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What’s this cross-breed called stagflation?

What’s this cross-breed called stagflation?
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First Published: Mon, Jul 16 2007. 01 35 AM IST
Updated: Mon, Jul 16 2007. 01 35 AM IST
The 1970s saw the emergence of a new disease in the world economy. Some ingenious mind named it stagflation—a cross-breed of stagnation and inflation.
Today, the world economy is once again debating the possible comeback of this scourge. Is stagflation around the corner? We may not yet know the answer for sure.
But our friends, Jinny and Johnny, are busy today in putting this disease under their microscope.
Johnny: I received an email today from a friend, asking what stagflation is all about. My guess is that it is some kind of coded message, which you send to your partner: STAy with your Girl Friend at the same LocATION. What do you say?
Jinny: You should not be joking about a serious disease. Stagflation is a deadly combination of two evils, stagnation and inflation. It is just like a patient suffering from constipation and high blood pressure at the same time. Both problems are equally bad. Most commonly, we hear about high growth rates and high inflation. But stagflation proves this old wisdom wrong.
You have high inflation, declining growth and consequently, high unemployment all existing together. What would you do?
Johnny: I am neither a doctor nor an economist. I would simply pray.
Jinny: Well, handling stagflation no doubt poses a serious challenge. Stagflation leaves you fit for neither laughing nor crying. You are not sure which problem to tackle first, stagnation or inflation. It is just like your doctor not able to decide which of your diseases he should treat first, constipation or high blood pressure. If you start whipping inflation too hard, it may have a two-fold effect. On the one hand, it may cool off some of the heat of inflation, but on the other hand, it may also lead to further slowdown of the economy. Your growth rate is already in a bind. Any tightening of monetary screws for controlling inflation may push the stagnation from bad to worse. Imagine what will happen if, due to monetary tightening, the growth rate comes down further without any corresponding fall in inflation. You would be caught in a stagflation trap. It is just like your doctor asking you to change your food habit to cure your high blood pressure. But the same, instead of curing blood pressure, results in further constipation. You may think that you should take care of the problem of stagnation first. But even if you decide to tackle the problem of stagnation first, you may end up in further trouble. Anything done for stimulating growth may further stoke the fire of inflation. Now you realize that you are caught between the devil and the deep blue sea.
Johnny: My God! Now tell me, what causes stagflation?
Jinny: There are more than half-a-dozen economic theories that explain the causes of stagflation. I am not going to confuse you further by talking in terms of an economist or a pathologist. Let’s take a simple approach. There could be many reasons. It is believed that the stagflation of the 1970s, most prominently seen in the US economy, was the outcome of price shocks of inputs like crude oil. If your economy is structurally weak, then even a minor external shock is likely to jolt your nuts and bolts. Some of your uncompetitive industries will have to shut shop because they can’t sustain production due to rising input costs. Those who manage to survive will be able to produce lesser number of goods at a higher price. The net result is a decline in production and rise in unemployment and prices. Some economists are of the view that excessive government regulation causes structural weaknesses resulting in the failure of the overall market to allocate goods and services efficiently. If the growth is hampered due to structural weaknesses, any attempt by the central bank for spurring growth by increasing money supply can lead to a counter-effect of rising prices.
Johnny: But what is the remedy for stagflation?
Jinny: There is no ready-made remedy for stagflation. It depends on what situation you are in. However, traditional remedies suggest the use of structural reforms and a sustained tightening of monetary screws at the same time. Tightening of money supply will further slow down the growth in the short run. But you try to counterbalance the same by removing the structural bottlenecks of your economy so that the full potential of growth is achieved. You gear your economy to face the external shocks more comfortably. All these remedies sound fantastic. But only the actual testing time will tell whether they are going to work or not.
Johnny: That’s true, Jinny. Only the actual test will tell whether the suggested remedies are successful. But I think one should not stop eating merely due to fear of constipation or high blood pressure.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at realsimple@livemint.com
What: Condition of high inflation, high unemployment and declining growth, also known as stagflation.
Why: Stagflation is caused due to many reasons like abrupt rise in the cost of production due to external shocks, structurally weak domestic economy, et cetera.
How: Dealing with stagflation requires simultaneous handling of both inflation and stagnation.
Whom: Rising prices and high unemployment directly affect the people at the bottom of the pyramid.
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First Published: Mon, Jul 16 2007. 01 35 AM IST