The Risks of 21st Century Stagflation

Jayati Ghosh

Well before the global financial crisis finally broke in September 2008, most people in developing countries were already reeling under the effects of dramatic volatility in global food and fuel markets. From late 2006, prices of most primary commodities first increased very rapidly, then collapsed even more sharply from their peaks in May-June 2008.

This was not due to real economic forces, but rather financial activity, specifically the involvement of investors in index funds. Commodities emerged as an attractive investment avenue for financial investors from around 2006, when the US housing market showed the initial signs of its ultimate collapse. This was aided by financial deregulation that allowed purely financial agents to enter such markets without requirements of holding physical commodities. This generated a bubble, beginning in futures markets that transmitted to spot markets as well.

From mid-2008 commodity prices started falling as index investors started to withdraw, accentuated by the global recession. But the fall proved to be quite short-lived, as prices started rising again from early 2009, even before there was any real evidence of global output recovery. The price increase between Dec 2008 and Dec 2009 has been 16% for all food items as a group, 96% for metals and as much as 110% for oil.

Once again, this increase does not reflect real economic forces: global demand and supply for most commodities remain broadly in balance. The recent price increase, as before, reflects heightened speculative activity in commodity futures. Such speculation is currently encouraged by low interest rates, combined with the immense moral hazard generated by financial bailouts, which have made the appetite for risky behaviour much larger.

Obviously this is bad news for most people in the developing world, since the international transmission of prices has been rapid for rising prices but not marked in periods of falling prices. The benefits of price increases do not reach the direct producers, even as consumers (already hit by stagnant wages and falling employment) suffer from higher prices.

But there is also a broader macroeconomic implication: the possibility of stagflation. The global stagflation of the 1970s was associated with cost-push inflation related to oil price shock and wage increases, within a context of low interest rate policy in the wake of recession. The underlying processes were national and global conflicts over income shares. This was eventually resolved in the 1980s by monetarist policies that suppressed real wages and led to falls in primary commodity prices.

It could be argued that such stagflation is not possible today because, even if  prices of primary commodities increase sharply, large excess capacity in manufacturing and weak bargaining power of workers will prevent other prices from going up to create a generalised inflation. But it may be possible to have cost push inflation pressures even with these other features.

Consider the following possible scenario. Because commodities are seen as “safe havens” or because of inflationary expectations, financial speculators in commodity markets drive up futures and (indirectly) spot prices. This leads to declining purchasing power of prevailing money incomes. While high unemployment may prevent workers from demanding increases in money wages, they may resort to credit-financed consumption instead, which would be enabled by easier credit policies. This may generate a price spiral that neutralises the attempt to preserve real wage incomes, leading to rising price levels with stagnant or volatile income growth – in other words, stagflation!

This threat of stagflation is not based on excessive government deficits and loose monetary policy. So macro policies like raising interest rates will be counterproductive. Instead the focus has to be on specific actions to control commodity prices. Strategies include preventing financial players from involvement in commodity futures markets as well as banning over the counter derivatives trading in futures.  Commodity boards, buffer holdings and other measures to stabilise prices are also important to ensure cheaper access of developing countries to supplies of such commodities.

If such stagflation does occur, it will reflect the attempt of the global financial class to increase its share of global income even in the wake of financial crisis. Most of the declining share would then be of wage incomes especially in the developing world. Therefore attempts to resolve this in a less oppressive way require a reduction of the political power of finance.

Such a political consensus in favour of restricting finance is unlikely to occur without even more extensive economic crisis. As it happens, this is still very much in the cards.