A History of Stagflation and Recent Experiences

When a person is asked what is the worst economic conditions one can think of the most common answer is, of course, high unemployment. We all know what unemployment means: people have no jobs, consequently no money to live by and the welfare of an entire nation is at stake. It just takes a look at the current situation in South Europe, especially in Greece and Spain, to understand that high unemployment can have devastating consequences. What makes life slightly easier for the unemployed is the fact that prices tend to fall when unemployment rises, as the Philips Curve claims. Yet, when a nation has to deal with high inflation and high unemployment simultaneously it faces a situation called stagflation.

The 1970's were such a period; in the UK, a recession caused the unemployment rate to rise by approximately 83% in the 1970-1979 period as it took about 14 quarters for the UK GDP to recover to it's pre-recession levels, with the overall output decrease at 4%, or about 1.5% in real terms if one uses the Bank of England data. Yet, even though the rise in unemployment was tremendous, the maximum value reached in the 1960's was just 4.2%. Yes, that is just 4.2% of the labour force and no it is not a typo. In comparison, only Austria had an unemployment rate of less than 5% in June 2013. Then why complain about growth?

The difference here was inflation. Inflation rose by an astonishing 200% in the 1970's, with annual rates reaching 24%. The starting value of inflation was not really that low either: in 1969, inflation was more than 5% while it rose to 24% in 1975. On average, the yearly inflation rate in the 1970's was 12.5% higher than any other period in the UK's history.

What is odd is that the term stagflation was not coined in the 1970's as one would expect. It was in fact first uttered in 1965 by a British politician, Iain Macleod, who warned about the situation "We now have the worst of both worlds—not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of “stagflation” situation. And history, in modern terms, is indeed being made."

This, however, was a rather strange conclusion: inflation in the 1960-1965 period was 3%, the unemployment rate was 1.5% and GDP grew on average 3.1% in real terms. Neither was the situation bad during the previous decade: in the 1950's output grew by 2.31% in real terms, unemployment was 1.24% and inflation was 4.3%, something which can be attributed to high growth during the years after the war (indeed if one excludes 1950-1953 the average inflation was 3%). Thus, what made 1965 different?

My guess is nothing. In fact, stagflation in the UK would not appear until the 1970's and the only pertinent issue was the level of inflation at a moderately high 4% in the 1965-1970 period. Yet, in no way did high inflation cause a stagnant economy. The next graph indicates the annual real GDP growth for the UK.

In the 1960's only once was real growth low, and this was at 1%, not something which would cause distress and something that South Europe economies would crave for at the moment. Inflation was indeed an issue; one which was due to policy (high government spending in periods of full employment). Yet, policy alone would not have created such an issue if oil prices had not skyrocketed in 1973-1974. To day, this has been the largest increase in oil prices, causing a major supply shock inflation which caused inflation to rise. The two major shocks in the decade, in 1973-1974 (252%) and in 1978-1979 (125%) were the main causes of recession. In total, oil prices increased by 1504% (that is 15-fold) in the 1970's.

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This, compared with a much greater dependency on oil than we currently have, caused the shock which came to be remembered as stagflation. The initial conditions had also been favourable: increased government spending in times of almost full employment caused higher than normal inflation and set the background for an even larger increase in inflation when the oil shock hit the world economy. Emphasis here should be made to the following point: as with hyperinflation, policy alone could not have caused stagflation; The oil shock was necessary for the situation to unfold and we would have not witnessed this part of history if it wasn't for it.

How about the politician's quote then? What triggered his comment if inflation was not higher than before and growth was still good? There are only two possible explanations: either he could see 7-8 years into the future or he was comparing with what had happened before and highly exaggerated. The first explanation is rather strange given that if he could do that he would have have made himself a very rich man, while the latter is more plausible if one looks at the data. According to the data mentioned above, inflation was higher by 1% and unemployment by 0.25% then the previous decade; strangely, GDP was growing by more during the time of his statement. It appears that the whole issue has been one of comparison between what the economy was doing and what the economy did. As politicians are more prone to dramatize situations than most people are, a subtle change in the economy (although percentage-wise the increase in unemployment was 20%) would spark just such a comment, especially if one thinks that Macleod was a Conservative while government was led by the Labour Party which had won a narrow victory in 1964. 

I wouldn't dare suggest that a period which satisfied the name and definition of stagflation never existed. Yet, the definition preceded the actual situation by more than 7 years, with no data or developments supporting the initial claim, which makes us wonder whether the statement had nothing more behind it than mere political agendas, since indicators just slightly deteriorated during the 1960's (with real GDP actually increasing). In addition, even though the recession was quite real, stagflation would not have justified its name had there not been a dramatic increase in oil prices.

Concluding, even though a resurrection of those who promote that stagflation would be an issue in the near future, I would just note that inflation both in the US as well as the EU and UK is falling and unemployment is much more stable (although higher) than it was a year (or more) ago. In addition, oil dependency has decreased over the years as alternative sources of energy emerged: solar, nuclear, geothermal and most importantly gas. Although I would not go as far as to declare that stagflation cannot occur, it would take a much more severe shock than the one in the 70's for it to take place.

Note: All data for the UK, including Oil Prices were extracted by the Bank of England's Three Centuries of Data file (.xls)

Do we feel Europeans?

Over the last few months, after watching most of the recent developments (either positive or negative) in the EU, what made the greatest impression on me is our ability to shift our minds and opinions from one end to the other. This should normally be considered as a positive, yet being ready to alter our words and actions in the blink of an eye has to mean that we are in fact being affected by those who express these opinions more than we should have; in addition, it also means that we had formed our mind about our previous conviction(s) without being sure of the subject.

There are of course plenty of examples in recent history: notably the case of Greek exit or Greek default. In the summer months, almost every media source in Europe was roaring with stories about Greece exiting the Eurozone, the EU or defaulting; the stories were either by economists, analysts, journalist or even politicians and heads of states. Speculation had reached its maximum. In mid-August or early September, the EU decided it had had enough of this and spoke strongly against those who were exploiting the situation in order to promote themselves. Then all of a sudden voices of support arose. People stopped thinking that a Grexit would be good and started supporting the Greeks. Can these two groups (those who were in favour of a Grexit and those against it) consist of different people? Or is it just that we have changed our minds over some time?

Overreaction and mean-reversion, some may state, may account for this situation. Maybe. Yet, what is an even more probable explanation for this is disintegration. We are not yet a family. Have a look at the following example: let us say that you have a brother whose business has failed and faces prison time because he owes money to the bank. What do you do? Wouldn't you feel bad if he had to go to jail and wouldn't you try to do anything to help him stay out? Most of us would do so. Now, how about this scenario: a person in the next town (unknown to you) is in the same position as your brother. Would you feel the same you would feel with your brother if that person went to jail?

The answer would obviously be no (OK we exclude the case were you would not really like your brother). The above scenario bares many similarities with the present state of the EU. Even if we hate to admit it we do not consider ourselves Europeans. Geographically, it makes sense. To a large extent, a person is much more a resident of Granada or Marseille than a resident of Spain or France. You may imagine how someone might feel when Europe is merely a notion. 

This situation is exacerbated by the lack of truly European ideals and policies. A simple case is the debate on whether we should have an EU army. If not, how would we react if for some strange reason a foreign nation attacks Cyprus, Poland or Romania? What will the EU do then? Condemn the action and just stand by watching or take military action against the assailant? People feel united if they have something to look and say "This is ours" instead of mere notions. 

We have obviously gone a long way since the early 2000's. Largely thanks to programs like the Erasmus student exchange we have destroyed many barriers to uniting the people. It is quite uncommon to find people today who have never traveled to another EU country, or do not have any friends or acquaintances in another EU nation. Yet, although people are more European now than ever before, we still do not feel it as strongly as we should have. This is the main difference between the EU and the US. Ask someone in Alabama, Texas or New York if he/she feels American. The answer will be a definite "Yes".

Another example is the large number of foreign embassies. If I am from the Netherlands or the UK and wish to travel and work in Denmark why should we need a whole embassy to take care of diplomacy and etc when by definition there should be no diplomacy amongst equals? National governments would in fact save many billions if their staff in each country was reduced. Yet we still hold the notions of previous decades and we refuse to give way to change. 

Thus we come to the main problem which tantalizes Europe, especially nowadays:

We are afraid it will not last. 

Europeans do not think that the EU is permanent. Why? Because many nationalist media sources in some countries say so, because deep down we are still afraid that we will not support each other when time is hard, because others in foreign states bet against our survival. Traders in many countries had put large bets against the euro surviving during the months when the Greek crisis was at its peak. Instead of condemning such actions our media said that it was something to worry about. As if we did not have enough already. In the end, all these investors ended up losing money. And instead of being happy that we have survived the first major crisis in the history of the EU and making sure we have understood what went wrong so as not to repeat it we just do it again (Spain). And again (Cyprus). And we believe that it was right the first time (Ireland), the second time (Portugal) and the third time (Greece) although each and every one of these examples pointed to the exact opposite. As if this was not enough we always brought the IMF to assist us, because the ECB did not have the "power" of doing so. We do not even seem to care about a country exiting the euro (be it the UK, Cyprus or Greece), or whether that should have any non-economic consequences in the Union.

We are undermining the EU from within. We are not allowing it to function as it should. Even worse, we  are preventing the proper functioning based on irrational beliefs and strange rationales derived from obsolete notions of the world. To paraphrase Warren Buffett "the flat world society will always exist". It is our choice whether we adhere to their beliefs or not.

If we cannot help ourselves no-one will. It is about time we show, first to ourselves and then to the world, that we are really united. This cannot happen with politicians and mentalities of the Cold War era. We need fresh blood, we need idealists and we need unison.

Nationalism, Empires and UK exit

The debate has been raging over the past few days on whether the UK should exit the EU, as it does not assume the role its politicians think it should have. UK Prime Minister David Cameron is supposed to present a road map for the relationship his country should have with the other Member-States to which Ireland's deputy prime minister and foreign minister, Eamon Gilmore, stated "The European Union is not an a la carte menu. We're either a union or we're not. This is not going to work if we have 27 or 28 categories of membership."

The way I see this is that Britain still holds the belief that it is still the mighty empire that it used to be until WWII. It is only natural that people in every nation look at their past and feel nostalgic of an era which they were "rulers of the world". This issue has already been covered in an older post (which can be found here) where the conclusion reached was that the time for rulers, emperors, dynasties and monarchs in both the North and the South is long gone.

What most people do not realize is that an exit from the Union might not be so easy and it may even bring the exiting country to its knees. Why do you think that Greece did not leave? Because the consequences would have been much harsher than if it applied the austerity measures. It is tough to imagine anything harsher that these but trust me on this one. Now if the UK decides to exit it things would be much harsher on them than the Union. For example, British businesses can now aim at a public of approximately 450-500 million people for their products. If the UK exits, they would only be able to target an audience of 60 million. Still it is a substantial amount you might say. But think about the consequences of that: Less availability of public to sell their goods would mean less demand for the goods, which will in its turn mean less goods, meaning that a drastic drop in employment would occur. Any of those who believe that a country with an 8% unemployment rate and a 20% youth unemployment (not adding that even now workers are worse off than they were 5 years ago, before the crisis) can bear to suffer a sharp drop in demand and a sharp increase in unemployment should reexamine their criteria for decision-making.

In addition, one may imagine that things may only get worse if Scotland decides to become an independent State and seeks to join the EU... The only reason that the Scots have not done this already is because they will have to re-apply for joining the Union after their independence. If the UK exits then why shouldn't they exit the UK, enter the EU and take the North Sea oil along with a 5-6 million people market with them? Not to mention problems with Northern Ireland and Ireland borders which have not been an issue for some years now.

Others might propose that the UK should join the European Economic Area (EEA) like Norway has done, meaning that it would have access to the EU market without essentially being a member. Sounds good? But isn't every nation doing this then? Well, to become an EEA member you would have to give your contribution to the EU budget (Norway pays about €350m a year to fund projects in new Member-States like Poland) and accept almost every EU regulation there is. So in essence if the UK chooses to do this, it will drive itself away from the decision-making process while simultaneously having to obey to almost every law the EU regulators decide to pass. That is no power, and almost full obedience to Brussels decisions. Doesn't sound as good as we thought does it? Not to mention that Germany and France would be allowed to run the show if they exit.

I wouldn't know what David Cameron feels like Britain should be treated. Yet he has to admit that the world has changed a lot since the 60's, 70's and 80's when they were the dominant force in Europe. Empires rise and fall over time and yet people are still stuck to illusions of grandeur and glory. If the UK wants to be treated as an empire it can do so but not in the EU.

There is however a point which I do not fully grasp: the Irish do not really want to the UK exit the EU. Neither do the Scottish, nor the City businesspeople nor the British entrepreneurs nor does David Cameron himself. The only people who seem to want this is the Ukip party which appears to be the Golden Dawn analogue in the UK.

Now, there are two facts which we should remember:
1. Nationalism has reached its day of demise
2. We are Union now. Deal with it.

Property Market: Cheap or not so Cheap?

A direct consequence of the EU crisis is that housing prices in South Europe have began to fall. For example take a look at the graph for Greece:

The downwards trend which started in late 2008 still holds strong pushing residential housing prices down. The same holds for Spain and Cyprus (Unfortunately I couldn't find data up to 2012 for Italy. All data and graphs are from the ECB)

Cyprus residential prices

Spain residential prices

The above and all current developments indicate that the severe inflation of housing prices which had occurred during the early and mid-2000's was something of a bubble. Mind you, these are data just for the first quarter of 2012. You may only imagine how lower the prices of the second quarter will be.

The housing bubble seems about to burst in the EU (it already has in some countries) and it's not just prices in the South that have gone down. UK prices have fallen for the first time in 3 months as Britain's economy shrank by 0.7% in the second quarter of 2012, the most in 3 years. (for more details on the UK's housing market read here)

If one looks at ECB it seems that housing prices all over the EU are either stagnant or falling, with a few exceptions. So, many people are faced with a dilemma? Should you buy or should you keep on renting? The answer is not so obvious. The reason is that during a crisis rents are higher while housing prices are lower, since most people cannot afford to buy (fall in demand, thus prices fall) but they have to live somewhere (rise in demand, thus prices rise). In more distressed economies like the South, many still choose to live with their parents and thus both rent and property prices seem to fall, although the latter seem to take the most hits.

True, prices have fallen dearly since last year. This, however, is only the beginning of the downwards spiral which will run its course for at least the full 2013 in strong economies and last even more in the weaker ones. (I hope you can tell which is which!) Moments of a rise in the indexes may occur but these seem more like an slight upwards move right before a severe downwards movement in the stock market.