The economic shock of 2022: Is the global economy at risk of stagflation?

Earlier economists did not even believe it could exist, now it is threatening the world again…

It is said more and more often that after the 1970s, the world could plunge into stagflation once again. In the 2010s, we were used to high economic growth, low unemployment, low inflation and low interest rates, and even in 2020-21 we thought that it was only the epidemic that caused a temporary setback, but now it is becoming increasingly clear that that time is over.

When does stagflation occur?

The name is clear: stagflation occurs when the economy stagnates and inflation appears at the same time. As simple as this is, what lies behind the whole phenomenon is strange:
until the 1970s, masses of economists believed that such a thing could not exist, or at most only in theory. At worst, as a very short-lived, isolated incident. Until they realized they were living in such a time.

That stagflationary period lasted globally until the first half of the 1980s, and there is a debate about when the period started, with more pessimistic people considering the late 1960s and more permissive people the early 1970s as the starting point. In the US, for example, inflation was over 10% at the turn of the 1970s and 1980s, GDP was barely growing, even falling back in some years, and unemployment was close to 10%.

Since then, there has been much debate among economists about what exactly could cause such a situation. There is a broad consensus among the various theorists that a policy decision can do a lot to bring about stagflation. The crisis of the 1970s is a perfect example: the world economy could probably manage the oil crisis of 1973 and the now known as Nixon shock of 1971 separately with some shocks, but together they were too much.

Two crises at the same time

When the OPEC imposed an oil embargo on Western countries in 1973, it was a textbook example of a negative supply shock: the oil price skyrocketed, making practically everything more expensive, since cheap energy is important for agriculture and industry, as well as for freight transport. But this would have been just one more period of higher-than-usual inflation. However, it occurred two years after one of the worst economic recovery programs of modern times: In 1971, Richard Nixon froze wages and prices for 90 days, raised taxes on goods exported from the US by 10 per cent and denounced the Bretton Woods system, which had been the basis of the world’s financial system since the end of the Second World War. The end result was that politicians and investors in many countries lost confidence in the US, and speculation against the dollar began.

Why is this one of the biggest threats?

There can be many situations where one economic indicator is not so good, but others compensate, such as relatively high inflation usually occurs at the time of low unemployment. In a period of stagflation, however, everything is bad: there is a high increase of prices, the economy is not growing, and therefore there will be few new jobs after a while (at least there is no high unemployment for now, but if there is no growth, this danger may emerge in time). And to make matters worse, there is no painless cure.

Why did not they believe it was possible?

One of the star theories of the 1960s was the phenomenon known as the Phillips curve: it was deduced from the trends of the previous hundred years that when inflation is high, unemployment is low, and when unemployment is high, there is hardly any inflation. They were beginning to think that it was a “one of two” choice for governments, and then the crisis came along, and the fact that we had inflation and GDP stagnation and high unemployment at the same time contradicted everything that had been researched for the previous 15 years. It is typical of the popularity of the theory at the time that for years they tried to complicate the model to fit reality, until they realized that what was true for the previous hundred years was no longer true, and that there was no stable and predictable relationship between inflation and unemployment. The Phillips curve has become a hugely influential theory, although not in the way they originally thought; to date, seven Nobel Prizes in economics have been awarded for research that started from its refutation.

Is there a real risk of stagflation?

Absolutely. High inflation is already here – in 2021, a series of problems emerged at the same time, which even individually would have increased inflation. These included the rise of oil prices, governments spending more to speed up the post-crisis recovery, and of course the fact that almost every country in the world has simultaneously restarted life (and with it industry, trade and services in general) after the worst of the pandemic, putting a strain on global supply chains. Then came the Russian-Ukrainian war and the series of sanctions against Russia.

Of course, Russia is the country most affected by the sanctions, but the economic situation of the countries deciding on the punishment is not easy either. Uncertainty in the energy sector is hurting everyone, with oil and gas prices rising globally. Moreover, although Russia is not a rich country, it is a very important supplier: for example, the lack of Russian aluminum, nickel and palladium would cause a problem for almost every car factory in Europe. And although we do not usually think of Ukraine as the world’s main supplier, even the loss of its products can cause trouble in some sectors; for example, a significant part of Europe’s edible oil supply is based on Ukrainian sunflowers. Moreover, the prospects are not helped by the fact that Russia is on the edge of bankruptcy either.

Could there really be another recession this year after 2020?

In principle, stagflation should not even require a slowdown in economic performance, a barely visible increase of around 0 per cent should be enough, but there is a real risk that world GDP will fall again this year. Of course, we cannot take anything for granted: there is still a lot of uncertainty about the war in Ukraine. If a ceasefire could be reached quickly, some sanctions were lifted, global supply chains were restored to some extent and energy traders stopped fretting and thus driving up prices, there would be a chance we could get off easy.

But the current situation is very reminiscent of what we saw in February 2020. Then came a series of analyses of the problems the growing epidemic was causing to the world economy, the experts began to say that economic growth could slow down badly if it continued, and then some more pessimistic analysts even risked a global recession. And even so, everyone was surprised by how steep the recession ended up being. It is by no means certain that the same will happen now, and the starting point of the problems is completely different, but there is one very important point in common: for 21^st century economic policy to have a war in Europe, accompanied by sanctions of unprecedented severity, is as unprecedented as a pandemic bringing a mass of countries to a standstill.

What can be done about it?

Unfortunately, there is no such answer to this question that would bring an easy solution. In a more simple crisis, for example, it might help if governments start spending more to stimulate the economy – as happened in 2021 in many places around the world, including Hungary – but this leads to higher inflation, which everyone is trying to avoid. However, a central bank rate rise could in principle curb inflation and even strengthen the local currency, but the resulting increase in the cost of lending could discourage investors.

There is not much else to say at this point, except that governments and central banks need to decide what the most pressing problem is locally, and deal with that first, and then deal with the rest. In the US in the 1980s, for example, the Fed central bank decided to bring down inflation at any cost, and did so with interest rates well above 10%, sometimes approaching 20%. (The Fed has just started its rate rise cycle this week, with the benchmark rate now raised from the 0-0.25 percent range to the 0.25-0.5 percent range, and is expected to have a base rate approaching 2 percent by the end of the year.) Then, after the economy came around, monetary easing could follow. But this is just one example, there is no universal panacea against stagflation.

What can small countries do?

The answer to this question is no more hopeful than to the previous one, unless we accept “be hopeful” as an answer. The dilemma of central bank interest rate rise and government stimulus policy exists here too, complicated by the fact that many of the causes of the problems are too big for any one small country to do anything about on its own. It still makes sense to start with one problem at a time. And, of course, it is also important that if decision-makers cannot improve the situation quickly, they should at least not make it worse.