Its back. The ugliest word in economics is making the rounds again.
The U.S. economy and many others now face the risk of stagflation in the second half of 2012 and beyond. Stagflation is the combination of falling output (a recession) and rising prices (inflation).
Rapid inflation is plaguing India and other developing countries, even though production and exports are falling. A columnist for Financial Times recently suggested stagflation was the new normal in Argentina.
Without a substantial boost to business spending and hiring, the U.S. is next.
Despite declining unemployment rates and other positive economic numbers, the U.S. stock market has declined about 6 percent since early April. Some U.S. firms are reporting higher profits, but the outlook is weak. During its most recent conference call with investors, Boise-based Micron Technology reported declining volume and lower expected operating income in the second half of the year.
It is all beginning to look more like the late 1970s, when the nation experienced stagflation at its worst. In May 1975, both unemployment and inflation were above 9 percent.
Not until the Federal Reserve raised interest rates sharply did inflation fall. The economy then grew strongly in both the 1980s and 1990s, keeping the unemployment rate close to its natural rate of about 5 or 6 percent.
To study how the economy can fall into stagflation, economists use a supply-and-demand model for the whole economy. The theory behind this model is attributed to economists James Tobin and Franco Modigliani, among others, and is sometimes called neo-Keynesianism.
This economic model differentiates between the long and the short run. In the long run, prices dont influence how much is produced and consumed, but do influence our level of productivity. When productivity rises, we can do and sell more no matter what the price. But in the short run, prices can influence the quantity of goods and services that consumers demand or businesses are willing to supply.
Graphically the model shows the quantity of goods and services (measured by real GDP) on the horizontal axis and the overall price level (measured by the CPI or other inflation index) on the vertical axis. The economys demand curve slopes downward (lower prices increase the quantity demanded) and the economys supply curve slopes upward (firms respond to higher prices by producing more).
With this setup, fluctuations in short-run economic activity are analyzed by considering any factors that might change demand or supply. For example, when overall demand in the economy declines, say because of a drop in consumption or lower government spending, the economys demand curve shifts back, or to the left. This leads to falling output and prices in the short run, but over time, and absent any new government policy, prices adjust and businesses become more willing to supply goods and services. The economys supply curve shifts out, or to the right, and the output returns to its longer-run level of output with lower prices.
The neo-Keynesians used this model to explain the miserable situation of stagflation.
Suppose something happens that causes businesses to dramatically cut back production, such as the oil-supply shock of the 1970s. The economys supply curve shifts back, or to the left, leading to falling output and rising prices stagflation. Absent government intervention, supply will return to its long-run level, because wages and the prices of other important production inputs eventually fall.
This model is relatively intuitive and widely accepted in the profession. The only problem is that things rarely turn out as the model predicts, because the government always reacts.
With government intervention through either fiscal or monetary policy, the model predicts the economy will grow, returning to its long-run trend of output, but with higher inflation.
Stagflation may be miserable, but should last for only a short period. Policymakers appear to want nothing of it. Whatever growth we get is likely to come at the high cost of inflation.
PETER CRABB Professor of finance and economics at Northwest Nazarene University in Nampa