Is there going to be a recession in the US and other leading economies? This question has naturally arisen among participants at this year’s meeting of the World Economic Forum in Davos. This is, however, the wrong question, at least for the US. The right one is whether we are moving into a new era of higher inflation and weak growth, similar to the stagflation of the 1970s. If so, what might this mean?
The similarities are evident between the present “surprise” upsurge in inflation to levels not seen in four decades and that earlier era, when inflation was also a surprise to almost everybody, except the monetarists. That era was also characterised by war — the Yom Kippur war of 1973 and the invasion of Iran by Iraq in 1980. These wars, too, triggered jumps in oil prices, which squeezed real incomes. The US and other high-income economies experienced almost a decade of high inflation, unstable growth and weak stock markets. This was followed by a sharp disinflation under Paul Volcker, chair of the Federal Reserve, and the Reagan-Thatcher shift towards free markets.
At the moment, few expect anything similar. But a year ago few expected the present upsurge in inflation. Now, as in the 1970s, the rise in inflation is blamed on supply shocks caused by unexpected events. Then, as now, that was a part of the picture. But excess demand causes supply shocks to turn into sustained inflation, as people struggle to maintain their real incomes and central banks seek to sustain real demand. This then leads to stagflation, as people lose their faith in stable and low inflation and central banks lack the courage needed to restore it.