What really caused Stagflation. Part 1 of many.
In this post I propose to discuss the philips curve, which posits a relationship between unemployment and inflation. The first note about the philips curve, is that it is fundamentally an empirical relationship, rather than one which is explained fully by theory. Here is a rather nice graph of unemployment vs inflation:
So as we can see, the relationship held extremely well in the two decades leading up to the seventies, and then collapsed completely. The salient question is, why. In particular, if we would expect the Phillips curve to hold now, we would be saying that we *must* target higher inflation to lower unemployment.
The interpretation I am going to advance is simple: I propose that, in demand side recessions monetary stimulus is effective, and that the central banks of 1950-1970 engaged in monetary stimulus to lower unemployment, and raise inflation, and it works, and as unemployment fell they allowed to inflation to lax. Thus, I am really saying that the Philips curve is caused by effective central bank intervention, and fails when central bank intervention fails.
This simplistic expectation makes perfect sense to me, in a demand side recession, people stop buying stuff. Since prices clear markets, this only happens because the price level is wrong. Thus the central bank should step in to reset the price level, and this lowers unemployment. However, it is clear that it should be impossible for the central bank to lower unemployment below its structural limit, which is why the curve becomes very steep at some non zero level of unemployment.
At high unemployment, monetary stimulus (or fiscal) amounts to buying stuff that was created out of idle resources. Since production is increasing the amount of goods, in direct proportion to the amount of monetary stimulus, then there can be no inflation. (The price level is the ratio of supply of goods to the supply of money).
If this is the case, we might expect to be able to see it happen in real time: Our prediction is that inflation will only rise when unemployment reaches its natural rate:
If we look at the period 1950-1970, we see that is the case. Inflation rises only as unemployment reaches a natural rate of, say, four percent.
Now, we can see that the region 1970-1980 this was not the case. This is the case, because in that time, the problems the economy faced could not be lowered by central bank intervention. The archetypal example of this is an asteroid strike. Suppose that an asteroid wiped out half of the capital of the United states, but all people were successfully evacuated. So half the houses, half the factories, half the farmland etc. Is it not absurd to suppose that all the economy would need to reach full employment would be central bank intervention? Of course it is, we would need to build new houses, new factories, etc. Even when it came to basic resources we would have a problem, needing different types of mines, to extract the resources for building cities, rather than for doing lots of high value electronics manufacturing etc.
This is the very essence of a supply side problem, and they take time to solve. Now, the supply side problems of the US were not quite so typical. Would it surprise you to know that the 1970-1980 decade represented some of the strongest growth in US history? The economy added nearly twenty million new jobs despite the recession. In fact, this was the problem. The labour force was growing faster than capital could be formed to employ the new labour. Have a look at this:
Labour force participation grew by five percent. That is a huge change, representing millions and millions of jobs. This at a time when population growth was also strong, and the demographically large baby boomer generation was entering the workforce, led to an incredible rate of increase in the labour force:
So the labour force grew by 30 million from 80 to 110, a 35% increase in a decade. Is it any wonder that production could not keep up with demand? This is what really drove high inflation in the seventies, coupled with contraction in the world oil supply, and a few other assorted shocks. But really, this is what drove high inflation, we had ever more workers competing for a limited production which could not grow fast enough to keep up with rising demand.
Now you might think, looking a this graph, that labour force participation looks a lot like a straight line. But it is the percentage increase that is important, and subsequent decades increased a little less, starting from a much higher base. It is self evident that larger economies can handle an influx of a given size better than small economies.
It is self evident that the central bank can do little to control this type of supply side constraint. The economy was already building new capital at a high rate, and it was close to full employment, despite the high unemployment rate, as the labour force was simply expanding faster than jobs could be created. To put that in today’s terms, in the 1970’s the number of new jobs a month needed to increase by a quarter of a percent of the total number of jobs, every money, just to stand still. Adjusted for the size of the current labour force, that is 375,000 jobs a month just to stand still. These days we would kill for a number in the 300,000 range. And they needed that every month just to maintain the unemployment rate.
Anyway, to get bank on point: The central bank could not intervene effectively, because the economy was functioning perfectly. High inflation was a perfectly rational response to demand outstripping supply. Since the economy was at or near full employment, increases in the inflation rate did nothing to reduce unemployment. Thus the central bank was powerless to lower unemployment, and could control inflation only by inducing a recession. This left the central bank with a very unappetising choice. It could control inflation only by inducing a recession, and the only way to keep it down was to control the expansion of the labour force, which meant that unemployment remained elevated for most of the next decade. Fortunately, by 1970’s the growth in the labour force (as a percentage) was slowing drastically, alleviating the pressure, and by 1980 all was back to normal.
In summary: The central banks can fix nominal problems, it cannot fix real problems. We have no need to fear 1970’s style inflation due to monetary stimulus, as until the economy reaches full employment, extra monetary stimulus, (or increased velocity) will only lead to increased output, not inflation.
Next post we will discuss Milton Freidmann’s explanation for why the philip’s curve broke down, and why I don’t find it as convincing as the explanation given out above.