War threatens the world with stagflation

THE specter of “stagflation” threatens the world again. This time, the risk is the direct consequence of political provocations and war, and not simply because of inexorable economic forces.


Stagflation is a compound word implying inflation with stagnation.

Stagnation refers to low growth, “close to zero”, inevitably increasing unemployment.

Inflation refers to price increases, not high prices, as is often implied.

The term “stagflation” is said to have been first used in 1965 by Iain Macleod, then economics spokesman for the British Conservative Party.

He became Chancellor of the Exchequer or Minister of Finance in 1970 for just over a month, the shortest term in modern times.

In 1965 he told the British Parliament that amid ‘rapidly rising’ incomes and ‘completely stagnant’ production, ‘we now have the worst of both worlds. We are in a kind of stagflation situation”.

The term caught on in the 1970s, when high inflation and unemployment ended an economic era dubbed the “Golden Age of Capitalism” describing the post-World War II boom (WW2 ).

Normally, during a recession, the rate of inflation, or the overall rate at which prices rise, declines. As unemployment rises, wages come under pressure, consumers and businesses spend less, reducing demand for goods and services and slowing price increases.

Similarly, when the economy booms, the labor market tightens, which pushes up wages, which in turn are passed on to consumers via higher prices. Thus, inflation increases and unemployment decreases during a boom.

However, stagflation poses a dilemma for central banks. Normally, when economies stagnate, central banks try to stimulate growth by cutting interest rates, encouraging more borrowing and therefore spending.

But it could also fuel further price increases and higher inflation.

On the other hand, if they raise interest rates to control inflation, growth could slow even further, further increasing unemployment.

1970s stagflation

Growth in world trade after World War II increased demand for US dollars, the de facto world currency under the Bretton Woods (BW) international monetary agreement of 1944.

The United States financed much of the reconstruction after World War II to expand its sphere of influence from the “free world” at the start of the Cold War.

After reconstruction after World War II, the demand for the greenback was met by an increase in US imports paid for in US dollars.

As foreign central banks accumulated more and more dollar reserves, the flows reversed in the 1960s, with net resources flowing in rather than out of the United States.

During the 1960s, economic growth in the United States was increasingly supported by government military and social spending.

Spending increased both for “defense,” especially the Vietnam War, and for social programs, for example, President Lyndon B. Johnson’s “War on Poverty” and “Great Society.”

As Johnson was reluctant to acknowledge the mounting costs of the Vietnam War, it was difficult to raise taxes to pay for his “swords and plowshares” expenses.

Instead, the spending was financed with public debt, by selling US Treasuries. Thus, the world financed the expenditures of the American government, including the war.

In January 1967, Johnson was under pressure to reduce the growing budget deficit. But it took a year and a half for the US Congress to adopt its new budget with tax increases.

When it was finally passed in mid-1968, the U.S. federal debt had increased even further, as spending on “arms and butter” had not decreased.

US monetary policy was obligingly expansionary. Unsurprisingly, inflation rose from 1.1% in 1960-64 to 4.3% in 1965-70.

Rising inflation has also eroded US competitiveness, further worsening its balance of payments deficit.

Inflation has also undermined the ability of the United States to honor its commitment to BW to maintain full gold convertibility at US$35 per ounce. This obligation has not gone unnoticed by foreign governments and currency speculators.

As inflation rose in the late 1960s, US dollars were increasingly converted into gold.

In August 1971, US President Richard Nixon ended the exchange of dollars for gold by foreign central banks, violating his BW pledge.

A final attempt to rescue the international monetary system – through the short-lived Smithsonian deal – failed soon after.

In 1973, the post-WW2 BW international monetary agreements were effectively abolished.

Commodity Supply Interruptions

European oil-exporting countries and other countries that held US dollar reserves suddenly found that their assets were worth much less.

Along with Venezuela, the Middle Eastern-led Organization of the Petroleum Exporting Countries reacted by abandoning its earlier drive to keep oil prices low.

In October 1973, the “nationalist” Saudi monarch Faisal banned oil exports to countries supporting Israel shortly after President Anwar Sadat attempted a reprisal after Egypt’s defeat by Israel in 1970.

The price of oil nearly quadrupled from $3 to nearly $12 a barrel when the embargo ended in March 1974.

This sharp rise in oil prices was accompanied by sharp increases in the prices of other commodities in 1973-74.

Besides oil, the prices of other commodities more than doubled between mid-1972 and mid-1974.

During this time, the prices of certain products such as sugar and urea have increased more than fivefold.

Commodity supply shocks and rising commodity prices have increased production costs, consumer prices and unemployment.

As rising consumer prices triggered demands for higher wages, these, in turn, raised consumer prices. Thus, wage-price spirals accelerated the rise in prices and inflation.

The 1979 Iranian revolution triggered a second oil shock.

The resulting “Great Inflation” saw US prices rise more than 14% in 1980.

In the United Kingdom – then considered “the sick man of Europe” – inflation averaged 12% a year between 1973 and 1975, peaking at 24% in 1975, while inflation in Germany the West and Switzerland exceeded 5%.

In the 1960s, unemployment in the seven major industrial countries – Canada, France, West Germany, Italy, Japan, the United Kingdom and the United States – rarely exceeded 3.25%.

But in the 1970s, the unemployment rate never fell below.

By mid-1982 it had risen to 8%, exacerbated by interest rate hikes, ostensibly to fight inflation.

The slowdown in growth of the 1970s – accompanied by rising unemployment and inflation – in the major industrial economies caught many economists off guard. Economic thinking then assumed that inflation and unemployment were alternatives.

The Phillips curve implied that low unemployment came at the cost of higher inflation and vice versa.

This crude and static caricature of Keynesian economics enabled a major assault on its influence.

The assault on development economics was collateral damage in this “counter-revolution”.

Peace is our best option

Last October, the International Monetary Fund, the European Central Bank, the US Fed and other such institutions believed that the factors driving inflation were transitory.

None of these authorities saw the urgency of raising interest rates.

But last month, the war in Ukraine and sanctions against Russia drove up the prices of commodities such as wheat and oil.

This will aggravate rising inflation in much of the developed world.

The threat of stagflation is undoubtedly more real today than six months ago.

In October 2021, Google searches for “stagflation” reached their highest level since 2008.

Mention of stagflation in online news stories jumped to more than 4,000 a week in mid-March, from just over 200 at the start of the year.

This time, “stagflation” is the direct consequence of political choices, notably war, and not of ineluctable economic trends.

Developing countries are quickly learning where they really stand in this unequal world of endless war, for example, from the European treatment of Ukrainian refugees.

Peace is therefore imperative. The alternative is the barbarism of great power conflict in which most of us have no vested interest.

Instead, our common hope lies in securing peace, to focus instead on the common challenges facing humanity. – March 29, 2022.

* Jomo Kwame Sundaram is an honorary member of the Academy of Professors and Anis Chowdhury is the former director of the Macroeconomic Policy and Development Division of the United Nations Economic and Social Commission for Asia and the Pacific.

* This is the opinion of the author or publication and does not necessarily represent the views of The Malaysian Insight.

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