I Fear Stagflation and Price Controls Are Coming
I’ve never seen much merit in Real Business Cycle theory. I’ve long accepted the standard Keynesian view that high unemployment is a grave evil – not an optimal response to adverse conditions – and that recessions are almost entirely caused by declines in Aggregate Demand. The Great Depression was not a Great Vacation; it was a disaster caused by the fatal combination of nominal wage rigidity and falling Aggregate Demand. Yes, Aggregate Supply matters too; indeed, Aggregate Supply is virtually the only thing that matters for long-run prosperity. Yet Aggregate Supply explains little about short-run business fluctuations, because Aggregate Supply rarely sharply changes in a year or two. Even the infamous 1970s oil shocks were tiny relative to GDP.
I hate to say, “This time it’s different.” I’ve repeatedly bet against such claims. Alas, this time probably is different. The sudden shutdown of enormous sectors of the U.S. and global economy clearly constitute a massive short-run fall in Aggregate Supply. While Aggregate Demand is going to fall too, this time Aggregate Supply fell first. This time, tens of millions have effectively begun a Great – but Sad – Vacation.
This combination is almost unprecedented. Countries at war have often faced a combination of falling Aggregate Supply and rising Aggregate Demand – primarily when they’re being invaded. But falling Aggregate Supply and falling Aggregate Demand simultaneously? Weird indeed.
Weird, but not exotic. We can analyze it with the standard textbook model. When AS and AD both fall, GDP definitely falls. Theoretically, however, inflation could either rise or fall. This in turn largely depends on the relative size of the shifts. If AS falls a little and AD falls a lot, we can count on the familiar pattern of low inflation or even deflation (which we briefly experienced last time around). If AS falls a lot and AD falls a little, in contrast, we should expect a return of stagflation – high unemployment and high inflation simultaneously. The same holds if AS falls enormously and AD “only” falls a lot. Like so:
The upshot: Though I’m not ready to bet on it, I fear that in 2021 we will see not only high unemployment but high inflation as well. (Complication: Official statistics may classify disemployed workers as “out of the labor force” because they’re too scared to hunt for a job). At this point, I would not be surprised by 10% unemployment and 6% inflation for 2021.
Yes, we should never forget base rates. Stagflation hasn’t happened for decades, so we should be skeptical about its imminent return. And yes, we should be ever-mindful of focusing illusion; as Kahneman explains, “Nothing in life is as important as you think it is, while you’re thinking about it.” I’m thinking about coronavirus most of the time now, so I tend to overrate it. Yet even taking these biases into account, I readily believe that we’ll have stagflation next year.
How bad will the inflation be? Again, I share the standard Keynesian view that moderate inflation by itself is no big deal. Yet the public outcry against even high single-digit inflation will be deafening. Historically, governments have a standard response to such outcries: economy-wide price controls. Richard Nixon imposed them in 1971 when inflation was only 4.4% and restaurants were open. If and when the government does impose price controls, the textbook tells us what to expect: Ever-growing shortages, rationing, black markets, and anti-business witch-hunts. We see this when government merely caps the price of a single good, such as apartments. When government caps the price of everything, we face dire economic chaos. Like so:
Optimists will say, “Price controls?! Come on, U.S. policy-makers learned their lesson last time.” I cannot assent. Few policy-makers even remember the 1970s. Many of those who do remember what happened failed to absorb the textbook explanation. Many of those who absorbed the textbook explanation at the time have forgotten it. And once price controls get on the agenda, the few policy-makers who know the damage they’ll cause will probably go with the demagogic flow. I doubt even the CEA will loudly protest: “Price controls would normally be a bad idea, but given our nation’s ongoing emergency…”
Tell me I’m wrong, please.