Stagflation

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Stagflation is a period of inflation combined with stagnation (that is, slow economic growth and rising unemployment), generally including recession.^[1] The portmanteau term "stagflation" is generally attributed to British Conservative MP and later Chancellor of the Exchequer Iain Macleod, who coined the term in a speech to Parliament in 1965.^[2][3][4]

Economists have identified two principal contributing causes of stagflation. First, stagflation can result when an economy is slowed by an unfavorable supply shock, such as an increase in the price of oil in an oil importing country, which tends to raise prices at the same time that it slows the economy by making production less profitable.^[5] Second, both stagnation and inflation can result from inappropriate macroeconomic policies. For example, central banks can cause inflation by permitting excessive growth of the money supply, and the government can cause stagnation by excessive regulation of goods markets and labor markets. When combined, the presence of both these factors is more than sufficient to launch an era of stagflation. For example, policies which promote growth in the money supply to allow consumers to afford higher priced oil contribute as a cause for runaway inflation, even if implemented to fight stagnation or recessions. The global stagflation of the 1970s is often blamed on both causes: it was started by a huge rise in oil prices, but then continued as central banks used excessively stimulative monetary policy to try to avoid the resulting recession and stagnation, causing a runaway wage-price spiral.^[6]

John Maynard Keynes wrote in The Economic Consequences of the Peace that governments printing money and using price controls were causing a combination of inflation and economic stagnation in Europe after World War I. Stagflation was also a very serious macroeconomic problem in the 1970s. In contrast to central bank responses to the oil price spike of the 1970s where similar policies were pursued on both sides of the Atlantic, the 21st Century began with America going one way to fight recession and Europe going the other way to fight inflation.

Contents 1 The stagflation dilemma 2 Keynesian and monetarist views 2.1 Early Keynesianism and monetarism 2.2 Neo-Keynesianism 2.3 Supply theory [8] 2.3.1 Fundamentals 2.3.2 Explaining the 1970s stagflation 2.3.3 Theoretical responses 3 Neo-classical views on stagflation 3.1 Keynesian in the short run, classical in the long run 4 Theory of differential accumulation [13] 4.1 Fundamentals of differential accumulation theory and stagflation 4.2 Similarities with "supply shock" and monetarist theories 4.2.1 Similarities with "supply shock" theories 4.2.2 Similarities with monetarist theories 4.3 Plain-language example 5 Alternative views of stagflation 5.1 Demand-pull stagflation theory [14] 5.2 Quality of money theories[citation needed] 5.3 Quantity theories of stagflation[citation needed] 5.3.1 Plain-language example 6 Considerations for monetary policy during periods of stagflation 7 Historical stagflation 7.1 Outlook and evidence for a future US stagflation from 2007 to today 7.1.1 Scenario introduction 7.1.2 Inflation - commodity price including oil 7.1.3 Recession - US - Salaries and Jobs 7.1.4 Inflation - Bretton Woods II - U.S. bonds and foreign currency reserves 7.1.5 Recession - China's trade surplus 7.1.6 Stagflation - U.S. money policy 7.1.7 Stagflation - It can be a choice 7.2 Stagflation of the 1970s 8 Responses to stagflation 9 Notes

[edit] The stagflation dilemma

This article or section may contain original research or unverified claims. Please improve the article by adding references. See the talk page for details. (January 2008)

Stagflation becomes a dilemma for monetary policy when policies usually used to increase economic growth will further increase runaway inflation while policies used to fight inflation will further the decline of an already-declining economy. Stagflation only becomes a problem when the marginal impact of the further use of the tools available to assist central bank direction of the domestic economy do more marginal harm than marginal good, if used. Generally the central bank can either stimulate the economy or attempt to rein it in through the mechanism of adjusting the domestic interest rate, its primary tool. Adjusting the rate down tends to improve growth but it may ignite systemic inflation. Adjusting the rate up tends to fight inflation but it may impinge upon growth. During periods properly described as stagflation both problems co-exist. Major economic conditions of unusual proportions will have already created crises on both fronts before stagflation can set in again. Stagflation is the name of the dilemma which exists wherein the central bank has rendered itself powerless to combat either inflation or stagnation, having brought into action every tool of measurement and intervention within its power or control.^{[citation needed]}

Part of the difficulty the national central bank faces with stagflation is that inflation may occur selectively among asset classes. For example, by the end of 2007, U.S. home values were falling (deflation) while consumer prices began to rise (inflation). Efforts of the Federal Reserve to aid falling home prices by lowering interest rates to make mortgages more affordable may increase inflation, since consumer purchasing power increases as loan interest rates drop. The central bank, in this case the Federal Reserve has a difficult, some say impossible task, at finding the “perfect interest rate” in a stagflation scenario.^{[citation needed]}

[edit] Keynesian and monetarist views

[edit] Early Keynesianism and monetarism

In 1919, John Maynard Keynes described the inflation and economic stagnation gripping Europe in his book The Economic Consequences of the Peace. Keynes wrote:

"Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some." [...]

"Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

Keynes explicitly pointed out the relationship between governments printing money and inflation.

"The inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent Governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance."

Keynes also pointed out how government price controls discourage production.

"The presumption of a spurious value for the currency, by the force of law expressed in the regulation of prices, contains in itself, however, the seeds of final economic decay, and soon dries up the sources of ultimate supply. If a man is compelled to exchange the fruits of his labors for paper which, as experience soon teaches him, he cannot use to purchase what he requires at a price comparable to that which he has received for his own products, he will keep his produce for himself, dispose of it to his friends and neighbors as a favor, or relax his efforts in producing it. A system of compelling the exchange of commodities at what is not their real relative value not only relaxes production, but leads finally to the waste and inefficiency of barter."

Keynes detailed the relationship between German government deficits and inflation.

"In Germany the total expenditure of the Empire, the Federal States, and the Communes in 1919-20 is estimated at 25 milliards of marks, of which not above 10 milliards are covered by previously existing taxation. This is without allowing anything for the payment of the indemnity. In Russia, Poland, Hungary, or Austria such a thing as a budget cannot be seriously considered to exist at all."

"Thus the menace of inflationism described above is not merely a product of the war, of which peace begins the cure. It is a continuing phenomenon of which the end is not yet in sight."

Up to the 1960s many Keynesian economists ignored the possibility of stagflation, because historical experience suggested that high unemployment was typically associated with low inflation, and vice versa (this relationship is called the 'Phillips curve'). The idea was that high demand for goods drives up prices, and also encourages firms to hire more; and likewise high employment raises demand. However, in the 1970s and 1980s, when actual stagflation occurred, it became obvious that the relationship between inflation and employment levels was not necessarily stable: that is, the Phillips relationship could shift. Macroeconomists became more skeptical of Keynesian theories, and the Keynesians themselves reconsidered their ideas in search of an explanation of stagflation. (See ^[1], Chap. 28, p. 541.)

The explanation for the shift of the Phillips curve was initially provided by the monetarist economist Milton Friedman, and also by Edmund Phelps. Both argued that when workers and firms begin to expect more inflation, the Phillips curve shifts up (meaning that more inflation occurs at any given level of unemployment). In particular, they suggested that if inflation lasted for several years, workers and firms would start to take it into account during wage negotiations, causing workers' wages and firms' costs to rise more quickly, thus further increasing inflation. While this idea was a severe criticism of early Keynesian theories, it was gradually accepted by the Neo-Keynesians.^{[citation needed]}

[edit] Neo-Keynesianism

Contemporary Keynesian analyses (see ^[7], Ch. 12) argue that stagflation can be understood by distinguishing factors that affect aggregate demand from those that affect aggregate supply. While monetary and fiscal policy can be used to stabilize the economy in the face of aggregate demand fluctuations, they are not very useful in confronting aggregate supply fluctuations. In particular, an adverse shock to aggregate supply, such as an increase in oil prices, can give rise to stagflation.

Neo-Keynesian theory distinguished two distinct kinds of inflation: demand-pull (caused by shifts of the aggregate demand curve) and cost-push (caused by shifts of the aggregate supply curve). Stagflation, in this view, is caused by cost-push inflation. Cost-push inflation occurs when some force or condition increases the "costs" of production. This could be caused by government policies (such as taxes) that affect the "costs" of production, or from purely external factors such as a shortage of natural resources or an act of war. In this case the strategy for defeating stagflation is to cut the money supply, hoping to cut inflation to manageable levels, then increase the money supply to spur economic growth.^{[citation needed]}

[edit] Supply theory ^[8]

[edit] Fundamentals

Supply theories are based on the neo-Keynesian cost-push model and attribute stagflation to significant disruptions to the supply-side of the supply-demand market equation. For example, when there is a sudden real or relative scarcity of key commodities or natural resources or natural capital needed to produce goods and services. Other factors may also cause supply problems, for example, social and political conditions such as policy changes, acts of war, restrictive socialist or nationalist control of production, etc.^{[citation needed]}

In this view, stagflation is thought to occur when there is an adverse supply shock (a sudden increase, for example in the price of oil or a new tax, for example) that causes a subsequent jump in the "cost" of goods and services (often at the wholesale level). In technical terms, this results in contraction or negative shift in an economy's aggregate supply curve.^{[citation needed]}

In the resource scarcity scenario (Zinam 1982), stagflation results when economic growth is inhibited by a restricted supply raw materials. ^{[9] [10]}. That is, when the actual or relative supply of basic materials (fossil fuels (energy), minerals, agricultural land in production, timber, etc.) decreases and/or cannot be increased fast enough in response to rising or continuing demand. The resource shortage can be caused either by an actual physical shortage of a resource or because other factors such as taxes or bad monetary policy have affected the "cost" or availability of raw materials and created a "relative scarcity" of resources. This is consistent with the "cost-push" inflation factors in neo-Keynesian theory (above).

The way this plays out is that after supply shock occurs, the economy will first try to maintain momentum - That is, consumers and businesses will begin paying higher prices in order to maintain their current level of demand. The central bank may exacerbate this by increasing the money supply in an effort to combat a recession. For example, by lowering interest rates. The increased money supply props up the demand for goods and services when it would normally drop during a recession.^{[citation needed]}

In the Keynesian model, higher prices will prompt increases in the supply of goods and services. However, during a supply shock (i.e. scarcity, "bottleneck" in resources, etc.) supplies don't respond as they 'normally' would to these price pressures. So, inflation jumps and output drops, producing stagflation.^{[citation needed]}

[edit] Explaining the 1970s stagflation

Following Richard Nixon's imposition of wage and price controls on August 15, 1971, there were two shocks blamed for causing spiraling prices. The first was the failure of the Peruvian anchovy fishery in 1972. This was a major source of fertilizer for the world and resulted in a series of secondary shocks to agricultural production, particularly in Latin America. ^[11]

The second major shock was the success of the Organization of Petroleum Exporting Countries (OPEC) constraining the worldwide supply of oil (Over a Barrel.) (see 1973 oil crisis). Both resulted in actual or relative scarcity of raw materials. The price controls resulted in 'shortages' at the point of purchase such as long lines at fueling stations (Panic at the Pump.).

[edit] Theoretical responses

Under this set of theories, the solution to stagflation is to restore the supply of materials. In the case of a physical scarcity, stagflation is mitigated either by finding a replacement for the missing resource(s) or by developing ways to increase economic productivity and energy efficiency so that you can produce more with less input. For example, in the late 1970s and early 1980s the U.S. economy responded to the temporary scarcity of oil by both increasing its energy efficiency and because oil production worldwide was increased significantly. These factors along with adjustments in monetary policies helped end stagflation.^{[citation needed]}

If the resource scarcity is being caused by flawed market intervention (i.e., bad government, etc.) then the solution is to eliminate the disrupting force on the market (e.g., better monetary policy, changes in tax laws).^{[citation needed]}

Recommended for more information: Oleg Zinam. 1982. The Myth of Absolute Abundance: Economic Development as a Shift in Relative Scarcities American Journal of Economics and Sociology 41 (1), 61–76.)

[edit] Neo-classical views on stagflation

A purely neoclassical view (see ^[7], Ch. 11) of the macroeconomy rejects the idea that monetary policy can have real effects. Neoclassical macroeconomists argue that real economic quantities, like real output, employment, and unemployment, are determined by real factors only. Nominal factors like changes in the money supply only affect nominal variables like inflation. The neoclassical idea that nominal factors cannot have real effects is often called 'monetary neutrality' (see ^[7], Ch. 11, p. 378-9) or also the 'classical dichotomy'.

Since the neoclassical viewpoint says that real phenomena like unemployment are essentially unrelated to nominal phenomena like inflation, a neoclassical economist would offer two separate explanations for 'stagnation' and 'inflation'. Neoclassical explanations of stagnation (low growth and high unemployment) include inefficient government regulations or high benefits for the unemployed that give people less incentive to look for jobs. Another neoclassical explanation of stagnation is given by real business cycle theory, in which any decrease in labour productivity makes it efficient to work less. The main neoclassical explanation of inflation is very simple: it happens when the monetary authorities increase the money supply too much. (See ^[12], Ch. 8, p. 139, Fig. 8.1.)

In the neoclassical viewpoint, the real factors that determine output and unemployment affect the aggregate supply curve only. The nominal factors that determine inflation affect the aggregate demand curve only. (See ^[7], Ch. 11, p. 376-7.) When some adverse changes in real factors are shifting the aggregate supply curve left at the same time that unwise monetary policies are shifting the aggregate demand curve right, the result is stagflation.

[edit] Keynesian in the short run, classical in the long run

While most economists believe that changes in money supply can have some real effects in the short run, neoclassical and neokeynesian economists tend to agree that there are no long run effects from changing the money supply. Therefore, even economists who consider themselves neokeynesians usually believe that in the long run, money is neutral. In other words, while 'neoclassical' and 'neokeynesian' models are often seen as competing points of view, they can also be seen as two descriptions appropriate for different time horizons. Many mainstream textbooks today treat the neokeynesian model as a more appropriate description of the economy in the short run, when prices are 'sticky', and treat the neoclassical model as a more appropriate description of the economy in the long run, when prices have sufficient time to adjust fully.^{[citation needed]}

Therefore, while mainstream economists today might often attribute short periods of stagflation (not more than a few years) to adverse changes in supply, they would not accept this as an explanation of very prolonged stagflation. More prolonged stagflation would be explained as the effect of inappropriate government policies: excessive regulation of product markets and labor markets leading to long run stagnation, and excessive growth of the money supply leading to long run inflation.^{[citation needed]}

[edit] Theory of differential accumulation ^[13]

[edit] Fundamentals of differential accumulation theory and stagflation

Differential accumulation theory sees stagflation oscillate inversely with periods where mergers and acquisitions are dominant as a major strategy of dominant capital groups to "beat the market" or exceed the normal, average rate of return on investments. If too many people try to "beat the average" a market imbalance results. Stagflation, which appears as a crisis at the societal level, contributes significantly to differential accumulation at the disaggregate level, that is, of dominant capital groups accumulating faster than smaller businesses. Since the 20th century, the dominant capital group which has benefited from stagflation has been the "weapon-dollar-petrodollar coalition" during periods of Mid-east crises and rising oil prices. These periods have oscillated between periods of relative "peace" during which mergers and acquisitions have been the dominant strategy for beating the average.

[edit] Similarities with "supply shock" and monetarist theories

[edit] Similarities with "supply shock" theories

Differential accumulation theory shares some similarities with the "shock" or "supply" theories in as far as the practice of mergers and acquisitions generally results in the merged companies shedding excess ("redundant") production capacity and laying off extra workers to boost profits. The cumulative effect of many mergers and acquisitions results in in a two-fold effect on the economy that can contribute to inflation and recession.^{[citation needed]}

• Reduced supply and competition (causes higher prices or inflation)
• Higher unemployment and lower economic output (causes recession)

The first effect is a reduction in overall production capacity of the economy (reduced supply), which pushes up prices (inflation). Reduced competition also causes prices to rise. Recession results because production capacity has been reduced and unemployment rises.^{[citation needed]}

[edit] Similarities with monetarist theories

Stagflation can be aggravated when a central bank increases the money supply to fight the recession that has resulted following a period of prolonged differential accumulation.^{[citation needed]}

[edit] Plain-language example

Imagine that the economy is made up of three railroads and each railroad has ten locomotives and 10 engineers. The locomotives and engineers represent the production capacity or the supply of the economy (labor and capital). The train cars represent the demand for goods and services which is based on the money supply. The price for goods and services is determined by the market.^{[citation needed]} In this example it's represented by the freight rates to move train cars.

The railroads now have three choices on how they can increase profits:

• First, a railroad can invest in more locomotives and hire more engineers so that they can pull more cars for the market price. This will result in an "average" return on investment for a railroad.

• Second, a railroad can reduce the cost to pull the same number of cars for the market price by making its existing locomotives and engineers more efficient (increase productivity). This also will result in an average return on investment.

• Third, a railroad can decide it wants to "beat the average" by reducing competition and costs so that it can pull fewer train cars but charge more money per car. Because prices are determined by the market, they must change the market to do this.

Now, lets say that railroad number one decides that it wants to "beat the average return" on its investment. So, instead of investing in more locomotives, it decides to buy (acquire) or merge with railroad number two.

After "railroad one" and "railroad two" become one railroad, there is less competition. The new railroad decides to reduce its costs by taking 5 locomotives out of service and laying-off 5 engineers to reduce its costs by reducing "excess" capacity. Now it can decide to raise its freight rates since there is less competition (in economic terminology, the market equilibrium sets the price so they've changed the market equilibrium).

The new merged railroad sees a temporary increase in profits because two things have occurred:

• The railroad has reduced costs (and increased the profit = revenue - cost)
• The railroad can raise prices because there are fewer locomotives available and less competition.

The new "economy" is now made up of only 25 locomotives instead of 30 and there are now five unemployed engineers. With fewer locomotives, the two remaining railroads can not pull as many cars. With less excess capacity, they can't respond as quickly to rising demand (i.e., they can't pull more cars).

The results are

1. Higher unemployment and fewer trains (recession);
2. Higher freight rates (inflation); and
3. Lower overall productivity (cost per unit of work).

So temporary stagflation results.

Finally, the recessionary situation is exacerbated when a central bank expands the money supply as a means of fighting the recession- for example by lowering interest rates. The economy borrows more money to pay the higher freight rates but because there are fewer locomotives and fewer railroads prices rise still further but only over the short-run.

Over the long run, other entrepreneurs are bound to see that there's a way to make money in this market by building new railroads and do so. This will increase production, increase employment and decrease prices and end the recession and the inflation until the next wave of mergers and acquisitions occur.

In this way, differential accumulation theory describes an oscillating cycle of periods of recession and inflation that are followed by periods of expansion and lower inflation.^{[citation needed]}

[edit] Alternative views of stagflation

[edit] Demand-pull stagflation theory ^[14]

Demand-pull stagflation theory explores the idea that stagflation can result exclusively from monetary shocks without any concurrent supply shocks or negative shifts in economic output potential. Demand-pull theory describes a scenario where stagflation can occur following a period of monetary policy implementations that cause inflation. This theory was first proposed in 1999 by Eduardo Loyo of Havard University's John F. Kennedy School of Government.

[edit] Quality of money theories^{[citation needed]}

Modern monetary economics assumes that a crucial role for central banks in maintaining stable prices is management of inflationary expectations. Thus central banks make every effort to appear not to pursue growth if a further stimulation of growth would fuel higher inflation. This theory rests on the fact that the overall marketplace is attuned to the possibility that when a central bank allows excessive inflation, higher long-term interest rates result, which lead to higher prices followed by higher wage demands in subsequent labor negotiations. Left unchecked, this is seen to bring round after round of greater inflation, which is known as the "inflationary spiral". Inflation can thus be seen to be embedded in the self-fulfilling nature of inflationary expectations. One school of thought is that inflation targeting and other forms of limited central bank discretion are the best way to maintain low inflationary expectations. The Federal Reserve in the US has, however, managed to drive inflationary expectations to a quite low level while maintaining broad policy discretion. These theories are often combined with "quantity" theories of money supply, though not always.^{[citation needed]}

[edit] Quantity theories of stagflation^{[citation needed]}

Quantity theories of inflation, such as monetarism, argue that inflation is due to the money supply rather than demand and predict that inflation can occur with high unemployment if the government increases the money supply in a period of rising prices.

In many cases increasing the money supply during a recession can help increase demand for materials and mitigate the recession. However, there are some cases where the root cause are part of the underlying of the nominal value of the money. Therefore the recession cannot be stopped by increasing the money supply. It just accelerates inflation on certain goods.

[edit] Plain-language example

Scenario: A country on an island with ten inhabitants each holding 100 units of the local currency. The country imports ten bottles of beer from the neighboring island. The island produces ten bottles of its own beer. The price in local currency for both kind of bottles is five units of local currency. To increase the buying power of the country, the central bank increases the amount of local money by donating each inhabitant an additional five units. The question is now, what happens to price of the two different beer. For the island beer the price of production decreased, because the real salaries on the island shrunk. So one can expect the price for the local beer to remain at least constant or even decrease slightly. For the foreign beer it's a different story. Questions to ask might be: What happens to the import price for the bottle in foreign currency? What happens to the exchange rate between the own and the foreign currency? In a stagflation scenario the questions might be answered as follows: The import price in foreign currency remains constant (or increases). For one unit of the local currency, one receives now less than before compensating for the increase of the amount of money. Therefore the island price of the bottle has to increase in local currency for compensation.^{[citation needed]}

One can learn that the root causes for the price of the imported beer remain outside the influence of the local monetary policy. Shifts in the amount of local money are just reflected in the price of the foreign good, not changing its effective price in the local currency. The conclusion follows, the only way to decrease the price is on one hand that the other island increases the supply (external) of the beer or on the other hand that the inhabitants reduce drinking it (internal).^{[citation needed]}

[edit] Considerations for monetary policy during periods of stagflation

Stagflation becomes a dilemma for monetary policy when policies usually used to increase economic growth will further increase runaway inflation while policies used to fight inflation will further the decline of an already-declining economy.^{[citation needed]}

An important monetary mechanism to increase economic growth is by lowering interest rates, which reduces the cost for consumers to buy products on credit and businesses to borrow to expand production. While this can increase economic activity, it can also result in increased inflation. The monetary mechanism to reduce inflation is by raising interest rates, which increases the cost for consumers to buy products on credit and businesses to borrow to expand production. While this can reduce inflation, it can also result in decreased economic activity.^{[citation needed]}

Stagflation becomes a problem only when the impact of the further use of the principal monetary policy tool available to assist central bank direction of the domestic economy does more marginal harm than marginal good, if used. Ultimately, the central bank can either stimulate the economy or attempt to rein it in through the mechanism of adjusting the domestic interest rate, its primary tool.^{[citation needed]}

A choice can be implemented that tends to improve growth, but does it ignite systemic inflation? A choice can be implemented that tends to fight inflation, but how badly does it impinge growth? During periods properly described as stagflation both problems co-exist. In modern times, it will be only after the central bank has used all possible tools to meet both goals, using the best quantitative measures it has at its disposal, for stagflation to occur. Major economic conditions of unusual proportion will have already created near-crises on both fronts before stagflation can set in again. Stagflation is the name of the dilemma that exists when the central bank has rendered itself powerless to fix either inflation or stagnation.^{[citation needed]}

The problem for fiscal policy is far less clear. Both revenues and expenditures tend to rise with inflation, and with balanced budget politics, they fall as growth slows. Unless there is a differential impact on either revenues or spending due to stagflation, the impact of stagflation on the budget balance is not altogether clear. One school of thought is that the best policy mix is one in which government stimulates growth through increased spending or reduced taxes, while the central bank fights inflation through higher interest rates. Whatever theory is employed, coordinating fiscal and monetary policy is not an easy task.^{[citation needed]}

[edit] Historical stagflation

[edit] Outlook and evidence for a future US stagflation from 2007 to today

[edit] Scenario introduction

U.S. Federal Reserve Chairman Ben Bernanke co-authored a paper in 1997 that correlated every major U.S. recession since 1971 with a combination of rising oil prices and a rising federal funds rate^[15][16] Both of these conditions occurred during 2007 while Mr. Bernanke was Chairman of the Federal Reserve and in control of the federal funds rate. After a prolonged period of raising interest rates for several years, oil prices began to rise substantially in the second half of 2007 as did inflation rates. Also during 2007, the US economy began showing signs of a recession brought on in part by the 2007 subprime mortgage financial crisis. This combination of occurrences re-awakened stagflation concerns with regard to the US Economy.^[17] It appears that Chairman Bernanke interpreted the results of his thinking while at The Brookings Institution (1997) as a signal that lower interest rates in and of themselves combat the recessionary side effect of high oil prices; in fact, by lowering rates as he has done, many fear that he has ignited an even greater demand and thereby built a fire which (circa May 2008) has driven oil prices to an all-time high, with the ultimate result that history may assess that Chairman Bernanke birthed the "mother of all recessions." The prospect of global stagflation came to light in late November 2007 when Eurostat the European Union's statistics office in Luxembourg said European inflation accelerated in November at the fastest rate in more than six years. On the same day, the United States Federal Reserve Chairman Ben Bernanke^[18] indicated that despite inflation worries, a further round of rate cuts will be likely on December 11, 2007. The US Bank Rate was slashed to 3% by Jan 2008 from highs of above 5% in 2007.^[19]

Hence the rate cuts by the Fed have led to the weakening of the US dollar. With the unexpected 63,000 job lost in February, the US is into a recession.^{[dubious – discuss]} In order to defence this turmoil in the financial market, investors have sought to diversify their investments away from equity into other asset classes such as bonds, cash and commodities.

[edit] Inflation - commodity price including oil

The testimony of Federal Reserve Chairman Ben S. Bernanke before the Joint Economic Committee of the U.S. Congress on November 8, 2007, noted that "prices of crude oil and other commodities had increased sharply in recent weeks" and that "the foreign exchange value of the dollar had weakened" — "factors were likely to increase overall inflation in the short run and, should inflation expectations become unmoored, had the potential to boost inflation in the longer run as well." It should be noted that the increased cost of crude oil and the declining dollar have been attributed as the direct result of a series of interest rate decreases initiated following actions by the Federal Reserve.^[20]

During 2006, certain economists believed that global stagflation might return when the price of oil was close to $80 a barrel, and the U.S. Federal Reserve was increasing interest rates. Commentators such as Stephen Roach and Paul Krugman cited a cooling of the Real estate economics combined with a failure to adjust monetary policy as potentially leading to higher than "comfort zone" inflation and slower growth.^{[citation needed]}

Until finally surpassed late April 2008, the all time highest trading oil price adjusted for inflation had been $39.50 ($103.76 in 2008 dollars) set during the second oil crisis in April of 1980. This price is driven by the usage of commodities as an instrument to hedge against inflation. “When investors lose confidence in the central bank, they tend to look for hard assets, the Fed’s capitulation on inflation is driving investors to commodities.” Philip K. Verleger, an economist and oil expert is cited. Oil prices have risen more than four times since 2000, partly because the demand has grown in Asia and the United States and the producers could not increase their daily output.^[21]

The wholesale prices rose by 7.4 percent in 2007. This is the largest annual increase since 1981. This might lead to a decrease of private consumption.^[22]

[edit] Recession - US - Salaries and Jobs

January 2008 was the first month in four years of a total job loss in the Unites States. The wages adjusted for inflation decreased by 1.4% in 2007.^[22]

[edit] Inflation - Bretton Woods II - U.S. bonds and foreign currency reserves

"What the United States owes to foreign countries it pays – at least in part – with dollars that it can simply issue if it chooses to. This unilateral facility contributes to the gradual disappearance of the idea that the dollar is an impartial and international trade medium, whereas it is in fact a credit instrument reserved for one state only." is a famous citation of the former French president Charles de Gaulle from a press conference of February, 1965. That's why he used the chance to exchange the dollars for a real, tangible asset - gold. Or as he stated, gold "does not change in nature," "[Gold] can be made either into bars, ingots, or coins...has no nationality [and] is considered, in all places and at all times, the immutable and fiduciary value par excellence." Back in the 1950s and '60s, world governments could simply tip up at the Fed, tap on the "Gold Window", and swap their unwanted dollars for gold. So France sent its Navy in 1967 and returned with 150 million dollars in gold.^[23]

The size of foreign reserves held by sovereign wealth funds owned by Asian and Arabian governments is predicted to reach the value of $13 trillion by 2017. This is equivalent to the value of all S&P 500 companies. The decrease of value of the dollar is shared by the funds. This might lead to swaps from the dollar to other currencies of these funds.^[23] This might lead to the so called "Dollar-Crash" and of course is a driving force behind the inflation in the United States.^[24]

"At the end of 2006, China’s foreign exchange reserves were $1,066 billion, or 40% of China’s GDP. In 1992, reserves were $19.4 billion, 4% of GDP. They crossed the $100 billion line in 1996, the $200 billion line in 2001, and the $500 billion line in 2004." Edwin Truman of the Peter G. Peterson Institute for International Economics is cited in a new paper.^[23]

On February 27, 2007, China's reaction to its complex domestic policy binds triggered a shock to financial markets (DJIA down 5%), as well as a reminder of the danger China had raised in February 2005 when Chinese economist Fan Gang, director of the state-owned National Economic Research Institute at Peking University in Beijing, recommended publicly [World Economic Forum, January, 2005] that China sell its hoard of United States public debt in form of Treasury security into the world market because interest rates were too low.^{[citation needed]}

China is the second-largest holder of U.S. Treasury debt in the world (after Japan). Such an action would send U.S. interest rates soaring, according to most generally-accepted models of the global economy, since such a massive sale would immediately drive down bond values, thereby raising not only the yield on existing bonds but also the rate demanded by the market into which new bonds were sold. The polico-economic indication from these models was that the U.S. Federal Reserve was already in the policy bind that would contribute to stagflation.^{[citation needed]}

Two days earlier (February 26) former U.S. Federal Reserve Chairman Alan Greenspan predicted a possible recession in the U.S. before the year 2007 was over. Some took this to be an indication that his model also recognized that China's policy binds had created a U.S. policy bind which prevented anti-recessionary action by the U.S. Federal Reserve. Others postulated that the higher interest rates prevailing in the U.S. in 2007 were known by him to be the U.S. response that was implemented to forestall the possibility of China's massive bond sale. Still others voiced the conclusion reached after the Nixon-era price controls, that high interest rates were in and of themselves inflationary, since the cost of money was factored into models for the unit cost of everything from the Commodity markets e.g., the price of wheat to the cost of making a high-budget film in Hollywood, a microeconomic measure prevailing in some modern economic models. On May 11 in 2007, former U.S. Federal Reserve Chairman Alan Greenspan redefined the odds on a U.S. recession during 2007 from "possible" to "1-in-3".^{[citation needed]}

May 2007 ended with the widely publicized report that foreign holdings of U. S. Treasury debt maturing in the three-to-ten year range had reached the 80% level, sparking comparisons to 19th century America when European lenders provided financing for building U.S. infrastructure projects such as railroads and canals. Today's worries leave U.S. domestic economic policy hostage to international economic factors flowing from spiraling the U.S. in balance of payments and government deficits. Also in June 2007 China began to show a reluctance to increase its hoard of U.S. Treasury debt and is thought to be the Asian seller with daily offerings of 10-year Treasury notes in the overnight market. This action drove down values and thereby increased the interest yield from its long-established rate below 5.0% to the 5.1-5.2% range with peaks at 5.3%.^{[citation needed]}

[edit] Recession - China's trade surplus

The first two weeks of June 2007 brought reports that the Economy of the People's Republic of China trade surplus for the previous month had exceeded $22 billion, which moved the United States Congress, the Organisation for Economic Cooperation and Development (OECD) and the International Monetary Fund (IMF) to forcefully describe China's trade and exchange rate policies as "unfair".^{[citation needed]}

[edit] Stagflation - U.S. money policy

At its May 2007 meeting, the U.S. Federal Reserve^[25] made the following policy statement: "In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information." The across-the-board reaction was that the widely anticipated July 2007 lowering of U.S. interest rates was no longer feasible, and the Fed's response confirmed to many who maintain a polico-economic model that U.S. economic policy was unfolding in a manner that confirmed that the policy bind which accompanies Stagflation was becoming more visibly present. Further evidence of a risk of stagflation in the US was reported in the New York Times on Feb. 21, 2008.^[26] Though the Federal Reserve is making efforts to prevent it, there are growing concerns that the United States may be entering a period of stagflation. Part of the difficulty the Federal Reserve faces with stagflation is that inflation may occur selectively among asset classes. For example, by the end of 2007, U.S. home values were falling (deflation) while consumer prices began to rise (inflation). Efforts of the Federal Reserve to aid falling home prices by lowering interest rates to make mortgages more affordable may increase inflation, since consumer purchasing power increases as loan interest rates drop. The Federal Reserve has a difficult, some say impossible task, at finding the “perfect interest rate” in a stagflation scenario.^{[citation needed]} To stimulate the struggling economic growth the Federal Reserve lowered the interest rate in September 2007. Another round is expected in March 2008. The dilemma is that in order to address inflation, interest rate should be raised instead. But Federal Reserve vice chairman Donald Kohn does not expect the inflation to remain on this high level. Therefore he does not expect stagflation. ^[22]

[edit] Stagflation - It can be a choice

Stagflation, whether domestic (within the U.S.) or exported to the world by a steadfast drive to inflate rather than contract, can be a choice within the geo-economic realm. An adage that the grey eminences of economics of an earlier time (including late Drs. Wilson Schmidt and Albert J. Eckstein) have offered in private to colleagues -- since thoughts of such a nature are simply not said for attribution^{[citation needed]} -- for decades in such times as a solution when a country has problems so bad that they can't be fixed is: "to inflate your way out of them."^{[citation needed]} Paul A. Samuelson whose text which laid out neoclassical economics was published in 1947 recently contributed an article to a mid-February (2008) edition of a major U.S. magazine directly addressing the so-called option of "inflate our way out of" the current conundrum and labeled it as "ERROR". With so many trillions of dollars held by foreign hands, a contractionary monetary policy obviously makes those claims effectively "larger." Conversely, an inflationary policy -- even one igniting systemic inflation -- has the obvious effect of making those multi-trillion dollar foreign claims as well as dollar-denominated wealth of U.S. citizens "smaller."^{[citation needed]} This strategy of mitigation of foreign claims is paid by the ordinary domestic population not hedging its own currency.

[edit] Stagflation of the 1970s

Stagflation occurred in most of the developed world during the 1970s, including the United Kingdom in the 1960s and 1970s and the United States during the 1970s, most famously during the Nixon Administration. In August 1971 Richard Nixon imposed wage and price controls in an attempt to control rising inflation. Price controls did not stop inflation and the country experienced stagflation in the 1973 recession. After the US aided Israel in the 1973 Yom Kippur War, many Arab OPEC nations-who were battling Israel during the Yom Kippur War- decided to issue oil embargoes against the US in retaliation^[27]; this embargo against the US would be known as the 1973 oil crisis. The oil embargo would end in 1974, but its effects would last until the 1980s^[27]. The difficulty in fitting its existence within a Keynesian framework led to a greater acceptance of monetarist theories in the 1970s and 1980s. The pendulum has to some extent swung back in the other direction, as monetarism has seemed to encounter increasing difficulty predicting the demand for money and the long period of low inflation and high employment during the Y2K/Dot-com bubble of the late 1990s and again during the 2004-2006 period, which temporarily drove oil prices high enough to measureably increase inflation during the first three quarters of 2006.^{[citation needed]}

The monetarists would respond that inflation was remarkably stable during the dotcom boom and recession and that the oil price driven inflation was nothing more than the natural increase in price of one commodity rather than true inflation. The rise in oil prices was just that, a rise in oil prices. It had nothing to do with the value of the overall currency even if consumers lost effective currency as a result. The elimination of oil as a commodity would eliminate this "inflation".

The most common example of a period of its stagflation and the government's response occurred following the resignation of US President Richard Nixon. Price controls had been in effect for a number of years, but were released due to the range of dislocations that they had caused. The country was in a state of political shock, the economy was stagnant and inflation persisted. President Gerald Ford instigated the "WIN" policy - "Whip Inflation Now".^{[citation needed]}

The plan was that the market would restore a balance in the allocation of goods and services, and over time it did. Many economists debated ways to use monetary policy to combat inflationary pressures. Others discussed the relative value of deregulation as a means to force economic activity to more effectively reflect supply and demand.^{[citation needed]}

During the late 1970s, President Jimmy Carter appointed Paul Volcker to the Federal Reserve in order to enact monetary policies to combat inflation in the United States. The primary tool used by Volcker was the raising of interest rates. The Reagan Administration retained some elements of this policy.^{[citation needed]}

Where neo-classical theory fails is when stagflation is caused by a scarcity of raw materials. Under normal market conditions, higher prices will lead to an increase in the production of basic materials; however, if there is a bottleneck in the supply of basic materials then the market does not respond as it normally would until either the bottle neck is eliminated or the economy adjusts to the lower level of input of resources. During the late 1970s and early 1980s the U.S. economy responded to the scarcity of oil by both increasing its energy efficiency and ultimately by bringing more oil extraction on-line.^{[citation needed]}

[edit] Responses to stagflation

Stagflation undermined the dominant Keynesian consensus, and placed renewed emphasis on microeconomic behavior, particularly neo-classical economics with its attempt to root macroeconomics in microeconomic formalisms. The rise of conservative theories of economics, including monetarism, can be traced to the perceived failure of Keynesian policies to combat stagflation or even properly explain it.^{[citation needed]}

Stagflation in the USA was defeated by then Federal Reserve chairman, Paul Volcker, who sharply increased interest rates to reduce money supply from 1979-1983 in what was called a "disinflationary scenario." Starting in 1983, fiscal stimulus and money supply growth combined to create a sharp economic recovery which is in line with standard macro-economic models; however, there was a five-to-six-year jump in unemployment during the Volcker disinflation. It appears that Volcker trusted unemployment to self-correct and return to its natural rate within a reasonable period, which it did.^{[citation needed]}

Supply-side economics emerged as a response to US stagflation in the 1970s. It largely attributed inflation to the ending of the Bretton Woods system in 1971 and the lack of a specific price reference in the subsequent monetary policies (Keynesian and Monetarism). Supply-side economics asserts that the contraction component of stagflation resulted from an inflation-induced rise in real tax rates (see bracket creep). In addition certain states in the USA had laws limiting nominal interest rates, which under high inflation resulted in negative real interest rates. In some places this caused a collapse in lending to business. The reality, as described throughout this article, is that there was a major confluence of economic events in the 1970s that occurred as the US adjusted to a post-Vietnam War economy that contributed to stagflation.^{[citation needed]}

[edit] Notes

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