve analysis particularly as a tool for policy-makers. However equally the early 80's discredited monetarist prescriptions in particularly because velocity turned out to be far more volatile than monetarists claimed. Central banks no longer follow a policy of targetting money supply, they usually use discretionary monetary policy to target short-term interest rates a practice which Milton Friedman opposed.  

As for New Keynesian economics it has become the standard because it does a much better job of accounting for things like imperfect competition and market rigidities compared to the New Classical macroeconomics developed by Lucas and others. There is a lot of evidence that these things are important in understanding the macroeconomy. It also does a better job of explaining how monetary and fiscal policy affect the macroeconomy and again there is a lot of evidence that they do. By contrast Real Business Cycle theory (closely related to New Classical macroeconomics) doesn’t have a good theory of how monetary policy works and is therefore not particularly influential in a world where monetary policy is extremely powerful and important.

It is striking that even in the Bush administration New Keynesians, albeit of a more free-market variety, were quite prominent: notably Mankiw and Bernake.

As for why stagflation isn't a serious threat now, the answer is simple: huge global excess capacity along with a large pool of unemployed workers. This means that even a large increase in aggregate demand is possible without leading to an increase in the price level. Obama and Bernake are doing exactly the right thing by creating a huge macroeconomic stimulus. The only scenario I can think of where stagflation becomes a worry is if there is a war in the Middle East perhaps because of an Israeli attack on Iran. At a purely economic level inflation isn't a serious worry as of now.

This definition of inflation is incomplete and quite misleading if you don’t include price effects caused by the money supply.

If you aggressively expand the money supply, everyone’s “buying power” has dropped even though “aggregate demand” is the same. Prices have risen because demand for real goods & wealth has exceeded the demand for money. The reduction in buying power would give the illusion of greater “actual demand for actual goods” which leads to your misleading definition.

Hasn’t the money supply also been decreasing due to the massive deleveraging happening at financial institutions and at the household level (losses in housing prices, paying down credit card debt, and so on)? Wouldn’t this decrease in money supply offset (at least partially) the increase going on at the Fed?

The money supply has been decreasing primarily because the velocity of money has slowed down. The money supply is measured by the aggregate amount of money multiplied by its velocity. Because of the credit crisis, velocity has slowed dramatically. The fed has been counteracting this by increasing the monetary base.

When the velocity picks up again, inflation should occur unless the fed acts to shrink the monetary base by unwinding the policies that grew it in the first place. It can do this by ending loan programs, pulling back unnecessary capital from banks that were loaned it in the first place, and by raising interest rates. Chairman of the Fed Bernanke seems to think this will be a relatively painless and straightforward process, but I have my doubts. We’ll know soon. Either the economy will stay in recession, or it will recover and inflation will start to tick up, and then we’ll see what the Fed manages to do about it.

But if interest rates are raised, won’t that slow the velocity of money right back down?

Your carefully cherry-picked list of “parallels” from Ford’s speech rather obscures the extent of the differences between Ford’s proposals and current policies. Among the other topics discussed in that speech:

  • Full-capacity agricultural production
  • A Council on Wage and Price Stability to “monitor wage and price increases in the private sector”
  • Deregulation of natural gas
  • Passage of surface mining legislation
  • Relaxing the Clean Air Act
  • A National Commission on Regulatory Reform “to identify and eliminate existing Federal rules and regulations that increase costs to the consumer without any good reason in today’s economic climate”
  • Cutting capital gains tax
  • Setting a target spending limit

So ISTM that Ford’s problem wasn’t so much that he was some kind of foreshadowing of Liberal Obama (oooh! scary!) implementing governmental stimulus programs, but rather that he flailed around with an inconsistent hodgepodge of regulatory and deregulatory efforts, tax cuts and tax surcharges, laissez-faire and centralized-control policies.

That’s a somewhat peculiar definition of “setting the stage”, considering that the 1991 recession intervened between Reagan’s 1982 recession and the expansion you mention.

We did have a President who said that. His name was George W. Bush. Unfortunately, there were plenty of gullible people who believed him.

No, if interest rates rise velocity increases because holding money becomes less attractive compared to interest-bearing assets. However the general idea behind monetary policy is that the other effects of higher interest rates on demand are greater than the effect of rising velocity and so inflation is prevented.