Uneasy Money

Karl Smith, Scott Sumner, and Yichuan Wang have been discussing whether the experience of the 1970s qualifies as “stagflation.” The term stagflation seems to have been coined in the 1973-74 recession, which was characterized by a rising inflation rate and a rising unemployment rate, a paradoxical conjunction of events for which economic theory did not seem to have a ready explanation. Scott observed that inasmuch as average real GDP growth over the decade was a quite respectable 3.2%, applying the term “stagflation” to the decade seems to be misplaced. Karl Smith says that although real GDP growth was fairly strong unemployment rates were much higher after the early 1970s than they had been in the 1960s and even in the lackluster 1950s (a decade of low inflation and low growth). Yichuan Wang weighs in with the observation that high growth in GDP produced almost no measurable effect on real GDP growth even though a simple Phillips Curve or AD/AS framework would suggest that all that extra growth in nominal GDP should have produced some payoff in added real GDP growth.

Here are some further observations on what happened in the 1970s. Inflation expectations began increasing in the late 1960s, so that a very modest tightening of monetary policy in 1969-70 produced a minor recession, but an almost imperceptible reduction in inflation. Nixon, not wanting to run for reelection with a stagnating economy — the memory of running unsuccessfully for President in 1960 during a recession having seared in his consciousness — forced an unwilling Fed to increase money growth rapidly while cynically imposing wage and price controls to keep a lid on inflation. The political strategy was a smashing success, but the stage was set for a ratcheting up of inflation and inflation expectations, though markets were actually slow to anticipate the rapid rise in inflation that followed.

Thus, the early part of the decade fits in well with Scott’s interpretation. Rising aggregate demand produced rising inflation and rising real GDP growth. Unfortunately, wage and price control quickly began to have harmful economic effects, producing shortages and other disruptions in economic activity that may have shaved a few percentage points off real GDP growth over the next few years. More serious was the first big oil-price shock in late 1973 in the wake of the Yom Kippur war, causing a quadrupling of oil prices over a period of a few months as well as horrific gasoline shortages attributable to the effects of remaining price controls on the petroleum sector, controls that, for political reasons, could not be removed even though other price controls had mercifully been allowed to expire. So in 1974, there was a rapid increase in inflation expectations fueled both by a tardy realization of the inflationary implications of the Nixon/Burns monetary policy of 1971-73, and a presumption that increases in oil prices would be accommodated in output prices rather than prices of complementary inputs being forced down. But because of general anti-inflation sentiment, monetary policy was tightened at precisely the moment when aggregate supply was contracting as a result of rising inflation expectations and an exogenous oil-price shock. That meant that real GDP began falling sharply even while output-price inflation was accelerating. It was that temporary conjunction of falling real GDP, rising unemployment, and rising inflation in 1974 that gave rise to the term “stagflation.” After initially focusing on inflation, the newly installed Ford administration quickly pivoted and provided economic stimulus to generate a recovery and the temporary inflationary bulge worked its way through the system. The recovery was robust enough to have enabled Ford to have been re-elected but for Ford’s monumental gaffe in his debate against Jimmy Carter, denying that Poland was under Soviet domination, and for lingering resentment against Ford from his pre-emptive pardon of Richard Nixon for any crimes that he committed during his Presidency.

By the time that Jimmy Carter took office, the US economy was well into a cyclical expansion, but Carter, after replacing Arthur Burns as Fed chairman with the clueless G. William Miller, encouraged Miller to continue a policy of rapid monetary expansion, producing rising inflation in 1977 and 1978. Once again, excess monetary stimulus produced rising inflation and rising inflation expectations just before a second oil-price shock, precipitated by the Iranian Revolution, began in 1979. The combination of rising inflation expectations and rapidly rising oil prices (exacerbated by the continuing controls on petroleum pricing causing renewed shortages of gasoline and other refined products) induced a leftward shift in aggregate supply, causing inflation to rise while output fell. Hence the second episode of stagflation.

So what does this all mean? Well, if one looks at the periods of rapid increases in aggregate demand in which oil price shocks were absent, we observe very high rates of real GDP growth. In the 1960s from the third quarter of 1961 to the third quarter of 1969, real GDP growth averaged 4.8%. Over the same period, the average annual rate of increase in the GDP price deflator was 2.6%. For the 10 quarters from the first quarter of 1971 through the second quarter of 1973, real GDP growth averaged 5.9%, and for 15 quarters from the second quarter of 1975 to the fourth quarter of 1978, real GDP growth averaged 5.1%. The average annual rate of increase in the GDP deflator in the 1971-73 period was 5.2% and in the 1975-78 period, the rate of increase in prices was 6.4%. In the periods of recession or slow growth associated with the oil-price shocks (i.e, 1973-74 and 1979, the rate of increase in the GDP deflator was 9.3% in the former period, and 8.4% in the latter. Thus inflation was higher in recession or slow growth periods than in rapid growth periods. That was stagflation.  Although economic expansions were about as fast in the 1970s as the 1960s, it would not be outlandish to suggest that rapid increases in nominal GDP in the 1970s did produce faster real GDP growth than would have occurred otherwise, though one might also argue that those temporary increases in real GDP growth had a non-trivial downside.

Why was unemployment so much higher in the 1970s than in the 1960s even though the rate of labor force participation was higher? I think that the obvious answer is that there was an influx of women and baby boomers into the work force without much previous work experience. Typically, new entrants into the labor force spend more time searching for employment than workers with previous experience, so it would not be surprising to observe a higher measured unemployment rate in the 1970s than in the 1960s even though jobs were not harder to find for most of the 1970s than they were in the 1960s.