On the Economy: Economic déjà vu: ‘Stagflation’ resurfaces

Terrorism, security drive new version

“Stagflation,” a term coined by economists of the late 1970s to describe economic conditions then, might have us in its grip again. But this time around it’s the cost of security, rather than the cost of energy, that is driving it.

The word first described a period when the U.S. economy grew very slowly and inflation was very high. Real, as opposed to nominal, growth was negative in most years from 1974 through 1980. Inflation was higher than growth in GDP.

Stagflation in the ’70s resulted from structural changes in the economy. The OPEC oil cartel increased crude petroleum prices four-fold in 1973. Energy costs were a significant portion of production costs in many sectors of our economy. What’s a producer to do? The solution was to pass these increased fuel costs through to the consumer as price increases. Price increases are the basis of inflation. Prices increased rapidly in 1974-75 to make up for the Nixon wage-price freeze, to recoup higher energy costs and in reaction to worldwide crop failures.

The Federal Reserve chose to fight inflation by increasing the discount rate, driving up borrowing costs and causing investment decisions to be postponed. Wage increases didn’t keep up with inflation and consumers saw their purchasing power diminished. The United States’ competitive position in international trade suffered because the prices of our goods were increasing faster than those of our competitors in other countries.

The basic economic problem was that suddenly resources were misallocated. We were using too much energy relative to other productive resources and the mix had to change. The economy had to reallocate manufacturing inputs while holding production steady. This caused productivity to decrease as we produced the same amount of gross domestic product with a greater amount of labor and capital.

Terrorism link

The fear of terrorism — and the measures we are currently taking to ensure our safety — will cause a similar structural change in the U.S. economy. And it may cause the same stagflation effects: increased costs, price increases, lower productivity, wage increases, decreased consumer purchasing power, tighter credit, negative real growth and recession.

This adjustment process could last several years, subjecting the economy to multiple short recessions.

Immediate, short-run costs will increase the cost of production and lower productivity. Businesses will spend more on security, insurance, contingency disaster planning, health-care costs (stress, anthrax, etc.), computerized security systems, bomb detection, X-ray equipment and irradiation of packages.

The cost of transportation will increase substantially. There will be more inspections, both by vehicle operators and public servants. Transportation delays will become common.

Productivity suffers

These types of expenditures don’t add to productivity. Cost increases must be recovered from selling the same amount of goods and services. Prices will go up and consumers will pay more for the same level of consumption, forcing them to reduce expenditures if wages don’t keep pace with rising prices.

There will also be long-run cost increases. Businesses will be forced to carry higher levels of inventory; just-in-time manufacturing suffers when planes don’t fly, trucks are slower and border inspections take longer. More inventory requires more warehouse space and more maintenance and might result in higher levels of inventory damage, more obsolescence and spoilage. More computers will be required, more expensive security technology, more video conferencing technology and many other tools to enhance safety and security and to compensate for greater friction in the economy.

Public costs will increase, requiring higher taxes or higher federal deficits. We’ll pay for more inspections and added security at public buildings, including airports. One economist has estimated these cost increases at more than $50 billion a year.

How much risk?

Many sectors of the economy will benefit from this restructuring, just as in the 1970s. Much depends on our attitude towards risk; we have a tendency to spend more than is rational to protect ourselves from publicized major catastrophes.

If we enter a period of stagflation, much depends on the reaction of the Federal Reserve and fiscal policy. If the Fed chooses to fight inflation by increasing the cost of borrowing, it’s possible that the U.S. economy will suffer a longer period of much slower growth. Additional tax rebates will increase budget deficits, forcing the federal government to increase its presence in the credit market, putting more upward pressure on interest rates and further slowing investment.

It’s not a pretty picture.