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.

9 Responses to “The Risks of 21st Century Stagflation”

  1. J. George says:

    First of all congratulations on launching this triple crisis blog and indeed is a timely creation. The financial market driven machinations on the commodities has been rightly highlighted as it has severe ramifications on the production landscape. For instance,under record breaking headline food price inflation in India the commodity trade sector raised or tried unsuccessfully to scuttle the monitoring by the Prime Ministers Economic Advisory Council.The misinformation campaign by these involved in the futures trading the standaoften quote a report that was paralysed by lack of data in the first place and a host of extraneous considerations in the second place.
    The oft prescribed recommendation to developing countries is to increase productivity in the agriculture sector while the pathways to doing that is fraught with ecological damages. The recommendations/exhortations of Secretary Clinton to the World on the World Food Day on 16th October 2009 is a csase in point. The factory farm’ model of ‘productivity’ gains therefore is flawed as it only suits the big processing units with considerable financial muscle. The question did not get highlighted at the Copenhagen but the key is financing the mitigation as well as adaptation strategies. I am sure these issues will be part of the discussion on this blogs Best of luck and happy blogging.

  2. Daniel S. Zbytek says:

    Thank you, it is a crucial point in a global economy that financial realm departed from a real one establishing itself as independent. Crisis of 2008/9 has shown enormous waste of money but also confirmed that real economy investment in developing countries has been directed by profits to be gained in the developing world notwithstanding to the needs of the Third World and diregarding innovative needs of the Globe economy. New order in global ecomony is a must. Brgds

  3. Kevin P. Gallagher says:

    Though not as comprehensive as the full ban on OTCs outlined here by Ghosh, former US Fed Chairman Paul Volcker has taken the financial world by surprise this week by advocating for limits on the amount of derivatives trading that commercial banks can engage in with general deposits.

    Interestingly, what has quickly become known as the “Volcker Rule” was enthusiastically endorsed by President Obama and formed a core of the President’s State of the Union address last week. Since then however, the proposal has received only lukewarm support in the US Congress–even by members of the Democratic party.

    Many of us probably think that even the Volcker Rule doesn’t go far enough. But perhaps the most significant thing this development raises is the fact that President Obama is more open to a diversity of economic ideas than previously thought. Earlier this year both Larry Summers and Tim Geithner opposed Volcker’s ideas. Yet, they were sidelined by the President on this one, and even told to go out and defend it…

  4. Hi Jayati:
    I don’t disagree with anything you said substantially, but I think the risks of stagflation are less significant than what you suggest. Yes there might be some cost push inflation associated to commodity prices, but in contrast to the 1970s the labor movement is less strong and the sort of wage-price spirals that were central for inflation acceleration then are less likely now. I think the serious risk is that fear of inflation will be used to constrain the ability of governments to expand demand, and we’ll have to live with higher levels of unemployment for a long period.

  5. Jayati Ghosh says:

    Matias, You are right that wage-price spirals are less likely because of the poor bargaining position of workers today. But it is still possible to have commodity price inflation – and more specifically, food price inflation – along with stagnant or even declining output and employment. This is different from the 1970s stagflation but nonetheless there is no obvious trade-off between inflation and activity in this case. To stop this it is necessary to tackle the roots of this particular type of commodity price inflation, including through controlling speculative activity in commodity markets. I think the Volcker Rule does not even begin to solve this problem because many non-bank financial players are involved in commodity futures through OTC contracts – futures trading should be allowed only in regulated commodity exchanges with high margin requirements, and probably absolutely banned for some commodities.

  6. Sasha Breger Bush says:

    Thanks so much for this important discussion of commodity prices!

    I agree that there is a strong case for banning futures/options trading especially in food commodities. The government of India until very recently banned all options trading in the country as a means of limiting the sort of dangerous speculation that you reference above. The US has banned trading in certain commodities at certain times as well.

    I would be very concerned, however, if trading was allowed only “with high margin requirements” as is also suggested above. In my opinion, this will not do much to restrict the activity of commodity speculators. Margin requirements are generally only a portion of the costs borne by large traders, and for the most part these costs are manageable. High margin requirments will likely be most exclusive of smaller hedgers, smaller commerical actors trying to manage price risks on these markets. For about twenty years, development instituions like the Bank have made headway in linking up smaller, Southern actors to futures markets as a substitute for real efforts to socialize risk and improve economic security (e.g. exporters, millers and other small processors, small rural banks, and farmers are increasingly linked to both global and domestic derivatives exchanges). For this reason, raising margin requirements may have negative consequences for precisely the population that you are looking to help, while not restricting access for those you wish to.

  7. ML SONI, Asstt. Registrar,Indian Association for the Cultivation of Science, Jadavpur, Kolkata-India says:

    Thank you Ms Ghosh for clarifying the positon as outlined by Matías Vernengo. I do agree that high flier of commodity prices like essential food grains, oils, vegetables, fuels and other commodities of essential needs have paralysed the economy of the developing countries like India due to steep recession in the financial markets.The statement once made by Indian Agriculture Minister, that the rising price of sugar especially,can be controlled by controlled usage of it, would it not be a non-considerate view from the angle of ordinary people of any nation. The financial recession and descending mark of unemployment added the cause of inflation gloabally. Banning food trading or limiting it to stengthened margin only will help in the present scenario. The heavy expenses on security of celebrities-leaders, top bureucrats/technocrats and other diginitaries added with corruption at all most all levels,hiding black money and misusing the government funds in petty functions are also the factors in this context.

  8. […] del consumo y el hecho que la caída del precio de los commodities no fuera significativa, (ver artículo de Jayati Gosh) explican el porqué de la rápida recuperación de economía brasilera después la crisis global. […]

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