Economy – Stagflation makes a come-back

When it comes to the UK economy, the road ahead is shrouded in mist. For the best part of 10 years we’ve had an incredibly benign economy, both in the UK and for the large part, globally. But every sign seems to be pointing in the wrong direction; especially for growth, which is slowing, and prices, which are rising. Extreme episodes of this are referred to by economists as ‘stagflation’ and the last time we had to deal with it was in the 1970s.
Stagflation occurs when the economy isn’t growing but prices are. Not a good situation for a country to be in. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fuelling sharp inflation in developed countries.
Yet today we have oil costing $100 a barrel and food prices, according to the Economist commodity-price index, 30 per cent more expensive than last year. And to top it all, the Bank of England said in its last quarterly inflation report that the economy would slow in 2008 and inflation would accelerate.
The problem with stagflation lies in how to deal with it. Any economy is, by and large, controlled by two major tools – fiscal policy (how the government collects and spends taxes) and monetary policy (the relationship between the amount of money in an economy and the rate at which it can be borrowed). Those with their hands on these economic levers are then able to offer trade-offs between growth and inflation. A central bank can either slow growth to reduce inflationary pressures, or it can allow general increases in prices to occur in order to stimulate growth. Stagflation creates a dilemma in that efforts to correct stagnation only worsen inflation, and vice versa.
Yet the situation today is very different to the 1970s – not least because the fate of the world’s major economies are far more closely intertwined. For one, the UK is far less dependent on oil than it was in the 70s. Unemployment is a lot lower and our workforce a good deal more flexible. Perhaps the greatest difference, though, is that our appetite for high street spending, underpinned by rising house prices and growing consumer debt, has been prodigious.
However, many believe that house price growth will slow; to less than inflation at best and stagnate or shrink back at worst. This may then lead to the already heavily indebted consumers ‘feeling’ less affluent and therefore spending far less. While this is not necessarily a problem per se it is if spending falls so far that unemployment begins to rise. This can then lead to a highly damaging and rapid negative spiral.
As explained above, the banks would then look to ride to the rescue by pulling on the monetary policy lever, freeing the supply of money. This would, in theory, stimulate investment and at the same time allow the value of the pound to fall, boosting exports. But it would be a brave central bank which did this whilst inflation was rising.
Is stagflation a real risk? Possibly. Our economy is far more robust that it was in the 1970s but it is approaching an interesting and important crossroad. Sadly, for the first time in a long time, deciding on the right path, is not going to be very easy.