Stagflation Is Back

As I have explained recently, inflation is here in both consumer and producer prices. I have also pointed to the low employment level: if we had the same share of the population working as we had this time in 2019, another 5.6 million Americans would be working today.

That would make a major impact on government finances, state as well as federal:*

  • If 5,662,000 unemployed stop collecting an average of $525 in weekly benefits; and
  • If the total taxable economic value they produce is worth $66,450 per year; then
  • The total gain from reduced costs of benefits and increased federal and state tax revenue would equal $305 billion per year.

This estimate is a static, fiscal calculation and does not include multiplier effects from increased consumer spending. It is also based on a straightforward assumption that the total taxes on the added economic value equal ten percent of that value. In reality, the static fiscal gains are likely to be higher, and dynamic gains – factoring in the multiplier effects – much higher.

Sadly, we are not going to see this gain in employment any time soon. The Biden administration and the Democrat majority in Congress seem to be deadset on adding more deficit spending to an already unsustainable budget. There is some resistance from the Republican side, but with the exception of Senator Lummis (R-WY) and a few others, that resistance is not as vocal and as substantive as it needs to be.

Instead of moving back toward the full employment we had in 2019, we are going in the opposite direction. As inflation rises, it has increasingly negative effects on business activity. Costs of production and investment will rise, throwing a wet blanket over capital formation; optimism about the future is gradually perforated by pessimism. As businesses change focus from expansion to survival under higher and less predictable costs, they gradually shift from creating more jobs to making do with the workforce they have.

The significantly slower pace of jobs growth in August and September suggests that we have already reached this point. What comes next is a decline in employment. And this, I am sad to say, is the really worrying part of the story: when inflation is high and unemployment on the rise, we have stagflation.

Figure 1 explains the relationship between unemployment and inflation, but in terms that are more solidly anchored in economic reality. Instead of unemployment, I have used the rate of employment, or the number of employed persons out of every 100 people in the workforce-age population. This is a more accurate gauge of the state of economic activity: when the economy gets really bad, a lot of unemployed simply leave the workforce. Bluntly, we can have a relatively low rate of unemployment and still be in the midst of a serious recession.

On the side of inflation I have replaced consumer prices with producer prices. This variable more accurately represents the information set upon which businesses make employment decisions; the higher the inflation rate in producer prices, the less inclined businesses are to hire more people.

Figure 1 reports a total of 885 pairs of data for these variables. They cover every month from 1948 through September 2021; sorting the observations based on PPI inflation (red) we can identify three interesting correlative segments:

Figure 1

Source of raw data: Bureau of Labor Statistics

Starting from the right, there are periods of economic activity that combine declining producer prices with a rising employment share. These periods are usually connected with strong growth in labor productivity and the incorporation of new technology into manufacturing and the production of services. They can also be driven by expanded competition on growing markets.

The mid-section of Figure 1 represents the “normal” state of affairs in a business cycle: rising employment is associated with growth in total absorption – spending by consumers and businesses – leading to upward pressure on prices; when total absorption weakens, so do price pressure and employment.

The left section, of course, is where our focus should be. When inflation surges and employment weakens, we have the exact opposite of a sound business cycle. We have stagflation.

In the set of data I used to produce Figure 1, there are approximately 100 months that solidly fall within the stagflation section, and approximately another 100 on its outskirts. We have only had one significant experience with stagflation, but the number of months it covers tells us that once stagflation shows up, it will stick around for a while.

Figure 2 reports data similar to that in Figure 1, but chronologically. It also replaces the employment ratio with unemployment, in order to make the time line more familiar to students of economic trends. Behold five distinct periods and how they sort into the three categories in Figure 1 (PPI is measured on the left vertical axis):

Figure 2

  1. This is the growth phase of a regular business cycle, with a slow increase in the PPI inflation rate and steadily declining unemployment.
  2. Stagflation. The usual definition of this period of time is that it began after the first oil crisis in 1973-74. However, there were signs of stagflation-style turmoil already in the early ’70s. Note also how unemployment does not rise steadily, but ratchets upward over an extended period of time. This is a sign of underlying structural problems in the economy, much like we have today.
  3. This is a leap-style growth period where inflation declines together with unemployment. Normally, a historic review of macroeconomic data from the 1980s and ’90s would separate these two decades, but they have so much in common that it makes sense to see them as one long phase of leap-style growth: deregulation and a major overall of the tax code in the 1980s; the big computer-based technological revolution in the 1990s.
  4. A shorter period than the previous, this is again a traditional growth period with gradually higher inflation as the economy increases its capacity utilization. Although the internet evolution continued, it did not have the fundamental growth effect that the ’90s tech revolution had; the Bush tax reform did not come close to the macroeconomic impact that the Reagan reform had.
  5. This is the tepid recovery from the Great Recession, which we sort under the “regular business cycle” category.

If stagflation sets root – and everything points to it doing so – we are likely going to be stuck with it for a number of years. Our ability to get out of it will depend on the presence of fiscal conservatism and political courage on Capitol Hill.

Not a very comforting thought, is it?

*) The numbers used here are based on averages for each variable, estimated from most recently available data from the Bureau of Economic Analysis (income, value added, government finance) and Bureau of Labor Statistics (employment).