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Inflation is always and everywhere a monetary phenomenon.
- Milton Friedman [Monetarist]
- Paul Davidson [Post Keynesian] |
By the mid-1970s the Great Prosperity had ended. GDP growth,
productivity growth and wage growth all slowed. Unemployment
rates and inflation rates increased. The slowdown affected all
of the rich countries, although all did not exhibit exactly the
same symptoms. For economists, the worst part was the simultaneous
existence of unacceptable levels of inflation and unemployment.
We coined the term stagflation to describe a situation
that our theories told us could not happen. This chapter examines
the impact of stagflation, the theories advanced to explain it
and the policies proposed to control it. Then it explores the
possibility that a long and deep economic slump about every fifty
to sixty years is part of the regular landscape of capitalism.
Another troubling aspect of the end of prosperity was increasing
inequality, but that will be covered in Chapter 23.
There is a common misapprehension that stagflation was a problem of the 1970s which we put behind us in the 1980s. Unfortunately this is not true. Inflation was merely contained in the 1980s by persistently high unemployment. The problem is that inflation is only one symptom of the end of prosperity: we have successfully treated the symptom, but suffer from the side-effects of the treatment. In June 1993, while the unemployment rate in the U.S. was still close to 7% and the economy was operating at 3 to 4 percent under its capacity output, the Fed began to signal that it was considering tighter monetary policies in order to head off potential inflation. [1 Source] The fear of inflation is still a powerful restraint on economic policy. It is not unusual in the United States for the stock market to react negatively to what most of us would regard as good economic news. When the unemployment statistics for February, 1996, that were released on March 8 indicated a surge in employment - and a decline in the unemployment rate from 5.8% to 5.5% - the stock market fell by over 170 points. The tumble was apparently based on the fear that the Federal Reserve would react to the good economic news by increasing interest rates. [2 Source]
The 1950s and 60s were characterized by high productivity growth (2.5 to 3.5% per year); rapid wage growth (also from 2.5 to 3.5% per year); moderate inflation (about 2% per year); low unemployment rates (usually under 5%, under 4% for about 1/3 of the two-decade period); and strong growth in real GDP (3.4% per year for the 50s, 4.6% per year for the 60s).
The economy of the 1970s and 80s was poorer on all counts. Productivity growth fell to the 1 to 1.5% range; real hourly wages (including benefits) grew about 0.5% per year in the 70s and only about 0.25% per year in the 80s; consumer prices rose 6.5% per year during the 70s and about 5.5% per year in the 80s; the average unemployment rate was above 6% in the 1970s and above 7% in the 1980s; GDP growth slowed to 2.8% per year in the 70s and 2.5% in the 80s.
Economists could offer little help. Keynes
and the Great Depression had taught us how to stabilize the economy
by managing demand: we could speed the economy and reduce unemployment
by expansionary monetary and fiscal policies; we could slow the
economy and reduce inflation by contractionary monetary and fiscal
policies. Note that this is of no help to an economy that is
suffering from unemployment and inflation at the same time.
We cannot simultaneously speed up and slow down the economy.
Stagflation was the kiss of death for the neoclassical/Keynesian synthesis. This synthesis was always on shaky theoretical ground, since it depended on different and incompatible bases for the two branches of theory (macroeconomics and microeconomics). But it had at least provided useful policy advice. Now, with the advent of stagflation, the policy advice was nearly useless. As the consensus broke down, economists scattered in several directions. Some concluded that the entire experiment had been a mistake, and returned to the old-time religion of pre-Keynesian neoclassical economics. Others decided that Keynes had not gone far enough in defining a governmental control mechanism for the economy -- they proposed an even greater governmental role in the economy.
Even in the 1950s and 60s, Keynesians recognized that some inflation would set in before full employment was achieved. But they believed that the relationship between unemployment and inflation was reasonably stable -- that we could calculate the 'cost' of maintaining a low unemployment rate in terms of inflation. The inverse relationship between unemployment and inflation is called a Phillips Curve. Maintaining the unemployment rate at about four percent (which was then considered to be full employment) would require that we tolerate an inflation rate of about three percent. Conversely, the inflation rate could be held at about one percent as long as we were willing to tolerate six to seven percent unemployment.
The Phillips curve thus presented policy-makers with a menu of options. Simply pick any combination of inflation and unemployment rates on the curve then ask your economists to design the set of monetary and fiscal policies that will get and keep the economy there. The normal business cycle might even be replaced by a political business cycle in which we move up and down the Phillips curve each time the ruling party changes. The Democrats would presumably favor low unemployment and find three percent inflation a reasonable price to pay. The voters would eventually tire of inflation and elect the Republicans, who would find a six to seven percent unemployment rate a reasonable price to pay for holding inflation to about one percent.
The Keynesians did try to explain stagflation. One cause was a series of supply shocks in the 1970s. Crop failures plus two huge increases in oil prices could not fail to harm the economy. Another cause was the surge of baby-boomers hitting the labor market in the 1970s. Not only were their numbers large, but the baby-boom generation women entered the labor market in roughly the same proportion as the men. With an ample supply of labor, business was under no pressure to raise wages and under very little pressure to raise productivity.
All this bad luck was compounded by bad policy. President Johnson continued, against the advice of his Keynesian advisors, to run budget deficits even when the unemployment rate fell below four percent. When 1970s presidents Nixon, Ford and Carter tried to slow inflation, they (and their Federal Reserve chairmen) backed off too soon - their "stop-go" monetary and fiscal policies disrupted the economy without curing its ills.
But that is all in the past. OPEC cannot even keep oil prices rising as fast as general inflation. We have absorbed the baby-boomers. Yet we entered the 1990s facing the same inflationary pressures at six percent unemployment rates that we once faced only at unemployment rates of four percent or less.
The monetarists were able to offer a simple solution. Inflation is caused by too rapid a growth of the money supply. So slow it down. Leading monetarist Milton Friedman made this point very dramatically on a TV economic series in 1980. Friedman came on camera with the Treasury's printing presses in the background spewing out sheets of $20 bills. "This is how you stop inflation," he said while pressing a large red button that stopped the printing presses. This rehash of neoclassical monetary theory came to be called monetarism.
Their major difficulty was in explaining why the same policies that had seemed to give us successful growth in the 1950s and 60s brought us disruptive inflation in the 1970s. Their starting point was to reject the Keynesian version of the Phillips curve. It was replaced with the "natural rate of unemployment." According to the monetarists, there is no permanent trade-off between inflation and unemployment. Instead, there is a "natural rate of unemployment" that is consistent with any stable level of inflation. The natural rate depends instead on job search factors and labor market policies. They claim, for example, that unemployment compensation increases unemployment rates by giving workers more time to search for jobs; that the minimum wage increases unemployment by putting the price of much unskilled labor above its value.
According to the monetarists, the acceptance of a four percent unemployment rate as full employment by the Keynesians was an error. The natural rate of unemployment was higher than four percent. Government deficits combined with accommodating monetary policy actually had the effect of increasing the inflation rate. Business executives, however, were "fooled" by this inflation into believing that the demand for the products they produced had increased. So they increased output. And the unemployment rate went down, below its "natural" rate. The hitch is that this situation was only temporary. Business people would soon realize that their costs were going up as well. So they would cut output and employment. In other words, a given rate of inflation only reduced the unemployment rate temporarily, and even then only if the inflation "surprised" people and fooled them into expanding production. The only way to keep the unemployment rate below its natural rate would be to continually increase the inflation rate. Even this would not work forever, as business people would begin to factor increasing inflation into their decisions.
This mechanism also works in reverse. If business people expect inflation at a certain rate, they will also be "fooled" by lower inflation rates into thinking that demand is falling. They will respond to the false signals of falling demand by cutting production and employment. So when we decide to stop inflation by reducing the rate of monetary growth, we will have to pay for our past excesses by letting the unemployment rate go above the "natural" rate until executives realize that inflation has actually been conquered. Monetarists disagree over whether to slowly reduce money growth and suffer through a long period with high unemployment or to quickly and drastically freeze the money supply and suffer from very high unemployment for a shorter period of time.
Its pretty tough to run for president on a monetarist platform. You would have to promise the voters a recession long enough and deep enough to squeeze out the inflation. By 1980, however, a new conservative economic philosophy came into prominence. Promoted by the editors of the Wall Street Journal, Supply-Side Economics was the keystone of Ronald Reagan's successful campaign in the 1980 election. Even the name was picked to indicate a rejection of Keynesian thinking, which is based on demand. Supply-siders claimed that stagflation was the result of diminishing capitalism's normal creativity by: 1) taxing away the profits and incomes that are the reward for successful entrepreneurship; 2) burdening business with too many costly and ineffective regulations; and 3) making it too easy for people to live well without working through overly-generous welfare payments.
Institutionalists and Post Keynesians claim that modern economies have developed inflationary tendencies. This becomes stagflation when we try to contain the forces of inflation by slowing down the economy.
The inflationary tendencies are themselves deeply rooted in the price/wage/income-setting processes of a modern economy. The only way that all of us can get richer is if productivity increases: if productivity goes up by five percent we can all be five percent richer. Any time a firm raises a price without improving the quality of the product or a union gains a pay increase that exceeds productivity improvements such gains come at the expense of others. Since many of the others have enough power to raise their own price, wage, or income, the result will be inflation.
Start with a major increase in the price of automobiles [without a corresponding increase in their quality]. Since other firms are not likely to lower their prices, the overall price level will be increasing [inflation]. Many workers will be able to get wage increases that allow them to keep up with the increased cost of living. The firms that employ them will then use their market power to raise prices enough to pay for the wage increases without reducing profits. Government also gets into the act and raises the income of social security recipients to keep pace with rising prices. By now we have a full-bore price/wage spiral.
Unfortunately, if this theory of inflation is correct, it leaves us with no simple solutions. There are four ways to contain or adjust to the inflation:
The theories discussed above focus primarily on the causes of modern inflation. We must now also consider the possibility that the economic slowdown of the 1970s and 80s is a "normal" long-term downturn of the type that occurs every fifty to sixty years.
Nikolai Kondratieff of Moscow (1892-1931?) was an early econometrician (economic statistician) even though the term was not invented in his lifetime. His 1920s research into economic data going back to the early stages of the industrial revolution convinced him that capitalism was subject to long waves in addition to the shorter --- and more familiar --- business cycles. The pattern he found was twenty to thirty year spurts of strong growth followed by a slowdown of similar length. The last phase of the slowdown was usually a depression. Kondratieff himself did not have an opportunity to develop an explanation of the causes: his research institute was closed by Stalin in 1928 and Kondratieff disappeared into a Siberian prison camp in 1930.
Other economists, statisticians and economic historians, including Joseph Schumpeter, amassed more data which tended to confirm the existence of Kondratieff cycles. Moreover, the pattern identified by Kondratieff has continued into the present. The historical picture drawn by these statistics is comprised of four Kondratieff cycles. Strong growth from about 1780 lasts until approximately 1815; growth then slows until the mid-1840s. The second cycle starts with a strong growth phase until about 1875 and slower growth until about 1895. A third cycle shows rapid growth until about 1918 (the end of World War I); slower growth through the 1920s is followed by the Great Depression. The fourth cycle starts with World War II and the record growth of the 1950s and 60s then goes into a slow, but inflationary, phase in the 1970s and 80s which still continues.
Some caution is called for in interpreting this pattern. Our statistical picture of the first two Kondratieff cycles is very foggy. There were no measures of total output, and the trade and price statistics that are used are only available for the first countries to start industrial revolutions. Most of our first cycle statistics are from Great Britain. Nevertheless, the unexpected but persistent global economic slowdown starting in the early 1970s has led to a resurgence of interest in Kondratieff cycles. Once the pattern had been identified, social scientists began to look for the causes.
Some searched for the cause in technology. Joseph Schumpeter thought each long wave was an industrial revolution unto itself, based on a cluster of critical innovations. The heavy investment in the early stage of each industry led to a rapidly expanding economy. When the critical industries matured, economic growth slowed until a new cluster of innovations came along.
One difficulty with this theory is that even when we observe a clustering of innovations, the direction of cause and effect is not determinable. Innovations might simply cluster because the economy has entered a period of rapid growth. Television could have been launched as early as 1932. All of the technology was in place. But the massive investment needed and high risk involved delayed the introduction of television until after the Great Depression.
Another difficulty comes when we try to put dates on innovations in order to evaluate this theory. For any major new industry, there is at least a 20-year span of time - and a much longer span for many industries - from the key inventions until the successful commercial exploitation of these inventions. So placing a date on an innovation is a highly subjective undertaking.
Some political scientists and economists (particularly Charles Kindleberger and Robert Gilpin) find the cause in the international political structure. The Theory of Hegemonic Stability suggests that the world economy experiences successful growth when there is a consistent set of enforceable rules governing international trade and finance. Such enforceable rules only exist when one country is in a hegemonic position, that is when one country has the undisputed economic and military power to make the rules. Great Britain played this role from 1815 to 1914. But in the period between World War I and World War II Great Britain lacked the power and the U.S. lacked the will to maintain hegemony over the world economy. This meant that no country was both able and willing to exert the leadership that would have been necessary to prevent the Great Depression. From the end of World War II until 1971 the U.S. acted as the hegemon, and the world enjoyed a quarter century of unprecedented economic growth. By 1971, Europe and Japan were in a position to contest U.S. economic domination, yet no method was developed by which power could be shared.
Note that this theory fits the facts of the 20th century very well, but cannot reasonably explain the 19th century downturns since there was a clear hegemonic leader during the entire period. Further, it suggests that economic 'slowth' will be with us until either 1) one of the three economic powers (U.S., EC or Japan) moves into a dominant position, or 2) the three learn how to share power in an unambiguous way.
Others looked for the cause in the relationships among capitalists, workers and government, or what economist David Gordon calls the Social Structure of Accumulation. This is similar to Marx's concept of the Social Relations of Production. Marx, of course, was trying to explain the changes in economic systems --- from feudalism to capitalism and from capitalism to feudalism. But it can also be applied to the investigation of changes within the economic system of capitalism.
We can start with a non-controversial point: the growth of a capitalist economy depends on the ability of capitalists to earn profits and thus accumulate capital. But this ability, in turn, depends on the structure of relationships among capitalists (e.g., competition or oligopoly), between capitalists and the labor force (e.g., combative or cooperative), among workers (e.g., competitive or cooperative), between capitalists and government (e.g., profits taxes, antitrust laws), between labor and government (e.g., unemployment compensation, labor laws) and among governments (e.g., free trade or government-promoted exports). These relationships taken together are what is meant by the "social structure of accumulation."
The social structure of accumulation has to be appropriate to the level of technology, size and growth of population and other factors. But the social structure of accumulation is embodied in laws, traditions, economic institutions such as the corporate structure, and even culture. That means that these laws and institutions, once established, tend to outlive the technological and demographic conditions which spawned them. As the social structure of accumulation becomes less appropriate to the underlying conditions, profit opportunities narrow, the accumulation of capital slows and economic growth slows. An economic crisis, usually in the form of depression, creates the social conditions which spur fundamental changes in the social structure of accumulation. [3 Source]
Let us first apply this concept to the second Kondratieff cycle (1845-1895). Successful capitalist growth and geographical expansion increased the rate of technological change. The railroad, the steamship, the telegraph, and new production technologies for iron and steel were among the results. But these new technologies also led to high fixed costs. Price competition among capitalists meant that many firms could not cover their fixed costs. Wholesale prices fell by two-thirds from 1873 to 1883. These conditions precipitated the shift from competitive capitalism to oligopolistic capitalism. Note that such a shift was not simply a matter of the capitalists having the will to consolidate their operations. A new culture of management had to be developed in order to administer multi-plant firms. The proliferation of clerical and administrative jobs required an expansion of secondary education to provide people with sufficient skills to fill these slots. Government had to devise new methods of containing the considerable market power of large-scale business. In the United States this took the form of allowing oligopoly while prohibiting monopoly and outlawing overt price-fixing. In many European countries it took the form of legalizing cartels in major industries while asserting some governmental controls over price increases.
The third Kondratieff cycle (1895-1940) encompassed numerous new developments. Capital equipment itself was subjected to large-scale, rather than craft, production methods. The separation between managerial work and factory labor was intensified by using time and motion studies to attempt to make the workers as standardized and interchangeable as the parts they made and the machines they operated. This period also saw the beginning of the expensive mass-produced "consumer durable": first the sewing machine, then the bicycle, automobile and radio. New production techniques increased productivity much faster than wages, yet mass-produced consumer durables required the simultaneous development of a mass market. The breakdown of the Great Depression led to another major shift in the social structure of accumulation: this time the leadership came from government which undertook the responsibility to assure high levels of consumer demand through Keynesian demand-management policies and various systems of transfer payments.
The fourth Kondratieff cycle (1940 - 19??), then, embodied a new set of relationships within its social structure of accumulation. Capitalists, as before, would decide what to produce and how to produce it; government would have a major role in the distribution of income; and labor would share in the subsequent productivity growth. The fundamental question is why this particular set of rules became less appropriate by the early 1970s. One reason has been examined above ---- guaranteed incomes and rigid prices gave the economy an inflationary bias and the ensuing inflation could only be contained by abandoning governmental support for full employment. Another reason is that the rapid globalization of the economy became incompatible with economic policies made by national governments. A firm that does not like the labor laws, taxes or environmental laws can simply move to a country with a "more favorable business climate." Or the firm can often negotiate limits to taxes or labor laws by presenting a viable threat to move.
The Great Prosperity - what some call the Golden Age of Capitalism - came to an end by the mid-1970s. The Keynesian policies that many credited as a cause of that marvelous quarter-century of growth could no longer deliver high growth rates without disruptive inflation. Monetarists and supply-siders argued that excessive government manipulation of the economy was the cause of our problems while institutionalists and post-Keynesians tried to make a case for more regulation of the economy. And many other economists resurrected Nikolai Kondratieff and pointed out that there was nothing new in all this: golden ages fall into slumps and even depressions with perplexing regularity.
Kondratieff Cycles (Long Waves)
Social Structure of Accumulaiton
Theory of Hegemonic Stability
Further Reading