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  • OK, so what caused stagflation?

  • This is an important question.

  • It's an important question because the answers people gave in the 1970s

  • and afterwards helped to set that paradigm I was talking about before.

  • And a paradigm is, in fact, a set of questions and the answers

  • that answer those questions, right?

  • Those things fit together.

  • So it tells us what to look at as problems,

  • and it tells us what to use as solutions.

  • And coming out of the 1970s, one really dominant powerful paradigm

  • said that the cause of stagflation was too much social

  • spending leading to high deficits.

  • Those high deficits would crowd out private investment,

  • discourage investment, pushing up interest rates.

  • So, thus, you could get high inflation at the same time as high interest

  • rates.

  • You could get high inflation in recession.

  • But, in fact, there is not only a political motivation to that argument,

  • but there's an empirical problem with that argument.

  • If you look at the actual history of the 1970s, the big episodes of inflation--

  • and it's obvious on graphs-- are tagged directly to oil price shocks.

  • Now, what's a price shock?

  • A price shock is when a key resource or commodity rises dramatically, rapidly,

  • in price.

  • And because that commodity is so important, just as oil was.

  • Oil was everywhere in the American economy in the 1970s.

  • Because it's so important, that pushes up all other prices

  • and causes a lot of disruption, dislocation, and uncertainty

  • in the economy.

  • And you can see from the graphs that this is exactly what happened.

  • In 1973, when OPEC embargoes oil to the United States,

  • stops oil flowing to the United States, it

  • pushes up the domestic price of gas 400%.

  • Americans wait by the millions in lines to get their gas.

  • They often can't get gas on several days of the week.

  • There are all kinds of regulations put in place.

  • Uncertainty is their response.

  • Many of them turn and invest in smaller cars,

  • which necessitates more spending, pushing up inflation.

  • But in general, prices rise throughout the economy.

  • And the same thing happens again in 1979 and 1980

  • when Jimmy Carter encounters his biggest foreign policy

  • crisis-- the Iran hostage crisis, which cuts off

  • a major source of oil to the American economy, pushes up prices again.

  • And people react to that, in part because

  • of the memory of what happened in 1973 and '74.

  • They start to push up prices and panic.

  • So those episodes of high inflation are caused by many things,

  • but oil price shocks are crucial.

  • This doesn't mean that they would have happened if a different policy had been

  • followed, or this policy versus that policy had been followed.

  • But what it does mean is that when we think

  • about the argument that high deficits or high social spending

  • is always bad and is always going to lead to inflation

  • and is always going to lead to rising interest rates,

  • we should probably look at cases where oil price shocks are not in the mix.

OK, so what caused stagflation?

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What Causes Stagflation?

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    James posted on 2015/06/25
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