Recently, I have often been asked whether we (New Zealand or the World) are experiencing a stagflation. There is no meaningful ‘yes’ or ‘no’ answer. You have to define the term before deciding what is going on.
Rutherford once said there were only two kinds of science: stamp collecting and physics. By ‘stamp collecting’ he meant the systematic collection and categorisation of facts. However physics goes beyond that, positing relations between facts – theories which may be changed or replaced by advanced theories when the old ones prove inadequate at explaining new facts.
It is easy to dismiss economics as theology which people pursue to justify their account of the world but there is a considerable body of economics which, like Rutherford’s physics, looks at relationships of the world without focusing on what should be done. The body of knowledge progresses – like physics – as new facts and circumstances become apparent. It is quite a challenge to keep up. Anyone who pronounced on quantum mechanics after having done but a few years of physics and little more would be thought a charlatan but similar people are common in public economics commentary.
The term ‘stagflation’ really belongs to the stamp collection part of science. It is a label. The danger of using it is that it stops one thinking as a physicist. It allows one to revert to a being an Old Testament prophet who rails against the wickedness of the people or the rulers (depending on one’s political ideology).
The term seems to have been invented about sixty years ago to describe a short-term situation where prices were rising but the economy was not booming. Implicit in the notion then was that price rises were a consequence of economic expansion (of demand growing faster than supply). Note that the assumed causality is going from economic activity to prices; a sceptic may be less certain.
Later it became applied to more medium-term circumstances when there were persistent price rises and ongoing stagnation of output. Perhaps its purpose was to alert us to something happening outside our standard theories.
Today? What we seem to have – internationally and in New Zealand – is price rises and slow or negligible economic growth. Call it stagflation if you like and put the episode in that section of the stamp album. But please don’t stop analysing rather than falling back on past policy tropes which did not work very well then either. If you are certain of your answer, you have not been following closely enough.
What do I think is happening? As far as I can judge, there are two groups of things happening which are only loosely connected. One is that economic activity is growing only moderately, in part because there are not a lot of spare resources to exploit. (Yes unemployment is low but it exists where there is a poor match between the skills and locations of the unemployed and the skills and locations of the jobs being offered.) Additionally, the underlying economic growth rate – as indicated by productivity changes – seems to be slowing down. I remain a little sceptical that all this is causing the inflation.
The second issue is there are substantial international price rises. Some has come from supply chain failures, which persist despite the Covid pandemic which precipitated them being largely over. Second, the Ukraine invasion has given a world price shock – wars are destructive and have to be paid for.
Stamp albums classify these price shocks as a ‘cost of living crises’. I am not sure the label is helpful. Observe that people are really concerned with the reduction in their real (adjusted-for-inflation) incomes. This leads one to wonder that if just about everyone is complaining about their lower real income, something must be going on which the ‘cost-of-living’ label is missing.
Some are experiencing rising real incomes, including shippers, armament manufacturers, banks and oil producers. They are all offshore, which suggests that New Zealand real incomes have generally fallen across the board (except perhaps in some export sectors).
If you think about the problem in terms of incomes, then the policy recommendations for dealing with the price shock are odd. Put up interest rates, which reduce the effective incomes of those with debts (particularly mortgages) even further. Increase unemployment, which also reduces workers’ income. Apparently the policy response is to intensify the underlying problem. Sounds a bit like bloodletting, which was used for thousands of years because there was nothing else to do; today we know bloodletting had no value and may well have made many of the sick worse off.
The standard response goes like this. The policy challenge is to prevent the external price shock triggering a bout of severe domestic inflation. Everyone wants to restore their real income to its pre-shock path from the international price rises, but everyone cannot since the post-shock path is below the pre-shock one. So everybody tries to recover their income by pushing up the price or wage they charge, thereby reducing other people’s income. In the album that is the ‘wage-price spiral’.
The Reserve Bank’s task is to restrain the passing-on of these wages and prices. Unfortunately, it cannot do it without adding to the pain. It is especially difficult at the moment because there is a lot of liquidity (your album says ‘money’) sloshing around in the economy – a consequence of the measures taken during the Covid pandemic – which makes it easier to raise wages and prices. The liquidity is no longer fuelling house price inflation although some of it is pouring into the collectables market. (Crypto-currencies have also gone off the boil.)
Is there an alternative? We could let inflation rip, allowing a kind of pass-the-parcel in a Belfast pub, until eventually we all accept the lower real incomes. It would not be a happy scenario; price levels could double and more, as they did in the 1970s when a not dissimilar situation applied following the income cut from the 1966 wool price collapse.
Alternatively, we could be clearer about what the problem is: the nation’s economic income has been cut and that income cut has to be shared among us (not you and me of course, but everyone else). The aim would be to get a better public understanding of what is happening in the hope that the Reserve Bank would not have to be as repressive. Once upon a time this was called an ‘incomes policy’.
Mind you, it would not be easy for the politicians to explain; they would be pressured to ‘do something’ even if there is little to be done to blunt the overseas shock. Moreover, the public debate would be confused by stamp collectors and Old Testament prophets. We are likely to be penalised more than necessary as a result. It is much easier to open the album at the ‘stagflation’ and ‘cost of living crisis’ than think like a physicist.