Inflation is high at present. Assessing to what extent this is due to demand overheating or supply shocks is essential to formulating suitable policy responses. This requires delving into past data and debate. A prominent view is that inflation in 1974-75 and 1979 was caused by Opec (Organization of Petroleum Exporting
Countries) supply shocks. Leading macro texts state that the huge, unexpected rise in unemployment and inflation in 1974 worldwide was due to Opec’s sudden actions. Leading macroeconomic texts expound this view. When discussing oil prices now, most recent economic commentary across the world starts with the 1970s’ Opec supply shocks.
Graphic: Ahmed Raza Khan / Mint
However, this conventional view is severely flawed. An alternative explanation of the 1970s’ outcomes that fit various facts much better is outlined below.
To evaluate what happened, let us review the basic facts as generally perceived. In October 1973, following the Arab-Israeli conflict, Opec raised the price of a barrel of crude oil, then at $3, almost fourfold. By 1975, the world economy slowed the most since the Great Depression, with Japan’s GDP falling for the first time since World War II. Similarly in 1979, following another West Asian crisis in Iran, Opec raised crude oil prices. Once more, both rising inflation and unemployment, or stagflation, ensued.
However, evidence indicates that what appeared to be the Opec-induced supply shock was a delayed, catch-up response to rising inflation. Under demand stimulus from the Vietnam war, the US economy was growing rapidly. The prevailing Keynesian policy under Democratic president Lyndon Johnson was to tolerate a bit more inflation to reduce unemployment. With the unemployment rate below 4% from 1966 to 1969, and crucial prime-age male unemployment below 2%, inflation was creeping up.
Economist Milton Friedman had warned from April 1966 onwards that the economy was overheated. Both he and Edmund Phelps argued that, as unemployment would return to its natural rate, inflation would also rise — in other words, stagflation.
This stagflation outcome was correctly predicted by the Friedman-Phelps-expectations-augmented Phillips curve theory. To compensate for the past rise in inflation, or because they expect higher inflation, workers will demand and get higher money wages. As the supply curve of labour shifts up, both inflation and unemployment will rise. Indeed, between 1968 and 1970, unemployment rose from 3.6 % to 4.9% while the consumer price index (CPI) inflation rose from 4.7% to 5.6%, and core inflation also rose in the US. But this mini stagflation of the 1960s, well before most people heard of Opec, went unnoticed.
Since US inflation was higher than Germany’s at the fixed exchange rate, gold started being shipped out of America, at $35 an ounce, the peg of the Bretton Woods system. This Bretton Woods gold exchange standard ended when US president Richard Nixon closed the gold window in December 1971. Under pressure from rising US inflation and its current account deficit, the US dollar kept falling. By 1975, the world had moved to floating exchange rates, without any gold backing for currencies.
Wage-price controls were imposed in 1971 and 1972. Hence, the tendency for inflation to rise along with unemployment, due to the Phillips curve shifting up, was suppressed. When these controls were lifted, inflation soared. Between 1973 and 1974, unemployment rose from 4.9% in 1973 to 5.6% in 1974, while CPI inflation soared from 8.7% to 12.3%.
Arguably, without these controls, the stagflation would have been clearly manifest by 1972. As it transpired, these developments before 1973 were overshadowed by the fourfold Opec price hike — the apparent villain of the piece.
However, even before Opec’s October 1973 whammy, world commodity prices were rising. Oil and commodities were, and still largely are, invoiced in US dollars in global markets. To offset the impact of a weak dollar on their real earnings, commodity producers from other countries raised prices — similar to workers getting higher money wages to compensate for higher inflation.
Since most commodities are largely traded in fairly competitive markets, they normally respond to both demand pressures and a falling dollar gradually, and fairly soon. However, for oil, due to the cartel’s price fixing behaviour, prices were stable for some time, despite a weaker dollar, followed by a huge hike to make up for it. As none other than Sheikh Zaki Yamani, the powerful Saudi minister and chief Opec strategist of the 1970s, remarked, oil prices are determined by “the divine laws of supply and demand”.
The collapse of crude oil to below $10 a barrel in mid-1986 is noteworthy. Following the disinflation under Federal Reserve chairman Paul Volcker, the dollar doubled against the German mark over five years, reaching a peak in February 1985. Despite a moderately robust US economy in 1986, the strong dollar broke the cartel’s pricing power in 1986.
Space does not permit looking at the differences in oil price determination and its macroeconomic impact now versus the 1970s. However, the underlying situation is broadly similar. The serial tsunamis of liquidity unleashed by former Fed chairman Alan Greenspan have spread globally, aggravated by the dollar peg or semi dollar peg policy of most emerging economies, notably the big ones (China, the Gulf countries and India) until recently. The world economy is now paying the price — this is not a supply shock imported from Mars.
Postscript: The above approach, which I have taught for more than a decade, has more recently been outlined by economists Robert Barsky and Lutz Kilian in academic journal articles.
Vivek Moorthy is professor of economics at IIM Bangalore. Comments are welcome at firstname.lastname@example.org