Stagflation: I've Been Hearing the S-Word a Lot Lately

Economics

The S-word

Aug 9th 2010, 17:10 by A.S. | NEW YORK

I'VE been hearing the S-word a lot lately. Unemployment is stubbornly sticking above 9%, despite the government's attempts to lower it. Meanwhile the Fed has pumped lots of money into the economy and maintained zero interest rates. Unless the Fed changes its policy, which is unlikely with high unemployment, high inflation seems inevitable. It suggests stagflation is our future.

The recovery is tepid, demand is weak and there still exists uncertainty. All these factors contribute to high unemployment because they translate into a private sector not creating jobs. But blaming unemployment on these factors alone suggests there is scope for traditional policy to lower employment to pre-crisis levels: for example, a Keynesian-style fiscal expansion to boost demand via government spending. My mentor in graduate school, Ned Phelps, cautions this weekend that Americans should be wary of such remedies as a magic cure-all.

The worst effect of focusing on supposedly deficient demand is that it lulls us into failing to "think structural"� in dealing with long-term problems. To achieve a full recovery, we have to understand the framework on which our broad prosperity has always been based.

First, high employment depends on a high level of investment activity "” business expenditures on tangibles like offices and equipment, and also training for new or existing employees, and development of new products.

Sustained business investment, in turn, rests on innovation. Business cannot wait for discoveries in science or the rare successes in state-run labs. Without cutting-edge products and business methods, rates of return on a great many investments will sag. Furthermore, innovation creates jobs across the economy, for entrepreneurs, marketers and buyers. State-led technology projects do not.

Professor Phelps notes that some of the high unemployment is structural rather than cyclical. This suggests that the natural rate"”the rate of unemployment when the economy is at full capacity"”is higher than pre-crisis levels, about 5 or 6%. This contrasts to cyclical unemployment"”the unemployment that occurs when are in recession and there's excess capacity. Cyclical unemployment can largely be remedied by cutting interest rates and through fiscal expansion, you just have to jumpstart demand to spur hiring. The current unemployment level is probably due to a combination of both cyclical and structural unemployment. Uncertainty is keeping consumers from buying and firms from expanding. Liquidity may not be a problem now, but the recent near death of corporate lending has increased the desire to build up balance sheets. There exists scope for policy to lower unemployment somewhat.

But there is also reason to believe structural unemployment has also increased. In the last few decades the economy has undergone a structural shift, from manufacturing to services, and many unskilled jobs have gone overseas. America also built much of its expansion in recent decades on veracious consumption. This cannot go on forever; the economy will have to be driven by something other than American consumption and under-saving. A bad recession has a way of shaking people out of jobs that are no longer viable. It pushes an economy to realise needed structural change a little faster. This means some people who've lost their jobs will not find similar ones because they simply no longer exist. Until another structural change occurs, for example a huge technological innovation or global wages increasing to American levels"”unemployment may not go back to 5% any time soon. There's not much expansionary fiscal or monetary policy can do about that, at least not directly.

So with a weak economy do we need to worry about inflation? Not at the moment, but as the recovery strengthens it's a non-trivial concern. The Fed might have to pull a Paul Volcker to rein in the scope of its recent expansion. You wonder if that will be politically feasible with permanently higher unemployment"”especially if it's mistaken for the kind of unemployment monetary policy can fix. The incentive to keep inflation high to erode the growing debt should also be a source of concern.

This is not proper stagflation. Unemployment will be higher (though lower than it is now if the cyclical element of it is gone) and so will inflation, but unemployment will not be higher than its equilibrium level. That will surely be of little comfort to people looking for work and facing rising prices.

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Good post, and I mostly agree, but I'm not sure how coherent the argument is. The Phelps quote seems to be referring to fiscal stimulus, which we should expect to push back against the structural reallocation of investment and human capital.

Meanwhile the post seems to be about monetary stimulus. I guess I can imagine a case that resisting an adjustment of capital positions (via monetary stimulus) also works against a reallocation of production, but I don't see that in this post. Maybe quote Arthur Okun, too?

Oh, and is the S-word "structural" or "savings?"

Hey, one guess is as good as another at this point.

I will believe inflation when I see it, which is the same response I've had to the inflation-doomsayers since 2008.

R-word Riots happening in suburbs when high unemployment sticks for years (cf France)

How about a "Pay per View" TV event?

"Dueling Economist Economists"

In the blue corner weighing in with deflation..... ...representing Washington, R.A.

In the grey corner weighing in with inflation.... ...reperesenting New York City, A.S.

Regards

Ned sounds like a closet-Austrian, like Kling over at Econlib.org.

Ned: "The worst effect of focusing on supposedly deficient demand is that it lulls us into failing to "think structural"� in dealing with long-term problems."

That could have come from Hayek in his Nobel Prize speech.

Ned: "Sustained business investment, in turn, rests on innovation."

Well you can't win 'em all. Actually, business investment rests on savings. Innovation is nice, but not necessary. There is plenty of technology out there that waits to be implemented. And investment rests on low profits in the consumer goods sector which motivate those producers to buy labor savings equipment. Again, it's the Ricardo Effect. Ned: "First, high employment depends on a high level of investment activity "” business expenditures on tangibles like offices and equipment,..."

That is Hayek's Ricardo Effect!

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