The crisis that is quickly manifesting itself across the developed economies has many features of the classic supply-side crises of the 1970s and 1980s. The question is, what can we learn from the remedies used decades ago, to select the policies that could bring us out of today´s crisis?
By now there is no doubt that the developed economies have entered a period of stagflation. While consumer prices have continued to accelerate to the highest levels seen in more than a decade in some countries, other indicators show that the United States, the United Kingdom and even Spain may already be in recession. The combination of stagnation and rising inflation is familiar from the experience of the 1970s and early 1980s.
In addition, some of the same factors that drove the stagflation of 20-30 years ago are present, especially the spectacular increase in petroleum prices, which now are about 200% above their 2001 level in real terms. Higher energy prices filter through into all sectors of the economy, setting off a leftward shift in the aggregate supply curve that causes inflation to persist even as the cycle turns downward.
How should governments respond? In the 1980s we learned about the effectiveness of supply-side policies –those policies that help reduce production costs and shift aggregate supply back out to the right– which included wage restraint, cuts in corporate taxes, deregulation and privatization and other policies to soften production costs. These policies help to stimulate growth while at the same time taming inflation, giving us the best of both economic worlds at the same time.
However, supply-side economics achieved its spectacular results in the 1980s and 1990s partly because oil prices declined sharply in real terms starting in the early 1980s. In turn, the reason that oil prices fell was that the geopolitical elements that caused them to rise –OPEC´s new strength as a cartel and the boycott of the U.S. market for political reasons– were reversed in the early 1980s. Soon after the middle of the decade, oil prices were heading back to historical lows in real terms. Without this welcome behavior in oil prices, supply-side policies might have had a limited effectiveness that would have been observed only in the medium and long term.
Oil prices are unlikely to repeat the performance of the 1980s. They have reached current levels partly due to speculation and supply shortages that could be reversed, but also due to structural increases in demand proceeding from developing countries. Once China, India and other emerging countries pass the GDP per-capita threshold where average consumers being to acquire cars, demand is unlikely to fall back to previous levels in the short term, and perhaps not even in the long term.
So how can governments respond to today´s stagflation? Obviously, Keynesian-type demand management policies will have only a limited effect, and will force policymakers to choose whether to focus on inflation or employment. Supply-side policies are the best option. But without the cooperation of petroleum prices, they are unlikely to offer a quick or painless exit from the current crisis.
However, long-term consumer and policy orientations toward more efficient fuel use, better access to alternative energy sources, greater productivity and possibly even slower long-term growth would be the appropriate responses to a crisis like this one. These solutions will not offer a quick remedy either, and they are far from painless.
But responding to today´s stagflation with these types of policies would kill two birds with one stone, as the saying goes: it could help us to emerge from our stagflationary crisis, and it could at the same time put the world economy on a more sustainable growth path, thus helping address the major economic challenge of the 21st century.