Hi Vivek,
In the last post, I wrote to you that we might be headed towards stagflation, given the high unemployment, low economic growth and high inflation. Since then, many have indicated that we might be headed towards one.
(You can read online by tapping on the heading and average reading time is 6 mins)
Conservative Approach:
If we look deeper into what caused inflation, we would see two different narratives. The food inflation had skyrocketed which was easily visible from the rise in the prices of onion. The core CPI inflation, which is calculated by excluding food and energy sectors was at 3.3% which was in fact is a 5 year high. This high food inflation can be attributed to supply shocks like timely rain that destroyed the crop and hence there was an increase in the prices.
So it is more likely that we aren’t infact in stagflation, unless high food inflation persists for a few more quarters.
But anyway, for this post I thought I’ll cover a bit on what stagflation is, a couple of examples from across the globe on it and how stagflation can be dealt with.
Stagflation Revisited
So everything was going smoothly for the Keynesian theory till it met one of its major roadblocks in the 1970s in the USA. The Keynesian theory said that growth in money supply increases employment and economic growth.
So if there was economic growth, increasing the money supply ( reducing interest rates) would increase demand, this also increased prices and increase employment. There was an inverse relationship between unemployment and prices as demonstrated in Philip's curve.
Come the 1970s and very high oil prices. This saw a general rise in prices and so there was high inflation. Going by Keynesian theories, there should have seen high economic growth and low unemployment. But this period saw a slowdown of economic growth. Now, this was new. How could the prices rise even if there was slow down in economic growth?
Essentially the Philip curve didn't hold true.
This was a deadlock. Without much growth there was high inflation, if there was an increase in growth, it would lead to much higher inflation, and if there was a focus on reducing inflation, the economic growth would fall further causing much higher unemployment.
Way Out : Past Example
Enter Milton Friedman. He believed that "inflation is always and everywhere a monetary phenomenon". His school of thought is called the 'monetarism'.
In essence, inflation was due to increased money supply and not because of an increase in oil prices. It is now well-established practice to target the monetary supply in high inflation, but back then the response by the Fed was in fact counterproductive.
The Fed, thinking that the inflation was due to high oil prices which was due to a supply problem, continued to have an expansionary monetary policy. Which further exasperated inflation.
It was not until 1979 when Paul Volcker took after the Fed did Fieldman's theory was put to test.
Volcker resorted to very high-interest rates thereby cutting the money supply. In fact, the interest rates were so high that the economy slipped into a recession and there was mass unemployment. It is said that because of this unpopular move, President Jimmy Carter was voted out when he stood for re-election for the second time.
Though unpopular at the time, when Volcker was done with curtailing money supply, the economy saw a much longer period of stable and sustainable growth.
That is the problem with solving stagflation, one has to compromise growth in the short to medium term to the effect that even it could lead to much higher unemployment before high inflation can be tamed.
Situation at hand
Now, if this higher inflation that we see today in India were to persist, we have to realise that it's not because of a supply problem caused by crop failure but because of increased money supply in the country. This is possible given the high fiscal deficit and the low repo rate that we see. These measures, done to boost demand would have infact been used in ineffective investments whist increasing the money supply. Now, to fight this, the central bank will have to raise Interest rates this will have an adverse impact on the already slowing economy. Hence, though unlikely, a stagflation at this juncture will be catastrophic. The government on its part has to now more than ever get it's investment focus right.
Regards,
Bheem
The Duologue is an effort by Vivek and Bheem to have a dialogue about varying topics.
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