A Cautionary Note about Stagflation in the 1970s

For those who worry that elevated federal deficits and quantitative easing (QE) by the Fed will lead to high inflation, a word about the macroeconomics of the 1970s. The topic came up in the news recently with the passing of economist and former presidential adviser Paul McCracken. In keeping with many orthodox accounts of the era, an obituary in the New York Times cast much of the blame for the stagflation [slow growth combined with high inflation] of the 1970s on “Keynesian” macro policies, in particular large budget deficits:

A wide-ranging thinker, Mr. McCracken was part of a postwar generation of economists who believed that government should play an active role in moderating business cycles, balancing inflation and unemployment, and helping the disadvantaged.

His nearly three years at the White House coincided with a turbulent era marked by rising deficits, rampant inflation, the imposition of wage and price controls, and the breakdown of the system of fixed exchange rates that had governed the world’s currencies since World War II.

As a result, by the early 1980s, Mr. McCracken, like other economists, questioned the Keynesian assumptions that had been dominant since the war. He concluded that high inflation had resulted from “a cumulative paralysis in our will” and called for greater fiscal discipline to limit the growth of government spending — a topic that continues to vex Washington….

Working for Nixon, Mr. McCracken was confronted with an inflation rate that had been rising since 1965, a byproduct of the deficits that the federal government had amassed during the Vietnam War…..

The article paints a picture in which McCracken stood in the middle ground between Keynesian “fine-tuners” of macro policy on the one hand and opponents of “activist” policies, such as Milton Friedman, on the other, who blamed inflation on excessive government spending and erratic growth in the money supply.

The view represented by the Times article is far from the only reasonable account of the causes of the stagflation of the 1970s, in particular the episodes during which the US experienced double-digit inflation (see figure below, in which year-over-year CPI inflation is shown in blue).

Here is an alternative mainstream view from a recent paper by Alan Blinder and Jeremy Rudd:

[We] concluded decades ago that the two OPEC [oil-supply] shocks, the two roughly contemporaneous food price shocks, and the removal of wage-price controls in 1973–1974 played starring roles in the macroeconomic events that constituted the Great Stagflation. Money and aggregate demand were bit players…

Also, the article points out that increasing mortgage interest rates were yet another source of stagflation, especially in 1978.

Controversy over fiscal policy is not the only issue that connects the economic situation of the 1970s to that of the present time in America. In a post last month, I mentioned recent surges in some food-commodity prices, which continue to worry many economists, especially those who specialize in the problems of less-wealthy countries and groups. Some may wonder if commodity-price increases brought on by adverse weather events and other developments could eventually help to regenerate 1970s-style stagflation in the US, not to mention their possible effects on real wages and the value of government benefits. Blinder and Rudd’s paper continues as follows:

But the experience since 1982 has been different, and far more benign, than what OPEC I and II led us to expect. While there were no food shocks between the late 1970s and 2007, the quarter century from 1982 to 2007 did witness several sizable oil shocks, both positive and negative. And compared to the experience of the 1970s, these shocks seem to have packed far less punch, on both inflation and output….

As a result, Blinder and Rudd argue, the shocks to commodity prices that have occurred since the early 1980s have not derailed the economy. He argues that the weakening of the effects of these shocks can be explained by reduced fossil-fuel dependence and other structural changes that have occurred since the 1970s. (See also this VoxEU article, which discusses some other theories about the causes of the 1970s stagflation and the reasons that no similar episodes have occurred in more recent decades.) Currently, of course, weak economic growth is also acting as a restraint on inflation.

In contrast to the prescriptions of deficit reduction and a quick phase-out of QE favored by many politicians of both parties, a good approach to the perhaps distant threat of stagflation would seek to temper price movements with the use of strategic commodities reserves, discourage waste and speculation, increase the use of solar energy with “green jobs” programs, and so on, while continuing to use deficit spending to help increase employment and economic growth.