The spectre of stagflation

 

Once again, the world economy is haunted by the spectre of stagflation - the possible return of simultaneous high inflation and stagnating economic growth, as witnessed after the oil shocks in the 1970s. Current fuel price protests by fishermen and lorry drivers add to the feeling of widespread crisis.

 

 

Every few days there seems to be more bad news, with higher inflation and predictions of lower growth on both sides of the Atlantic. Europeans are feeling the pinch when buying food, petrol and electricity, with euro-zone inflation running at 3.6% in May 2008 according to Eurostat estimates - way above the long-term European Central Bank target of 2%. Spain’s was 4.7% and Belgium hit a 23-year high at 5.2%.

 

There are many external causes for the current price rises. Energy prices are driven higher by global instability, with knock-on effects on the cost of food and consumer products. In the past, emerging economies such as China helped the West to keep prices down by providing competitively-priced imports. Now it seems that increasing demand for raw materials, consumer products and indeed food in these countries is having the opposite effect. Increased demand for crops for biofuels and bad harvests have added further pressure.

 

Europe’s growth is suffering from the global credit crunch, with exports hit by an unfavourable euro-dollar exchange rate as well as reduced demand in the US. Rapidly rising prices affect domestic consumption as households cut back on spending, also affecting growth. And we may not have seen the worst yet. If wages rise rapidly to accommodate higher price levels, Europe could enter into a vicious circle, with negative impacts on productivity and growth as well as inflation.

 

 

But is this stagflation? There are significant differences from the situation in the 1970s. At 3-4%, euro-zone inflation is way below the double-digit increases seen then, demonstrating recent progress in combating it.

 

Despite sluggish growth, most of Europe is also a long way from any signs of recession. The European Commission’s most recent forecast put the EU-27 growth rate at 2.0% in 2008 and 1.8% in 2009, despite downward corrections. European economies might slow down further (and for some, such as Italy, the situation is critical), but the overall picture is that the EU has escaped a recession this time, with the International Monetary Fund recently revising its euro-zone growth forecast for this year up from 1.4% to 1.75%.

 

 

EU economic policy might help to counter the current difficulties, but high imported inflation coupled with sluggish growth is not easy to deal with, creating real policy dilemmas.

 

The usual policy response to inflation – and indeed the EU Treaty obligation – is for the ECB to increase interest rates. This would ultimately reduce inflation, but might have a dramatic negative impact on growth. 

 

Many advocate an expansive fiscal policy - lower taxes and/or more government spending - but there is limited scope for this. The Growth and Stability Pact limits government deficits (and most euro-zone countries are already rather close to the limit) and it would create inflationary pressures, triggering an ECB response.

 

Experiences from around the globe also show that fiscal expansion has a limited impact on growth while debt piles up. Furthermore, most EU economies are in the upswing of their economic cycle, even though growth rates are relatively disappointing – not a time to pump debt-financed money into the economy.

 

 

So what can be done? Steady economic leadership instead of talk of looming disaster would help calm over-exaggerated fears of economic meltdown - and blaming current economic woes on ECB policies is neither correct nor helpful.

 

In the long term, more needs to be spent on enhancing productivity, for example through investment in infrastructure, education and innovation. More also needs to be done to reduce Europe’s dependence on energy, for example by improving energy efficiency. Europe should also not forget its international, moral obligations – rising fuel and food prices will hit developing countries much harder than us.

 

Most importantly, European coordination and cooperation of fiscal and structural policies should be tightened, with the aim of getting a binding commitment to growth-enhancing policies. This would act as a strong signal that Europe is taking the necessary steps to become more competitive.

 

Just as the euro created a credible commitment mechanism, which changed inflation expectations for all euro-zone countries (even those which had previously struggled), such a Europe-wide common and binding commitment could increase the long-term expectations for Europe’s growth rate, making it more resilient to external economic shocks.

 

Contrary to many politicians’ instincts, this is also the time for more structural policy reforms. Better functioning labour, product and services markets (including in agriculture) can reduce inflation and cushion the impact of slowing growth. Increased fiscal discipline could also be a serious asset for Europe if the situation deteriorates into stagflation, leaving room for manoeuvre.

 

Keeping fiscal balances at least within the limits of the Stability and Growth Pact is a good starting point to ease overall inflationary pressures, and public wage increases need to be kept in check. Private wages should rise no more than productivity, despite the pressure from increased prices.

 

Government spending and taxation can also be used more effectively. Lowering employer and employee contributions from wages can boost labour markets and counteract wage inflation. Shifting spending from social security benefits to active labour market policies such as training can have a doubly beneficial effect of lowering unemployment as well as stimulating higher value-added employment.

 

This will take time to deliver, but it is the best long-term answer to economic difficulties created by external pressures. Thankfully, we are still a long way from stagflation, but the economic climate has worsened and much of what is happening is beyond the immediate control of European policy-makers. However, if the current crisis encourages Europeans to coordinate their structural and fiscal policies more closely, some good might still come from it.