Number 139, April 2008. Jayati Ghosh
There is no doubt about it: the US financial structure is crumbling, possibly even collapsing. The collapse of a major Wall Street bank and the enormous bailouts that are being offered to financial institutionsin the US by the US Federal Reserve are only symptomatic of the wider crisis created by the unravelling of the real estate boom based on dodgy lending practices.
Everyone knows that what has already come out is only the tip of the iceberg. The financial crisis has clearly spread quite dramatically: from “sub-prime” borrowers to “prime” borrowers; from bad mortgage debt to bad credit card debt; and from banks to hedge funds to insurance companies. There is no doubt that there is much more bad news to come within US markets. And most certainly, given the sheer size of the US system and the complex forms of financial pyramiding and entanglement with other financial structures in different countries, the global financial system will feel the impact.
There is also little doubt that the US economy is heading into, if not already in, a major economic recession. The economic data from the last two quarters is poor, and the prognosis is worse. In the last quarter of 2007, the US economy grew at only 0.6 per cent, and much of that increase was due to higher exports rather than domestic demand. Retail sales have declined in the first two months of 2008 compared to the previous year.
The most recent employment data show that the US lost 63,000 jobs in February 2008, following a fall of 22,000 in January. Initial claims for unemployment have been rising and have already reached levels associated with previous recessions in 1990 and 2001.
Indeed, such figures suggest not a mere recession but even a more substantial depression is in the offing for the US. This is likely to intensify as the effects of the housing foreclosures and worsening financial position of households combine with rising unemployment to create significantly reduced consumption demand. Investment will suffer not only because of the reduced assessments of future market demand but also as the financial crisis makes it harder to access finance for new investment. And so the elements of the downward spiral are all in place.
And here too, the rest of the world will feel the impact, as the large economy whose voracious demand for imports had fuelled the most recent global economic expansion stops being an engine of growth. So there is no doubt that world output growth will be adversely affected, particularly in those countries (such as China) that had been growing
rapidly on the basis of rapid increases in exports to the US.
The collapse of the US dollar vis-à-vis other major currencies is not only related to these troubles; it also reinforces them, while simultaneously generating cost-push inflationary pressures within the US by making imports more expensive. Import prices have increased by nearly 14 per cent in the year to January 2008, which is the fastest increase
since such data began to be published in the early 1980s. As a result, there is evidence of greater inflationary pressure already at work. The year-on-year producer price index in February rose by 7.4 per cent, making it the biggest increase in more than 26 years. In the past three months, the consumer price index increased at an annual rate of 6.8 per
This combination of stagnant or falling output and rising prices is why more and more economists and analysts in the US have started using the dreaded S-word – stagflation – to forecast the immediate future of the US economy as well as the world economy. This immediately brings to mind analogies with the period of the 1970s, when not only the US but the entire world economy suffered a prolonged period of income stagnation and even decline and increased unemployment, accompanied by rising price levels. At that time, the rise in oil and other commodity prices combined with attempts by workers in developed countries to maintain their real wages in the face of rising costs of living generated inflationary spirals, and economic volatility and depressed investor expectations caused real output and employment to stagnate.
The stagflation hypothesis appears to be reinforced because the current period is also a time when global commodity markets are experiencing some of the highest prices ever. Crude oil prices, at more than $111 a barrel in the middle of March, are higher in real terms than they were at the height of the oil shock of the 1970s. Other commodities such as metals have been showing very high and rising prices for the past year.
World wheat prices are also at record highs, hit by falling output (because of acreage shifts in the US to biofuels, along with bad weather conditions in major exporting countries like Australia and Canada).
And now gold prices have hit record highs, crossing $1000 per ounce in early March. This is something that typically happens when inflationary expectations are high, as investors seek safety in real assets rather than financial assets, and gold remains the most convenient of such commodities.
So does all this suggest that not only the US but the entire world economy is heading towards stagflation? The answer may well be yes, but not for the reasons that are generally being offered by many analysts. Several economists have offered an essentially monetarist analysis of stagflation, whereby it is brought about by central banks trying too hard to prevent recession, and thereby keeping interest rates too low and monetary policy too loose. According to them, this creates an excess of money supply, which then generates higher inflation. Instead, they argue that if the Fed holds its nerve and simply tightens its monetary policy in the face of rising price levels, then inflation will be
brought down even at the cost of some temporary pain in the form of a recession.
Remember that the essence of stagflation is a prolonged combination of stagnant income and rising prices, rather than a stagnation that has a temporary rise in inflation followed by a more widespread deflation. While there is no question that aggregate world incomes will grow more slowly than they have in the recent past, whether or not there will also be rising inflation depends not upon monetary policies and the attempt to control money supply, but on the ability of different groups in the economy to maintain their distributive shares.
That is because inflation in modern economies is essentially about two forces: the fight over distributive shares in national income by different groups, and the role of expectations about inflation. Thus, if there is a rise in commodity prices (that would increase the relative income share of commodity producers) then this will only lead to a rise in the general price level if capitalists insist on maintaining their margins over costs at the same level. If they are unable to do so for any reason, then the rise in commodity prices need not translate into a generalised inflation.
Similarly, if the initial rise in prices pushes down real wages and workers are not in a position to demand increases in nominal wages that would maintain their real wages, then the inflation is controlled. Tight monetary policies are usually a way of enforcing this by allowing greater unemployment, so they work indirectly rather than directly to
control inflation. So inflation reflects a wider fight over income distribution.
Expectations add another dimension to this, by making different agents behave in ways that are determined by their anticipation of future inflation. If higher prices are anticipated, producers and retailers will set their prices higher to absorb such expected effects, and workers will scale up their demand for nominal wages. In this way, the
expectations become self-fulfilling and create an inflationary spiral that becomes hard to break.
Therefore, whether or not there will be stagflation depends ultimately on international political economy and the relative strength of different groups in the world economy. It may be argued that working classes and peasants have been so weakened by the onslaught of neoliberal policies of the past two decades that they are in no position to fight to maintain even their already significantly diminished shares of income. If this is true, then the likelihood for the immediate future is an economic recession with worsened conditions of living and higher unemployment across the world, albeit with lower rates of aggregate inflation.
But if the world has changed in other ways that make further attacks on people’s livelihood more difficult in most countries, then the current crisis may well become an opportunity. A period of stagflation and generalised capitalist crisis could augur a different global political economy and more creative approach to economic policy making, in which rapacious profit making is restrained and ensuring better material
conditions for the majority becomes instead the basic policy priority.
This is not as far-fetched as it may sound. The 1970s may be remembered with fear and loathing by finance capital, but they were also a period in which several developing countries began the industrialisation process that culminated in the “success stories” of east Asia and elsewhere. And surely the destructive tendencies of the most recent
phase of capitalism require a shift in economic strategy in a more democratic direction, which can only be enabled by the clear collapse of the existing strategy.
* Jayati Ghosh is Professor of Economics at the Centre for Economic
Studies and Planning, Jawaharlal Nehru University, in New Delhi, India.
She is on the executive committee of the International Development
Economics Associates (IDEAS), a network of economists critical of the
mainstream economic paradigm of neo-liberalism.
April 8, 2008. © International Development Economics Associates 2008