Inflation is becoming increasingly felt by consumers as prices have been rising at or near historic rates. As a result, the term stagflation is becoming part of the public discourse. Of course, former Obama administration economist, Jason Furman, took some heat for tweeting that current inflationary conditions are a “high class problem.” That has put him the crosshairs and has fueled partisanship. However, those calling him out often fail to address similar policies and understanding fostered within their party. The objective of this post is to take a closer look at stagflation and its source.

One of the issues with economic models at understanding stagflation is the ignorance of any theoretical framework. According to Milton Friedman, the need for an underlying theory is displaced by a statistical relationship. This logic has resulted in economics degrees being full of math and statistical models and no discussion of economic theory. In fact, my degree in economics didn’t require a single class in economic theories and there was never a chance at debate! That’s incredulous when you think of it.

Inflation Theories

Friedman and Edmund Phelps created a model that addressed the Federal Reserve’s impact on the natural rate of employment, economic growth, and inflation. Their model overturned the negatively sloped Phillips Curve that plotted changes in wage inflation as function of unemployment.

The Phillips Curve

In the 1960s, governments used the Phillips curve as a way to engage in expansionary demand policy. The rationale was that there would only be a small trade-off of higher prices. How wrong they were! Phelps and Friedman attempted to demonstrate that actual and expected rates of inflation had to be considered. Also, the impact on policy and holding the unemployment rate below the equilibrium rate would cause inflation to accelerate.

This “progressive” look at inflation and employment concluded that policies could only temporarily impact growth. Let’s take a closer look at their model.

Friedman & Phelps

Using the Fed’s dual mandate of inflation and employment as the source of stimulus, we begin our journey with expansionary monetary policy. The assumption is that this leads to economic growth and an increased wealth effect. The increase in “wealth” yields an increase in the demand for goods and services, which of course spurs on increased production. The increase in demand requires a higher demand for labor that lowers the unemployment rate below the “natural rate.”

As the unemployment rate falls, the demand for labor causes wages to rise and rising inflation. Consumers then begin to see the impact on prices they pay, inflation expectations begin to rise.  As prices and inflation expectations rise it diminishes the purchasing power of consumers. The loss of purchasing power lowers demand for goods and services and initiates a rise in the unemployment rate. The rise in unemployment and slowing production then leads us into an economic slowdown.

As a result of this logic, the only way for Fed policy to be impactful and spur growth is to engage in unexpected policies so that the public doesn’t know the inflation is coming. This theory sounds really amazing and has led to the understanding that the Fed’s policies are a source of virtue. The only issue is that there is no underlying theory that governs this understanding other than statistical relationships.

The Roots of Stagflation

Since this post is about stagflation, it may be good to attempt to define it. In short, stagflation is an economic period of rising prices and a drop in real economic growth. In other words, the inflationary policy of central banks is causing economic output to fall as prices are rising. Let's look at two issues that arise in their assumptions.

Issue #1

There are many issues with Friedman and Phelps model. The first issue is that it assumes that the money injected into the economy will yield the same productive output as money that is naturally invested. The presumption that there is zero malinvestment is serious issue. All you have to do is look at the U.S. dollar when the Fed is expanding monetary policy against emerging market currencies. You’ll see that the money isn’t being invested in the U.S. as emerging market currency prices spike against the dollar.

How much is domestic production increasing because of Fed policy? The answer is that it is pushing foreign versus domestic investment. It’s also emphasizing debt and stock buybacks here in the U.S.

Issue #2

The second issue is who gets first access to the money the Fed is pumping into the system. This is done through Federal government spending plans and Fed monetization? The answer to this is important since it determines who gets the lions share of goods that can be bought at lower prices. The expansion of the national debt and monetization by the Federal Reserve has led to the top 1% increasing their share of wealth from 24% in 1989 to 32% in 2021. When you consider that the bottom 50% has 51.6% of their wealth in real estate, you get an even more dire picture.

An important issue is that most of the middle and lower class wealth is their home. Not exactly an investment. The “wealth effect” of high stock prices only benefits the top 10%. Also, those that have access to this money first can buy a disproportionate amount of goods and services before prices rise to offset any increase income and wealth.

You may say that we need more policies designed to give money to these disadvantaged groups that are lagging those with first access. The important thing to remember here is that an individual’s demand is constrained by the goods they produce. Therefore, you can’t spur on demand without a product. As a result, there isn’t any economic growth produced, only higher prices and shortages.

High Class Problem of Inflation

Of course, those that hold to the magical thinking that debt and inflation is real growth are feeling good right now. For example, in the chart below you’ll see unemployment and personal PCE Inflation. You’ll notice the drop in unemployment as inflation has been rising. Does this suddenly prove the Phillips Curve correct?

Clearly, this is the basis for the understanding that inflation isn’t a worry and stagflation isn't a possibility. The conclusion is that rising costs and shortages are really just a matter of becoming too wealthy, too quickly.

The lack of domestic investment in production, the lack of savings, high debt levels, and a breakdown of the global supply chain that has been financed with cheap money isn’t an issue for the establishment. Of course, increasing partisanship fails to address the decades-long build-up to this point. The fact that another administration can arrange the deck chairs on the Titanic better is misleading. These inflationist policies know no political boundaries.

Our present predicament is decades in the making. Current inflationary trends result from the Federal government and Federal Reserve policies that aren’t rooted in any sound theory. These policies of convenience are only rooted in a series of casual statistical relationships. These statistical relationships have been accepted as gospel and benefit classes disproportionately.

Inflation, Stagflation, and Employment

Periods of inflation should be negative on employment depending on the cause of the inflation. For example, debt, restrictive labor policies and monetization should be negative for employment. The focus on spurring demand without commensurate production ultimately lowers the standard of living. The result is the futile attempt to create the virtuous circle of liquidity through debt expansion, which doesn’t emphasize production, and only leads to an increase in people leaving the workforce.

The issue of worker shortages is very real right now. Even if we could produce more, we are held back by people watching prices rise uncontrollably, lowering their expectations, and leaving the workforce. In the chart below, you can see how the number of people in the workforce has changed since 1980. I know we have an aging population, but if you look at the trend of people leaving the workforce since 1997, it’s very troubling. We had a short period before COVID where real wages were rising, and the labor force stabilized. However, that took a major jump higher following COVID-related polices.

While it has come down, the number of younger entry-level workers leaving the workforce is troubling. This is showing that higher wages can’t compensate for the rise in prices they’re experiencing. The policies are making it impossible for companies to pay a “living wage,” despite significant increases in the wage rates. In short, the situation can’t be corrected by simply spending our way out of it.

 Conclusion

The long-term misallocation of capital has left us in a continual mode of diminished relative production and foreign dependence. The lack of self-sufficiency is subsidized by money printing and accelerating debt accumulation. For now, the stock market has largely shrugged this off. However, the potential impact on earnings and consumer spending may soon be manifest as the stagflationary trend continues.