May 26 2008

It may not be a recession, but it sure feels like one…

FT.com / Columnists / Wolfgang Munchau – Inflation and the lessons of the 1970s

It seem that everyone’s speculating about the US economy today. Recession or no recession, that is the question. The economy has even surpassed the Iraq War as the number one issue in the US presidential race! John McCain, who has publicly admitted that economics is not his strong suit, may just find himself in trouble in a general election where the most important concern among voters is the economic situation.

So what IS that situation, anyway? Is the US in a recession? In other words, has real gross domestic, or total output in the US economy, actually declined over the last six months? Technically, the answer is no. My fellow blogger, Steve Latter, explains this clearly here. What is true, on the other hand, is that the current situation shares many similarities to the global economic slowdown that did occur in the 1970s.

In 1973 OPEC, the newly formed oil cartel consisting at the time of only Arab states, reduced its output of oil and cut off exports to the United States in response to US support of Israel in the Yom Kippur War, in which the Israelis officially occupied the Palestinian territories of the West Bank and Gaza and seized the Golan Heights from the sovereign nation of Syria. To punish the US for its position on this conflict, OPEC cut off supplies of oil to the west, driving gas and energy prices upwards by 70%, triggering a supply shock characterized by a decline in total output and an increase in both unemployment and inflation, a phenomenon known as stagflation: a macroeconomic policy maker’s worst nightmare.

Recently the world has seen a similar (albeit of a different cause) rise in the price of oil and energy prices. Today the rise in energy prices is driven primarily by rising demand, rather than reduced supply (since the 1970s the OPEC cartel has grown to include many non-Arab nations, making it harder to achieve collusion to restrict output and drive up oil prices). Global demand for oil has risen steadily, driven ever higher due to rapid growth in China and other developing nations, and exacerbated by the falling value of the dollar, the currency in which oil prices are denominated.

The supply shocks of today have combined with falling aggregate demand in the US due to weak consumer spending to slow real growth rates to nearlry 0%. So technically, the US has avoided a recession, but the effect on American workers and consumers may be just as painful as the real recession of the 1970s. In order to prevent the “r” word from becoming a reality today, central banks (including the US Fed) have eased money supplies, lowering interest rates, fueling even greater increases in the price level.

…the global weighted average inflation rate will be 5.4 per cent this year, while the global money market interest rate is currently only 4.3 per cent. This means that global short-term real interest rates are negative – at a time when inflation is rapidly accelerating. As monetary policy has been excessively accommodating for more than a decade, inflationary pressures have built up in the global economy.

Central bankers like Ben Bernanke have to make tough decisions sometimes, weighing the trade-off between unemployment and inflation, and determining their monetary policies based on whatever they deem to be the “lesser of two evils”. Rising energy prices have forced firms to cut either cut back their production and raise the price of their products, both actions that result in less overall spending and output in the economy. Falling house prices have led consumers to cut back their own spending, further reducing demand for firms’ output. These factors have all pushed the unemployment rate from around 4.8% a year ago to 5.1% today, which combined with an estimated additional 3-5% of American workers having dropped out of the workforce, (referred to by the Department of Labor as “discouraged workers”) paints a pretty ugly picture of the reality for the American worker today.

The harsh reality of the weak labor market has led Mr. Bernanke and the Fed to pursue an expansionary monetary policy aimed at avoiding further increases in the unemployment rate and decreases in the GDP growth rate. Expansionary monetary policy means lower interest rates, with the goal being increased consumption and investment, both factors that could worsen the inflation problem already experienced thanks to the global supply shock. Evidence indicates that the inflation problem, even in the US where slow growth usually leads to lower price levels, is not going away:

In the US, a survey-based measure of inflationary expectations recently showed an increase to more than 5 per cent. I would estimate there are now several hundred basis points of difference between the current Fed funds rate and an interest rate that would be consistent with price stability in the medium term.

…meaning the Fed, in its attempt to avoid recession and rising unemployment, has created a condition where real interest rates are actually negative, a highly inflationary condition. All this wouldn’t be so bad if wages in the US were rising along with the price level. This however, does not appear to be happening:

The main difference between the situation in the 1970s and now is today’s absence of wage inflation, which explains why absolute inflation rates are a little more moderate. I guess this is probably because of some combination of deregulated labour markets and globalisation. But the lack of wage-push inflation is not necessarily good news. Falling real wages mean falling disposable income and tighter credit conditions mean less borrowing for consumption.

Rising prices for energy, transportation and food have put American households in a tough situation. In the past, periods of inflation have often been characterized by rising wages, meaning the full brunt of nominal price level increases was not entirely born by the American worker. Today, on the other hand, a recession has thus far been avoided, but the combination of record numbers of “discouraged workers”, rising unemployment and inflation may make the pain of our current economic situation just as real as recessions of the past.

In the words of billionaire investor and economic sage Warren Buffett just today:

“I believe that we are already in a recession… Perhaps not in the sense as defined by economists. … But people are already feeling the effects of a recession.”

“It will be deeper and longer than what many think,” he added.

Discussion Questions:

  1. What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?
  2. What impact do rising energy prices have on the behavior of individual firms?
  3. Why are low interest rates likely to make the inflation problem even worse?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

9 responses so far

9 Responses to “It may not be a recession, but it sure feels like one…”

  1. Manuel A.on 11 May 2010 at 1:00 pm

    We were discusing this topic today in class, if the "trade off" is exploitable, we can pick where on the phillips curve can want to be. Then, if the unemployment rate is at 9.9% and if the price level is currently low, would a rise in the money supply, done by the feds, lower interest rates, then in the end, make inflation rise. Would this alone, help bring the U.S halfway between the phillips curve to lower unemployment?

  2. Kevin V.on 29 Nov 2010 at 8:33 am

    1) Nominal GDP is GDP that is not adjusted for inflation while Real GDP is. For example. Nominal GDP is, let's say, 8%. The rate of inflation is 4%. For Real GDP, we would have to adjust accordingly by taking off the rate of inflation from the Nominal GDP therefore giving us the Real GDP. In order for there to be a recession, the real GDP has to decline. Nominal GDP might remain the same, but the rate of inflation would have to increase, which would reduce real GDP or vice versa.

    2) As energy prices rise, individual firms will adjust accordingly to the increase in expenses. They might increase the prices on their products, reduce how much supply they are ordering, or they'll cut off unnecessary expenses. I don't think an individual firm would go as far as laying off workers unless energy prices really shot through the roof. Most they would do with employees might be a temporary wage cut.

    3) On a supply and demand graph, since interest rates are lower, consumers will tend to want to borrow more, therefore increasing demand. Since the supply stays put where it is, demand moves up the supply line, which would increase the inflation rate and will continue to do so if it's left alone. Pretty soon, demand will out-pace supply and inflation will run rampant.

  3. Nathan R.on 17 Mar 2011 at 3:33 pm

    What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?

    Nominal GDP is the value, in current prices, of all final goods and services in a country in a given period of time. Real GDP is the value, in constant prices, of all final goods and services in a country in a given period of time. Real GDP must decrease for their to be a recession.

    What impact do rising energy prices have on the behavior of individual firms?

    Rising energy prices means higher prices of production for firms, this means a restricted output and an unpwards shift in price as demand stays the same. So ultimately more expensive energy=less purchasing power.

    Why are low interest rates likely to make the inflation problem even worse?

    Low interest rates are likely to make the inflation problem even worse because, lower interest rates means a higher demand for interest rates, but the supply cannot chance, so prices of the the interest rates have to increase, which drives up inflation.

  4. Beatrice Benderon 17 Mar 2011 at 7:38 pm

    1. What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?

    GDP is adjusted to inflation while Nominal GDP is not adjusted. Nominal GDP also represents the current prices of goods and services. In order for the economy to be in a recession the real GDP needs to decline.

    2. What impact do rising energy prices have on the behavior of individual firms?

    Rising energy prices will effect the behavior of the individual firms. The costs of production will increase and firms will be more attentive when purchasing supplies . Firms might also increase the price of their products.

    3. Why are low interest rates likely to make the inflation problem even worse?

    Low interest rates are likely to make the inflation problem even worse, because this will eventually increase the demand for certain goods or services. Meanwhile the amount of supply will not have changed indicating that the demand for goods is higher leading to an even greater inflation. It would only increase the inflation problem.

  5. Orpa Alamon 18 Mar 2011 at 10:10 am

    1. Nominal GDP is the GDP before is is adjusted for inflation where as Real GDP has been adjusted for inflation. In order for there to be a recession the real GDP must decrease, because the inflation must increase for the to be a recession.

    2. If the the energy prices increase the firms will adjust their expenses. They can do so by decreasing production, increasing price on their product or using more energy efficient methods.

    3. Low interest rates are likely to make the inflation problem worse, because lower interests leads to high demands for interest rates. Since the supply doesn't change, and demand increases causing it to move up the supply line. This then will lease to an increase in the inflation rate and unless some thing is done to change that, will continue to worsen the inflation problem.

  6. Matt Burnhamon 18 Mar 2011 at 10:42 am

    1. What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?

    – Nominal GDP is the calculation of national output using the quantity of the produced goods multiplied by the prices of that year. Real GDP is the same calculation of national output but is adjusted for inflation. Real GDP must decrease for their to be a recession.

    2. What impact do rising energy prices have on the behavior of individual firms?

    – The costs of production will increase and firms will have to pay more for the upkeep of capital.

    3. Why are low interest rates likely to make the inflation problem even worse?

    Low interest rates means consumers will want to borrow more from banks to buy goods, but the supply would not have changed making the inflation worse.

  7. Maphrida Forichi andon 19 Mar 2011 at 11:18 am

    1. What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?

    -Nominal GDP is a gross domestic product (GDP) figure that has not been adjusted for inflation whereas the Real GDP is an inflation-adjusted measure that reflects the value of all goods and services produced in a given year. In order for recession to occur, the Real GDP must decline

    2. What impact do rising energy prices have on the behavior of individual firms?

    -Rising energy prices will increase the costs of production for individual firms, which will forcefully increase the cost of the final product or service for the consumers

    3. Why are low interest rates likely to make the inflation problem even worse?

    -Low interest rates would make the inflation problem worse because the demand for interest rates would then increase. However, the supply would not meet the demand, and because of this the price for interest rates would increase and worsen inflation

  8. Alexandre Kleison 19 Mar 2011 at 12:08 pm

    1. What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?

    Nominal GDP is the value of all goods and services in a country during a certain period of time. The real GDP is adjusted to inflation, whereas the nominal GDP is not adjusted to inflation. In order for the economy to be in a recession, the real GDP must decline.

    2. What impact do rising energy prices have on the behavior of individual firms?

    An increase in the energy price for an individual firm will increase their costs of production. This means that there will mostly likely be an increase in the price.

    3. Why are low interest rates likely to make the inflation problem even worse?

    Low interest rates are likely to make the inflation problem even worse since lower interest rates will lead to a higher demand to borrow money. The supply being fixed, it means that the demand will increase leading to a higher inflation rate.

  9. Penelopeon 20 Mar 2011 at 11:02 pm

    1.What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?

    Nominal GDP measures the value of all the goods and services produced in current prices. Real GDP is inflation subtracted by the nominal GDP rate. In order for the economy to be in a recession inflation must increase, which means that there must be a decrease in real GDP.

    2.What impact do rising energy prices have on the behavior of individual firms?

    Rising energy prices would increase the individual firm's private costs such as the production.

    3.Why are low interest rates likely to make the inflation problem even worse?

    Low interest rates will cause a high demand for these rates. As a result of the high demand, the interest rates will have to rise which would mean it will be undersupplied causing even worse inflation.