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Economic Monthly Report

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Ice and fire: a return of stagflation?

Fri, May 23 2008, 12:52 GMT
by La Caixa Economic Research Dept.

La Caixa

«The situation where we are is between ice and fire. Ice has to do with the economic slowdown and fire has to do with inflation.» Dominique Strauss-Kahn, managing director of the International Monetary Fund, could not have been more graphic at the press conference prior to the Spring meetings of the IMF and the World Bank at the beginning of April. Following some years of extraordinary world growth, the analysts recognize that a time of slowdown has now begun. In the United States it is accepted that the economy has moved into recession. In Europe, the loss of drive is evident. In Spain, the drop in the growth profile has made it necessary to make a downward correction in forecasts for 2008.

In addition, inflation appears to have returned. Structural and cyclical factors lay behind the fact that a barrel of oil marked up new all-time highs in April. And that prices of basic foods (soy, rice, maize and wheat) have shot up in price over the past year. The inflation rate in the Euro Area in March (the latest figure available) showed the highest level since the launching of the euro in 1999. In Spain, growth of the consumer price index went to its highest level in 13 years. But the most disturbing problem is to be found in the developing countries. The increase in cost of foods basic to their diet could lead to increased poverty in broad segments of the population as well as in the emerging countries that are benefiting from globalization.

Ice and fire. Economic stagnation combined with high inflation. Is stagflation on its way back? This takes us back in time to the beginning of the Seventies. At that time, economists were convinced that unemployment and inflation developed in opposite directions. That is to say, a rise in unemployment and an excess of production capacity would lead to a drop in wages and the inflation rate. On the other hand, an increase in economic activity and corporate profits would sooner or later translate into higher wages and increases in prices. This opposing relation became known as the so-called “Phillips curve”, one of the analytical centre-pieces of macroeconomic thought derived from Keynesian theory dominant at that time.

Suddenly the curve fell apart. When the Arabian and other oil exporting countries decided to establish a cartel for their sales thus creating the first oil crisis at the end of 1973, the Western economies saw their growth slow down, with some going into recession, along with a rapid rise in unemployment and, at the same time, a sustained increased in the inflation rate. The restrictive policies scarcely managed to affect inflation rates and they ended up with increased unemployment. Expansionist policies scarcely had any effect on the unemployment rate while, on the other hand, they stimulated price increases. Some years were to pass before the experts were able to better understand the mechanisms that operate in relating unemployment and inflation and to design suitable policies to deal with those imbalances.

Can we establish parallels between the stagflation of the Seventies and Eighties and the current situation? In this issue of the Monthly Report we raise this question and sketch out some of the key factors that make it possible to differentiate and distinguish between the two situations. Furthermore, closely related to the problems of stagflation, we look at the dilemmas faced by the central banks and review the case of Japan, which remains an enigma ever since the collapse of its asset markets at the end of the Eighties. The verdict will not be easy but what we learn from the difficult period of stagflation should serve to avoid our once more falling into the same errors.

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Published on  Fri, May 23 2008, 12:56 GMT