Samuelson on Stagflation

"Stagflation" is back in the headlines—but the term is being misused, and that's an important story. We're told by eminent newspapers and commentators that stagflation is the messy mixture of both high inflation and high unemployment. It isn't. Stagflation, at least as the concept was initially understood in the 1970s, meant something different. Yes, it signified the simultaneous occurrence of high inflation, high unemployment and slow economic growth; but its defining feature was the persistence of this poisonous combination over long periods of time. Although we're drifting in that direction, we're not there yet.

Let's see why this is a distinction with a difference. The coexistence of high (or rising) inflation with high (or rising) unemployment is not an abnormal event. But it's usually temporary, because the higher unemployment—stemming from an economic slowdown or recession—helps control inflation. Companies can't pass along price increases; they're stingier with wage increases. It's only when this restraining process is not allowed to work that inflationary psychology and practices take root, creating a self-fulfilling wage-price spiral. Higher wages push up prices, which then push up wages. Then we get stagflation: a semipermanent fusion of high joblessness and inflation.

Naturally, no leading politician is willing to acknowledge the self-evident implication: that recessions, though unwanted and hurtful to many, are not just inevitable; sometimes they're also necessary to prevent the larger and longer-lasting harm that would result from resurgent inflation. Interestingly, many economists (even those in academia and private industry who, presumably, have more freedom to speak their minds) suffer the same deficiency. They treat every potential recession as a policy failure when it is often simply part of the business cycle. They thus contribute to a political and intellectual climate that, focused on avoiding or minimizing any recession, may have the perverse result of aggravating inflation and leading to much harsher recessions later. The stagflation that began in the late 1960s and resulted from this attitude was indeed dreadful: from 1969 to 1982, inflation averaged 7.5 percent annually and unemployment 6.4 percent.

What's renewed interest in stagflation is the latest consumer price index (CPI), the government's main inflation indicator. Released last week, it makes for discouraging reading. For the year ending in January, all prices were up 4.3 percent. Excluding the temporary surges after Katrina, inflation hasn't been higher since July 1991. Even eliminating food and energy prices (about a quarter of the index), January's year-to-year increase was 2.5 percent.

All these figures exceed the Federal Reserve's informal inflation target of 1 to 2 percent a year: a range deemed so low that it's effective price stability. And these aren't the truly disturbing numbers. The more upsetting figures are those for the last three months. In this period, the full CPI rose at a 6.8 percent annual rate. Without food and energy, the increase was still 3.1 percent. Medical services were up 5.1 percent, women's and girls' apparel 7.3 percent, and water, sewer and trash collection fees 6.7 percent (again, at annual rates). Inflation is accelerating.

Price increases of individual items can have many immediate causes: poor harvests for food; OPEC for energy; uncompetitive markets for health care; corporate market power for drugs; union market power for construction costs. But persistent inflation—the general rise of most prices—has only one cause: too much money chasing too few goods. It's not a random accident or an act of nature. The Federal Reserve regulates the nation's supply of money and credit. The Fed creates inflation and can control it.

For the past six months, the Fed has been under enormous pressure to ease money and credit. It has. The overnight Fed funds rate has fallen from 5.25 percent in early September to 3 percent at the end of January. Politicians are clamoring for the Fed to prevent a recession and cushion the effects of the housing collapse. Banks, investment banks and other financial institutions want cheaper credit to enable them to offset losses on subprime mortgages. There is fear of a wider economic crisis if large losses erode confidence and, by depleting the capital of banks and other financial institutions, undermine their ability and willingness to lend and invest.

Unfortunately, the Fed shows signs of overreacting to these pressures and repeating the great blunder of the 1970s. Underestimating inflation then, the Fed repeatedly shoved out too much money and credit in a vain effort to keep the economy near "full employment." Inflationary psychology became widespread, and the resulting wage-price spiral fed on itself. Now, switch to the present. Again, the Fed has underestimated inflation. It expected the economic slowdown to suppress inflation spontaneously. This belief helped rationalize the dramatic easing of credit through the five rate cuts since mid-September. But so far, the lower inflation hasn't materialized in part because, outside of housing, there hasn't been much of an economic slowdown.

It's true that the Fed is treading the proverbial tight rope. No one wants a financial crisis; but no one should want the return of stagflation either. The trick is to provide enough credit to prevent the former and not so much as to cause the later. In judging what that balance should be, the Fed needs to be less intimidated by present problems and more concerned with long-term consequences. The American economy—a marvelous but flawed engine of wealth—periodically goes to speculative or inflationary excesses. If most of those excesses aren't given the time to self-correct, we may be trading modest pain today for much greater pain tomorrow. Trying to prevent a recession at all costs is a fool's errand that could ultimately backfire on us all.