04 January 2022
The stagflation of the 1970s is widely believed to have heralded the eclipse of Keynesian economics and the rise of monetarism. In a previous post (What caused the stagflation of the 1970s? Answer: Monetarism) I had argued that this was not the case and that the stagflation was directly caused by the monetarist policies of the time.
But there is an even more important question that does not seem to have been answered, or even seriously raised: How could the US have avoided stagflation? Considering our experience in handling the Great Recession and the Covid pandemic and in the light of theoretical advances, especially Modern Monetary Theory, this is a surprising omission.
Through 1974 the price of crude rose by an average of 170% year-on-year, because OPEC raised oil prices. If an oil importer in the US had been importing 1 million barrels of oil at a price of $5 and the price went up to $10 then it would need twice the amount of money it did earlier if it wished to import the same quantity of crude as it had previously. Down the line, those to whom it sold refined oil products would need a greater amount of money to buy the same amount of gasoline, etc that they used to. If money in the economy was not expanded to the required extent, then less crude would be imported from abroad and less gasoline consumed down the line. The result would be a contraction in overall output, or what we would call a recession. This is indeed what happened when the Fed tried to constrict money supply growth.
In hindsight, we can see that the policy was completely wrong. The inflation of the mid-1970s and after was caused by a huge rise in oil prices. The inflation should not have been fought; it needed to be accommodated by an increase in money supply. The question we should really ask is: How should the money supply have been increased? There were many options.
The Fed could have bought financial assets and increased money supply. But as we saw after the Great Recession, if money supply is increased in this manner it tends to stay in the market for financial assets instead of moving into the market for real goods and services. The usual result is an inflation in the price of financial assets, and little more.
The Fed could have printed more money equal to the difference in crude import costs, given it to the importers of crude to pay foreign crude exporters, and in return asked that the domestic price of oil be kept unchanged. Developing countries could not have exercised this option because the willingness of crude exporters to accept newly printed currency depended on the existence of goods and services (or investments) that could be bought with the newly minted currency. Also, it would have amounted to a blanket endorsement of any price increase by OPEC.
Another problem was that domestic oil producers too increased oil prices, though to a lesser extent because of price controls imposed by the Carter administration. They too could have been compensated in the same manner as crude importers but then there would have been no incentive for crude producers, domestic and foreign, to control prices.
But after the experience of the Covid pandemic and the spread of MMT, we know that there was another option. The government could have directly put money into the accounts of ordinary individuals and left it to them to decide whether the money should be entirely spent on higher priced oil and other goods or saved. There would still have been inflation, and given the international price of oil this was inevitable. But the pain would have been mitigated to a great extent and the problems associated with price control could have been avoided.