I don’t always love being right. For example, some time back I predicted in this space that conditions were right for an outbreak of inflation. As 2022 gets underway, I am reminded of what unwelcome relatives can say as they walk in the door: “We’re Here!”
As most of you have not doubt heard, inflation rates are being measured at levels we have not seen since early in the Reagan Administration. That was the “hell to pay” period in which the the no-nonsense Chairman of the Federal Reserve did the hard work to wring inflation out of the system in a way that held for the next forty years. But now people are starting to talk about “Stagflation”, which seemed like a good idea to wade back into this area for a little more “inflation education” from someone who both studied it and lived through it the last time. Lots of people use these terms and very few really understand them, so let’s get you fixed up.
I got into a detailed explanation of what is and what is not inflation in another piece a few years ago. For those disinclined to go back and read my earlier piece, here is the executive summary: Inflation is always and everywhere a monetary phenomenon. More money than the economy can use results in inflation, or a situation where each unit of that money (a dollar, in our case) becomes worth a little bit less than it was before. And the corollary concept that is extremely important is this: prices can go up and down even without inflation, as anyone knows who has tried to buy gasoline or lumber after a hurricane or a new car when nobody can get computer chips.. The trick is recognizing that inflation (the general rising of all prices) and specific price changes because of market conditions (the raising of a specific price for a real, recognizable reason) are two completely different things that, unfortunately, often look the same (and often happen concurrently, making proper identification difficult).
So, what is the variant called “stagflation”? This requires a brief history lesson. Back in those august days of the 1960s when everyone knew everything (or thought they did), an economist named A. W. Phillips noticed a relationship between inflation and unemployment (a stand-in for recession). When inflation rose, unemployment went down, and vise versa. Mr. Phillips graphed the points and they looked like this.
A whole bunch of knowlegeble economists accepted the brilliance of this idea (called, for now-obvious reasons, The Phillips Curve) that just as we could fine-tune a dial on a radio, we could choose where we wanted to be in a tradeoff between inflation and unemployment/recession. Is the economy a little slow? Inflate and everything will soon be fine. Is inflation too high? Just slow the economy down a bit (also known as “do something that will throw some folks out of work”) and the rest will take care of itself.
This was the world as it was in about 1970. In that world, the idea that you could have inflation and recession (or stagnation) at the same time was blasphemy. So a whole bunch of people were really confused when, in 1974, we got a nasty recession at the same time we had increasing inflation. “Stagflation” was the catchy term that was batted around as lots of brainy (but wrong) people rubbed their chins and tried to understand.
In the couple of years either side of 1980 I was fortunate to be an economics major at a school which had a significant number of professors who were dissenters from the then-current orthodoxy of Keynesian (named after John Maynard Keynes) economics. I still recall Dr. T. Norman Van Cott lowering his head and peering at us over his glasses as he said “There is no such thing as a Phillips Curve”, which he proceeded to show using more recent data which peppered points almost everywhere along the graph (except where Mr. Phillips had predicted they might be). A more recent version of that graph looks like this:
Here is the key takeaway: There is inflation – your money losing value. There is stagnation – the economy slowing down in a recession. These are two different things. You can have one, you can have the other, and (most importantly) you can have both, and in varying degrees. Inflation does not cause stagnation and stagnation does not cause inflation (there are some really technical, minor ways that each can have an effect on the other, but that goes beyond our broad-brush discussion here).
I am going to surprise some of you and say that Joe Biden is not responsible for today’s inflation. The ingredients for inflation were already in the cupboard (thanks to a loosey-goosey Federal Reserve over the last several years which has been regularly erring on the side of too much money rather than too little. I once heard an economist describe problematic inflation as being like a run on the bank – by the time you realize it’s happening, it is too late to stop it.
Stagnation (or recession), unlike inflation, is a real phenomenon caused by policies that deter economic actors from engaging in business activity. “Economic actors” are people like you and me, after being run through the economics jargon machine. Higher taxes (of certain kinds), increased business regulation (again, of certain kinds) and other things are within any government’s tool belt, and those tools can indeed induce people to act in ways that deter economic activity. A market economy like ours is not a magical black box that takes oxygen into one end and spits golden eggs out of the other. It is an aggregation of people making seemingly unrelated decisions, such as “should I open a second restaurant”, “should I buy a new car or keep my old one” or “should I get a job, get married and raise a family or should I stay in Mom’s basement getting high?” Whether the economy is healthy or stagnating depends on lots of things, not least a climate that encourages legitimate business activity or discourages it, coupled with the reactions of those of us on the ground.
So Inflation is here. Stagnation is kind of hanging around on the front porch, and how serious it is depends on who you are listening to. The good news is that inflation does not automatically lead to stagnation, as long as it doesn’t get out of hand. And the bad news is that killing inflation is often not undertaken until it has gotten out of hand, and is therefore generally unpleasant More often than not, it results in recession – if only because we all start reacting to faulty price signals again. Tightening money to curb inflation can, in a real sense, trick people into thinking that things are worse than they really are, and acting a recession into existence. It is like how way everyone can run to one side of the boat when others do so (whether there is anything to see there or not), resulting in the capsizing of an otherwise seaworthy boat.
Stagnation? Whether it is coming or not is an open question. My prediction is that it is coming, if only because any effort to actually tame inflation is going to involve tightening money that will turbocharge any recessionary tendencies by making them look worse than they are on their own.
The takeaway is that inflation and stagnation are two different concepts. Stagflation is either having both of them at once or a sign that the one using the word has not a clue about how to understand basic economics. And (just like with inflation and stagnation) you can have both of those things at the same time too. The good news is that, having read this, you won’t be one of those unfortunate souls.