Stagflation

In this lesson we will be revisiting a topic we have covered before; Stagflation. We will be defining it and providing reason for why stagflation might loom ahead in the future.

Definition

In 1965, Ian Macleod, a British Tory MP, first coined the term stagflation in a speech, “We now have the worst of both worlds – not just inflation on the one side or stagnation (economic recession) on the other. We now have a sort of 'stagflation' situation.”

Stagflation is the combination, at the same time, of slow economic growth and relatively high unemployment accompanied by inflation. So, in reality, stagflation is the worst of both worlds, accelerating prices (inflation) and an economy with no growth (going through a recession).

Recent Stagflation

Discussing Stagflation will bring to mind a couple of recent examples, the UK in the 1960's and 70's and the US in the 1970's. Not surprisingly the stagflation experienced overseas even caused the problem to arise here in Australia.

In the US in the early 1970s when, to the surprise of many who followed Keynesian theory which suggested that stagflation could not possibly occur, oil prices were tripled by OPEC (the Organization of the Petroleum Exporting Countries) in the aftermath of the 1973 Arab-Israeli war - fuelling sharp inflation in developed countries. This caused simultaneous recession and inflation - Stagflation.

The reason this surprised Keynesians was that recessions (and the subsequent unemployment caused by them) should be cured by inflation, while recessions are cured by inflation. When both occur at once, Keynsian theory is seriously challenged. This weakness in the original theory brought about the development of Neo-Keynesianism, which dealt with inflation with a more detailed model.

Is the US at risk?

It is generally accepted that the growth in the US housing market has caused a significant slowing of US economic activity. Furthermore, the recent experience in the sub-prime markets still has many investors spooked about the US economy. Add to this the threat that inflation could continue to be a problem in the US and therefore require the Federal Reserve to increase interest rates and you can see why an increasing number of analysts are saying stagflation is a real possibility. Many economists are of the opinion that stagflation will only occur if the oil price is around $130 a barrel for a persistent period of time - time is ticking.

The decision is not in yet as US interest rates are relatively low.

As the US economy is still the largest in the world and therefore any slowdown there will have a softening effect here, it is worth being aware of the effect of stagflation. As the saying goes, '...the US sneezes and the world catches a cold'.