Explanations of stagflation
A famous case of stagflation occurred during in the US in the 1974 — 75 period. In March 1975, industrial production fell by nearly 13% while the yearly rate of growth of the consumer price index (CPI) jumped to around 12%. Likewise a large fall in economic activity and galloping price inflation was observed during 1979. By December of that year, the yearly rate of growth of industrial production stood close to nil while the rate of growth of the CPI stood at over 13%.
Civilian unemployment increased from well below 4% to just over 6% by the end of 1970. The rate then retreated to 5% in 1973 only to skyrocket to 9% by mid-1975—the highest rate since the Great Depression. The unemployment rate remained above the normal level of 5% for the next two decades, including ten double-digit months during 1982-83.
Previous views on stagflation
The stagflation of 1970s was a big surprise to most mainstream economists who held that a fall in real economic growth and a rise in the unemployment rate should be accompanied by a fall in the rate of inflation and not an increase.
According to the then accepted view, the central bank influences the real rate of economic expansion by means of monetary policies. This influence however, carries a price, which manifests in terms of inflation. For instance, if the goal is to reach a faster rate of economic growth and a lower unemployment rate, citizens should be ready to pay a price for this in terms of a higher rate of inflation. Thus was it believed that there is a trade-off between inflation and unemployment (the Phillips curve). The lower the unemployment rate the higher is the rate of inflation. Conversely, the higher the unemployment rate the lower the rate of inflation is going to be.
The events of the 1970s therefore came as a shock for most economists. Their theories based on the supposed existing trade-off suddenly became useless.
Explanation by Phelps and Friedman
In the late 1960s Edmund Phelps and Milton Friedman challenged the popular view that there can be a sustainable trade-off between inflation and unemployment. They had been arguing that, contrary to the popular way of thinking, there is no long-term trade-off between inflation and unemployment. In fact, over time, according to them, loose central bank policies set the platform for lower real economic growth and a higher rate of inflation, i.e., stagflation.
As long as the increase in the money supply rate of growth is unexpected, this theory implies, the central bank can engineer an increase in the rate of economic growth. However, once people learn about the increase in the money supply and assess the implications of this increase, they adjust their conduct accordingly. Subsequently, the boost to the real economy from the increase in the money supply rate of growth disappears.
In order to overcome this hurdle and strengthen the rate of economic growth the central bank would have to surprise individuals through a much higher pace of monetary pumping. However, after some time lag people will learn about this increase and adjust their conduct accordingly. In short, according to this theory there is no long-term trade-off between inflation and unemployment.
The Austrian view
According to the explanation of Phelps and Friedman, as a result of the increase in the money supply rate of growth, a greater supply of money enters the economy and each individual now has more money at his disposal. This is, however, not a tenable proposition. When money is injected, there must always be somebody who gets the new money first and somebody who gets the new money last. In short, money moves from one individual to another individual and from one market to another market.
The beneficiaries of this increase are the first recipients of money. With more money in their possession (assuming that demand for money stays unchanged) and for a given amount of goods available, they can now divert to themselves a bigger portion of the pool of available goods than before the increase in money supply took place. This means that fewer goods are now available to those individuals who have not received the new money as yet (i.e., the late recipients of money).
This of course means that the effective demand of the late recipients of money must fall since fewer goods are now available to them. The fact that their effective demand must fall is made manifest through the increase in prices (more money per unit of a good) and to the consequent fall in the last recipients' purchasing power.
Hence an increase in money supply cannot cause a general increase in overall effective demand for goods. Only through an increase in the production of goods can this be achieved. The more goods an individual produces the more of other goods he can secure for himself. This means that an individual's effective demand is constrained by his production of goods, all other things being equal. Demand, therefore, cannot stand by itself and be independent. It is limited by production, which serves as the mean of securing various goods and services.
The dependence of demand on the production of goods cannot be removed by means of loose monetary policy. On the contrary, loose monetary policy will only undermine the rate of growth of real goods and services.
Once money is created out of "thin air" and employed in the economy, it sets in motion an exchange of nothing for something. This amounts to a diversion of real wealth from wealth generators to the holders of newly created money. In the process genuine wealth generators are left with fewer resources at their disposal, which in turn weakens the wealth generators' ability to grow the economy.
So contrary to alternative theories, money cannot grow the economy even in the short run. On the contrary, an increase in money only undermines real economic growth. Notice that this conclusion is reached regardless of whether the money rate of growth is expected or unexpected.
The strengthening in monetary growth may not always manifest as visible stagflation. For instance, during the 1948 — 1969 period, the rate of price inflation and the unemployment rate were negatively associated. (An increase in the rate of inflation was accompanied by a fall in the unemployment rate.)
Example: On account of past increases in the rate of growth of the money supply and the subsequent softening in the rate of growth of goods produced, the rate of growth of price inflation is going up. Now, because the underlying bottom line of the economy is still strong notwithstanding the damage inflicted by a stronger money supply rate of growth, the rate of growth of the production of goods only weakens slightly. Within such a situation the unemployment rate could still continue falling.
- Douglas Harper, Historian. Stagflation, Online Etymology Dictionary, referenced 2011-04-25.
- Edward Nelson and Kalin Nikolov. "Monetary policy and stagflation in the UK", Bank of England Working Paper #155, 2002; Introduction, page 9. (Note: Nelson and Nikolov also point out that the term 'stagflation' has sometimes been erroneously attributed to Paul Samuelson.) Referenced 2011-04-25.
- Frank Shostak. "Did Phelps Really Explain Stagflation?", Mises Daily, October 10, 2006. Referenced 2011-04-25.
- Mark Thornton. "The 'New Economists' and the Great Depression of the 1970s", Mises Daily, May 07, 2004. Referenced 2011-04-25.
- Business Cycle Theory and Stagflation (pdf) by William Barnett II and J. Stuart Wood, March 2002
- The Return of Stagflation by Nicolas Bouzou, March 2003
- Another Sibling in the Flation Family by Sean Corrigan, August 2004
- Nightmares of a Central Banker by Antony P. Mueller, February 2007
- The Specter of Stagflation by David Saied, November 2007
- Why I Expect Serious Stagflation by Robert P. Murphy, June 2009
- Stagflation on Wikipedia