The signals that we’re in for some heavy weather are gathering pace. For a generation old enough to remember, things look quite familiar. It seems we’ve been here before...
The Fed announced that it is unlikely that there will be further rate cuts. With inflation creeping up further and the economy on the brink of a recession (if not already in one), this is not a surprise, to beat inflation, rates need to go up, to get the economy going, rates need to go down.
This is an awkward dilemma. We haven’t seen this kind of policy dilemma’s since the 1970s. That decade also coined a word for it, stagflation. From the experience in that decade, we also know how to deal with it. And that ain’t going to be a nice experience.
Stagflation in the 1970s caused general bewilderment for policymakers because, as we just explained above, economic forces were pulling policy instruments in opposite directions. Traditional Keynesian theory could deal with inflation and it could deal with a recession, but not with both.
What actually happened in the 1970s was a so called ‘supply shock‘ (or, better, a series of supply shocks). The previous decade of high growth had pushed unemployment to extremely low levels, just at a time when the labour movement was radicalizing and gathering strength.
This also coincided with a slowdown in productivity growth, which was the most fundamental reason behind the economic problems of the 1970s. Why?
It’s simple, really. If labour produces 3% more output a year (because of better machines, more efficient ways of working, production process innovation, etc.), it can also earn 3% more a year without getting more expensive.
But the new realities were that labour productivity slowed down markedly in the early 1970s just when the climate was getting much more difficult for labour to moderate it’s wage demands, which was really necessary. If productivity grows at 1%, but wages keep on rising at 3%, labour becomes more expensive by 2% a year.
This squeezes profit margins and sets off inflation as some companies can increase output prices to recoup the rising cost of their employees. Increasing output prices is, well, inflation. And this made wage demands increase further, setting in motion a wage-price spiral.
The reasons behind that slowdown in productivity growth are still a bit of a mystery, but it’s likely that the whole ‘Fordist’ paradigm of mass production had ran it’s course, the low-hanging fruit had been picked and the technology to shift towards a new production paradigm was still in it’s infancy.
Then came another catalyst in the form of an oil shock (sounds familiar!). In fact, it was not only the price of oil going up, but also the prices of many commodities (that also sounds familiar!), and there was another shock, the explosion of the system of fixed exchange rates that was set in 1944 in Bretton Woods.
The abandonment of that system made it possible for the US dollar to fall significantly against other currencies, which it duly did (another familiarity), and OPEC, the organization of petroleum exporting countries wasn’t too happy with this, as oil is priced in dollars.
The Yom Kipur war of 1973 gave them the perfect excuse to hike oil prices (and use it as a political weapon; the US and The Netherlands were singled out for a total oil boycot, prompting the legendary Dutch prime minister of the day to say to a bewildered nation that “things would never be the same again“).
So, in summary, we had a couple of supply shocks (productivity slowdown, labour scarcity, commodities, the demise of the Bretton Woods system) and particular political circumstances (labour radicalization, the emergence of OPEC) that produced a series of supply shocks.
A supply shock is basically a one-off increase in the prices of inputs that are used in most production processes. They create inflation (obviously), but also reduce economic growth and increase unemployment, hence the term stagflation.
Supply shocks were a rather new phenomenon for policy makers and freed from having to defend exchange rates because of the demise of the Bretton Woods system, there was a good deal of policy experimentation on how to deal with that. We can now learn from that experimentation.
Countries like Germany, Japan, Switzerland, The Netherlands gave priority to fighting inflation and embarked on sound money policies, whilst other countries (the UK, Italy, France until 1977) made fighting unemployment their main task through reflationary demand stimulation (increasing public spending, tax cuts, and the like).
The countries embarking on deflationary policies fared a lot better than others, which experienced runaway inflation as a result. In the UK, for instance, inflation reached 20%. And once inflation is out of the bottle, it’s very difficult (and costly) to reign it in, as inflationary expectations become embedded in the minds of wage and price setters.
This is the main reason why those countries embarking on deflationary policies fared better, inflationary expectations did not get much chance to really establish themselves in those countries. The Bundesbank, (West) Germany’s central bank became the paragon of these sound money policies.
It’s hard to believe now, but in the US, a republican administration actually embarked on wage and price controls. Obviously, this was before the Reagan revolution which turned the belief in free market into something of a fetish.
Inflation was only quelled when the Fed under Volcker embarked on similar policies in 1979 as the German Bundesbank five years earlier, but the costs of those 5 years were high, interest rates had to rise into double digit territory, setting off the international debt crisis and a world-wide recession in the process.
What can be learned from these experiences in the 1970s? The main lessons are:
- Sound money policies are best.
- These have to be applied as early as possible.
Are those lessons actually applicable today? In order to answer that question we have to look whether the situations are really that comparable.
This time around, what are the differences and similarities?
- Now, there are also a series of supply shocks, we have a commodities boom and a sinking dollar
- Unlike the 1970s, there is no marked slowdown in productivity growth, and the power of organized labour to increase wages is much reduced (due to globalization and a decline in unions power)
- Inflation hasn’t (yet?) reached the levels of the 1970s
- So it might seem that we’re better off, however, there are additional serious shocks to the system, the US housing market is in a deep slump, the end of which might not be in sight for some considerable time to come, and we have a very brittle financial system which is a drag on the system (as it’s willingness to supply credit is not exactly rife at the moment).
We think that the situation is likely to be worse today than in the 1970s. This is the result of a couple of opposing forces:
- Better is that the inflationary dynamics are not nearly as strong as in the 1970s, as organized labour has lost it’s strength, productivity growth has not been affected (so far, at least), so there is less chance of a wage-price spiral
- However, the room for embarking on deflationary policies to quell inflation has also been reduced, and reduced quite significantly. If the Fed would increase interest rates, the housing market would really crash, and the financial system could worsen further
- And monetary policy seems less powerful. The credit crisis has made banks and other financial institutions credit shy, lowering interest rates doesn’t have the same punch as before.
And there is one joker in the pack: Chinese inflation. If inflation in China (approaching double digit rates already) would really take-off, one of the main deflationary forces in the world economy (cheap imports from China) would shift into reverse.
The Chinese economy is so open (international trade actually constitutes a much larger part of the economy compared to the US, Japan, or the European Union) that it is importing relatively more inflation from the commodities boom compared to these other regions.
The Chinese economy, meanwhile, has been surprisingly robust during this onslaught. One would expect the economy to cool off, thereby also soften the impact of the commodities boom on prices, but very little of that seems to have happened until now.
For the Chinese authorities, it’s a finely balanced game. Cooling the economy off too much could endanger world economic growth further (and it could even destabilize China itself). Unabated growth could cause inflation spiraling out of control (and would have much the same effect).
So, surprising as it may be, those lessons from the 1970s are useful in an unexpected part of the world: China. They should err on the side of caution. One way to do that would be something that is inevitable anyway, let the currency rise.
China has already embarked on such a policy for a number of years, but they’re doing it at a very pedestrian pace. It would be a good idea to speed that up just a little bit.
It would export some more inflation into the rest of the world economy (not that much, as commodities would become cheaper for Chinese producers), but at the same time, increase some demand away from Chinese towards goods produced in other parts of the world at a time when there is really no room for further demand stimulation there.
Now, the question is, have those Chinese authorities learned the lessons from capitalist economic experiences three decades ago? At the same time, the question can be posed to authorities in the US what lessons they have learned about unregulated markets going on a rampage…
This article has 3 comments:
Now the peak oil folks are saying, 'see, we told you so' (high gas prices, political turmoil), and the environmentalists are saying ,' see, we told you so ' (food shartage, storms, bad weather).
We need to keep cool heads at this point. First, there is evidence enough that the various political situations, including relative falling petroleum supply (i.e., we cannot just crank up oil supply to meet demand) coupled with a panicked rush to commodities due to the financial collapse and various derivative contracts, shorting, etc. are big factors in the energy issues.
Now, peak oil eventually may be real, and with half the world waking up and developing, we need to take the underlyiong theory seriously. I think $120+ barrel oil may end up saving us IF we act NOW to start developing alternatives. We need tax incentives, government sponsorship, as well as good old American ingenuity to kick in NOW.The $120/barrel oil creates the economic framework to make alternatives possible.
This is not the time to give up as some of the more liberal peak oil advocates imply we should. A wise Catholic Saint once said something like 'Know that God can do anything, but act as though He will do nothing'. Let's not forget there is a God, and He could be testing us, He could be punishing us. We do not know for sure. But do not give up. Turn back to some of our basic Christian values (and natural law in general), think about what we are doing and why, and let's roll up our sleeves to solve this issue- not just prepare for the end, and hide in the wilderness. It is not all criticism for the more liberal peak oilers- some of their ideas about reviving urban living are not all bad, and make sense certainly in the short to medium timeframe. Much of their criticisms of suburbia deserve some consideration.
Let's also not get all tied up with Gore gloom and doom over highly speculative theories about disasterous human induced CO2 warming of the planet. In fact we may be headed for a little ice age! Let's develop any energy source we can, and not let the environmentalists tell us (especially the U.S., China and India which have extensie coal reserves) that coal is out because of the CO2 problem. This is pure insanity at this juncture. If the peak oil problem is allowed to play out because of our inaction, you will see an environmental disaster of unimagineable proportions. Even the anti-Christian Malthusian Darwinists could not create a scenario so hororible (though God knows they keep trying).
Turn back to basic values, including. God, country and family, roll up your sleeves, do not give up, and let's work together (with the rest of the world) to solve the problems ahead of us.
siv0.com
TakeBackTheFed.com