The Beginning of The Great Stagflation?

It was the year of 1958, when British economist and statistician Alban William Housegeo Phillips published a paper in Economica, named The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861 - 1957. Phillips observed that the data shows a relationship between unemployment and money wage growth. The data showed that wage growth was low whenever unemployment was high and vice versa. 

Phillips, however, was not the first one how observed this. You can already find similar findings in the writings of David Hume in 1752, or 30 years prior to Phillips in an essay from Irving Fisher in 1926. Nevertheless, Phillips did not argue that higher wage growth rates will lead to lower unemployment, but Phillips argued that there is a stable relationship because in times of a tight labor market, it would be easy for workers to bargain for higher wages. 

It was Paul Samuelson and Robert Solow, who developed Phillips model further and replaced money wage growth with inflation. They assume that higher wages will ultimately lead to higher prices, a wage-price spiral. While Phillips saw higher growth rates in money wages as a result of low unemployment, Samuelson and Solow claimed that there can be a trade-off between inflation and unemployment.

Politicians loved that idea: Whenever there was high inflation, politicians started to refer to Samuelson and Solow, saying that society would be much worse off if inflation was lower and therefore unemployment  would be higher. If one wants a booming economy, there would be high inflation as a side product. 

Nobody would argue against the fact that, in a tight labor market, businesses have to compete with one another to acquire workers and therefore bid up wages. However, the idea that there would be a linear correlation between unemployment and inflation, is a mistaken, especially over the long and medium term. 

If a central bank is expanding the quantity of money within the economy, because it hopes for stronger economic growth, demand for goods and services in the economy will increase. Strong demand will lead to an expansion in production capacity (businesses need more workers) and wages (and thus prices) will start to rise. However, this leads to disequilibrium as the unemployment rate falls below its' natural rate and prices rise further. 

Nevertheless, sooner or later workers anticipate that there has been a rise in the quantity of money and their inflation expectations will adjust accordingly. Thus, they will decrease demand for goods and services and as a result unemployment will return to its' natural level. Therefore, the increase in GDP cannot last for long and can never withstand over the long term (Milton Friedman and Edmund Phelps made this criticism as early as the mid-1960s, but it nobody wanted to listen to them).

In principal, Friedman and Phelps predicted what should become reality in the 1970s, but during the 60s, politicians had no reason to deal with this criticism because the Phillips Curve worked back then. 

In the 70s everyone was reminded that it is not only unemployment that influences inflation numbers. Firstly, President Richard Nixon implemented wage- and price controls, which led to a pick up in commodity prices and secondly, there was the 1970s energy crisis (1973 and 1979). In October of 1973, during the Arab-Israeli Yom-Kippur war, the Organization of Arab Petroleum Exporting Countries (OAPEC) started to cut back on oil production to put pressure on western allies of Israel. 

As a result, oil prices went up 70 % - from 3 to 5 US-dollars. As a result (and because western governments have printed lots and lots of money during the 60s) inflation took off. In 1972 US YoY inflation was at 6 %, 1974 it was at 13 %. The next chart shows US YoY inflation and US unemployment in the 70s.

However, as one can see, rising inflation did not lead to falling unemployment, but to economic stagnation. According to the Phillips Curve, this should not be possible. While inflation fell during 1974 and 1976, it took of again during the end of the decade before Fed chairman Paul Volcker was able to fight inflation because he raised interest rates heavily. What followed was 40 years of a deflationary environment.

The last 40 years have been deflationary although broad money supply (M2) has risen steadily since 1980. There are two factors which whitewashed the growth in the quantity of money: Productivity growth and a growing labor force. The baby boomers started to enter the labor force and simultaneously women decided to earn a living for themselves to become more independent. As a result, the labor force started to increase.

Additionally, globalization pushed international money wage rates down because Asia started to participate on international trade. Many companies moved their production facilities from the West to the East (especially jobs for lower-skilled workers). 

Simultaneously, big technological progress brought down prices in many parts, especially in electronics, a sector that should become more and more important. Prices fell for a variety of products, for example cloths, telephones, personal computers and other stuff. The aging of the population played another role that this environment was price deflationary.

Nevertheless we should not call the monetary regime during that time a deflationary one. Monetary policy have been anything but deflationary. Monetary inflation of M2 has been around 6 % since the 1960s and has been growing exponentially.

It cannot be denied that - if the money supply has not grown at such pace - prosperity would have been greater for the broad mass of the population, because prices have been hindered to fall by monetary policy.

This kind of monetary policy had another side effect: Prices of financial assets have gone through the roof and this influenced people how they save and invest. Weirdly, they think that it is an investment when they are building a home because they expect that land and real estate prices will continue to rise indefinitely. Nevertheless, the 2000 and 2008 financial crisis would have corrected those excesses, if we would have let it. 

However, politicians deserved to kick the can down the road instead of a short, hard turnaround which was urgently needed. They see the cure as the disease and vice versa. If one assumes (as the politicians) that the boom is the cure, another crisis means that the medicine (cheap money) stopped too early or was not high enough. 

As a result, debt was already at high levels before the pandemic hit in spring of 2020. Public debt has been 86 % to GDP within the Eurozone and 106 % in the United States. The years prior both economies managed to hold the debt either constant (US) or to diminish it a little (EU), compared to GDP. 

When governments closed businesses to slow the spread, demand collapsed. As a consequence, governments had to widen their deficits again. In the United States, many businesses fired their workers, who received big transfer payments from the government than. On the other side of the pond, the German/Austrian Kurzarbeit was implemented: Workers cut down on working hours (partly to 20 %) and governments subsidized wages, or subsidizes wages as the programs are still in plays. 

As a result, debt/GDP ratios have been on the rise since - 130 % for the United States and 100 % for the Eurozone.

While I think that an opened economy (one without, or just the first lockdown) would have led to a better outcome than the actual one, most governments and economists have thought otherwise: Most of them lockdown the population, especially in the European Union, where even the big Auto factories were closed in spring of 2020. 

After a slight recovery during the summer months, where governments reopened, the virus returned during the winter months and again governments had no other concept than closing everything. Even though factories mostly remained open, retail and restaurants were closed again. 

With no options of consumptions left, people with middle and higher income increased their savings and therefore the overall savings rate spiked. All this things needed to be taken into consideration if we want to answer the question if the economy will turn into a stagflationary environment after the grand reopening. 

Again, comparably to the events in the 1970s, a supply side shock has brought the economy into disequilibrium. With currently prevailing, highly expansive fiscal policies, it can be clearly observed that stimulating demand in times of a lack of supply due to lockdowns will hardly have any effect on production. One forgets that the economy is a living vessel in which many different actors make different, spontaneous decisions.

Government officials think that the economy works like a machine that one switches off and turns on later. They assume that the recovery will happen fast, but they overlook that imposed business closures do not affect all sectors of the economy equally. This is a phony assumption.

Daniel Lacalle correctly writes on his website:

'There are sectors that will take years to recover: Travel and Leisure, Autos, Retail, Fashion, Music, Cinema, Tourism and Energy all face years of weak demand, balance sheet reparation and survival-mode strategies. 

 

The collapse in earnings and cash flow followed by the more-than-likely tax hikes that we will likely see are also going to create an enormous burden on Research and Development, innovation and technology.'

The Biden-administration and EU politicians have already started their campaign for higher taxes and sadly I have no doubt that they will find another innovative way for a new tax. That is the only part where politicians are being innovative: Taxes.

Currently Europe is in the middle of the grand reopening while the process is already done in the United States where it has started months prior. Accelerating demand and bottlenecks in supply chains have pushed prices higher and I think that in Europe there will be more catch-up effects to come as the economy has not even fully opened. However, German YoY CPI inflation is already at 2011 highs - 2.5 % YoY, expected 2.3 %.

Money that has been saved because of a lack of consumption possibilities is flowing back into the economy. People go out to restaurants and business, demand is returning, supported by government transfer payments.

The economy is accelerating and so do prices, as they should in a reopening phase. However, as high debt on the one side and manipulation of interest rates by central banks is not supportive for economic growth, my prognosis is that growth will slowdown later that year. While the US has at least implemented some support for the supply side, the EU has solely spend money to increase demand.

Moar of the same therefore will lead to a more concentrated economy. Small and medium businesses may not have the same access to debt as big corporations and they definitely do not have as much asset to collateralize. Therefore more and more of them may escape from the market place. A pity, if we remember that it is small and medium enterprises that make our economies thrive.

Big business suffers the same problems as governments: The greater they become, the more inefficient they get. This is bad news in times of increasing economic crises. Output will stagnate because of a lack of competition, because small competitors either go out of business or get bought by big business. 

Simultaneously, governments are creating an environment where people stop to look for a job in low-income sectors because they prefer to receive the governments transfer payments. As a result, wages for low-income jobs go up, which may look gratifying at first. 

Governments intervene big already and they will continue to do so and as a result supply chains will erode further, and maybe they already have. If governments keep wages above the equilibrium level, supply will diminish while the money supply will continue to grow. More quantities of money will hunt less and less quantities of goods. 

The economy may stagnate, but inflation will remain high and as a result job markets will come under pressure. Supposedly governments will impose infrastructure projects to fight it, but they only will reallocate resources and hinder labor and capital to be used in parts of the economy where they would be more in need. High demand and falling supply is the perfect recipe for stagflation...

And still, central bankers are counting on an expanded model of the Phillips Curve (they now assume that inflation expectations remain constant). But will they?

Have a great weekend!

Fabian Wintersberger

Disclaimer: This is a personal blog. Any views or opinions represented in this blog are personal and belong solely to the blog owner and do not represent those of people, institutions or organizations that the owner may or may not be associated with in professional or personal capacity.