Krugman Revisits Stagflation

In an earlier post, I complained that the new discourse about full employment has failed to address the question of what went wrong with full employment last time. Specifically, I questioned the New York Times’s explanation of the Great Inflation as the result of Federal Reserve officials hell-bent on “push[ing] the labor market’s limits in the 1960s.” In a new post, Paul Krugman also raises doubts about the idea that stagflation was the poisoned fruit of “excessively ambitious macroeconomic policy.” Instead, he emphasizes “supply shocks” – increases in the price of oil and other commodities – “amplified by the widespread existence of cost-of-living adjustments in wage contracts.”

There are a number of things to say about this. First, this is a fairly common story about stagflation. The paper that apparently inspired Krugman’s rethinking, an estimate of Phillips Curve relationships between unemployment and inflation since 1978, does not actually provide direct evidence on the origins on the origins of the Great Inflation. Krugman seems to assume the Phillips Curve is historically invariable, so that the “very flat” Phillips Curve that the paper suggests for post-1978 data can just be projected back to the 1960s and earlier 1970s, an extrapolation that would then supposedly demonstrate that “overheating can’t explain the inflation surge” in the earlier period.

Another way of thinking about this would be to view Phillips Curve-type relations as historically and institutionally specific. In this case, you could not just project data from the 1980s backwards and expect it actually settle questions about the earlier period. In the figures below, reproduced from this paper, the venerable economist Stephen Marglin has shown that you can represent the relevant historical unemployment/inflation data as constituting several distinct curves. The implication is that the relationship between unemployment and inflation changes over time, based on institutional factors including class power. Notably, Marglin’s figures show that the 1956-69 curve is steeper than the 1973-83 curve, suggesting that Krugman’s proposed back-projection would be misleading.

To understand why the various curves take the shapes they do would require attention to historical events, rather than transhistorical generalizations. In this case, it is easy to find contemporary reports that the recessions of 1969-70 and 1973-5, not to mention the Nixon program of wage controls, had a restraining influence on wages.

A second point raised by Krugman’s post is the importance of supply shocks, especially oil, in the Great Inflation. There can be no question that the cost of energy contributed to inflation and, as the graph below indicates, the 1980s disinflation benefited from a collapse in oil prices.

Still, I think it is misguided to explain the 1970s as essentially a problem of oil crises. There are several reasons but the most basic is chronology. The first oil crisis began in October 1973. But inflation in the U.S. economy was already grave enough for Nixon to implement price and wage controls in August 1971. The word “stagflation” entered American usage during the 1969-70 recession. It was to this problem that the Nixon controls were addressed. Fed Chair Arthur Burns wrote in his journal in Nov. 1970 that “the country now faces an entirely new problem – namely, a sizable inflation in the midst of recession; that classical remedies for fighting inflation or recession will simply not do… new medicine is needed for the new illness.” So the oil crises have to be seen as an aggravating factor, not the original cause, of stagflation.

Krugman ends his piece with the question, “How do you ask someone to be the last worker to be unemployed for a mistake?” But it is not obvious what he believes the less mistaken policy alternative would have been at the time of the oil shocks. Back in 1983, Krugman was fully cognizant of the role of energy costs, but still believed that “creating excess capacity” (i.e. creating a recession) was the only possible solution:

The inflationary impact of the oil shock of 1979 forced the governments of industrial countries to make a hard choice. There were (and are) only three logically consistent ways to approach a situation of uncomfortably high inflation. The first is to learn to live with it, by indexing most long-term economic arrangements to more stable measures of value. The second is to try to legislate inflation down through some kind of incomes policy. The third is to reduce inflation by creating excess capacity in the economy.

In 1979 and 1980 there was virtually a consensus that only the last choice was workable. A policy of monetary (and initially fiscal) restraint was instituted with bipartisan support in the United States and similar if generally less dramatic steps were taken in most other major countries. The three-year global recession which followed can be viewed in broad outline, if not in detail, as a choice in which a remarkably wide cross-section of leaders in the industrial world concurred.