Like Covid-19, transient price shocks are contagious. They generate wage demands and further price hikes among hard-hit workers and businesses. Even when a transient shock is reversed, the final rise in prices is a multiple of the first, determined by an inflationary “R”. This measures the retaliatory recovery of the actual income lost. If half of the initial and subsequent real income losses are recouped through wage and price increases (R = 0.5), the price increases end up doubling the initial shock. If two thirds are recovered (R = 0.67), they triple. If R = 1 or more, an exponential wage-price spiral is triggered. The resulting wage and price increases are rarely reversed when the transitional increase is reversed. Downward spirals are rare except during depression. Wages and prices are skyrocketing.

The lost lesson of the 1970s is that shocks, which sharply reduce real national disposable income, lead to cost inflation. Unlike demand-driven inflation, rising prices lead to higher unemployment, instead of falling unemployment leading to higher prices. Hence stagflation.

Following expectations of future inflation is a trap and an illusion, not far removed from the hypothesis of the rational man. Whatever price expectations tomorrow may be, inflationary pressures mainly come from efforts to recoup yesterday’s unexpected or unprotected losses. The answer is a reaction to unexpected price increases. Tomorrow’s expectations also correlate with yesterday’s increases.

In May of last year, I wrote an OMFIF commentary titled “Welcome to the World of Stagflation”. Forty-seven years ago I wrote an editorial in The Economist titled “The word is stagflation”. Much of what I wrote then remains true.

Real national disposable income changes little each year, mainly increasing. But major shocks can cause large global losses or redistribute income from spenders to savers. The Covid-19 pandemic is one example. The explosions in oil prices in the 1970s illustrate the latter. The surpluses of some oil exporters increased by more than 100% of their national gross domestic product and could not be spent. The disposable incomes of some importers collapsed by more than 10%. The 2008 financial crisis and its consequences greatly affected the distribution of income and wealth. I leave it out of this analysis.

Norman Macrea, the late Deputy Editor-in-Chief of The Economist, brilliantly described demand-driven inflation as “too much money for too few goods”. Over the past three decades, many economic commentators have apparently assumed that money-fueled excess demand in labor and product markets is the only explanation for the rise in prices.

Monetarists blame money. Milton Friedman wrote that “inflation is always and everywhere a monetary phenomenon in the sense that it is and can only be produced by a more rapid increase in the quantity of money than by production”. This assumes that the speed is constant or on a predictable trend. In reality, monetary tightness is safer to curb product (and asset) price inflation than lavishness is to raise product prices.

The major shocks are tendencies-bender. Cost inflation changes the correlation between inflation and unemployment from negative to positive. The impact of productive potential is uncertain. Higher wages can reduce employment more than output, increasing productivity while leaving GDP per capita lower. The deflationary consequences of the demand for cost inflation reduce output relative to potential, which means that inflation accelerates as the negative output gap widens.

Cost inflation is the missing dimension in the conventional oxymoric wisdom touted by too many economists. With my apologies to Norman Macrea, this can be described as “too many claimants pursuing too little income”. Following a sharp drop in income, workers, businesses, retirees, beneficiaries, finance ministers and foreigners can react in three ways.

1. Expenses can be sustained by saving less or borrowing more. This can support demand during a temporary loss of income, including a budget deficit, but is not a solution to a permanent loss.
2. Expenses can be reduced, such as with a private layoff or public austerity. It only recycles and increases (through insolvencies) lost income.
3. Efforts can be made to recover losses or defend income. It is the genesis of a spiral of devaluation of wages, prices, pensions, social benefits, taxes and exchange.

Income claims can be legal (public and private defined benefit pensions protected against inflation or indexed bonds); exercised through market power (private sector wages and prices); or by political power (public sector wages linked to those of the private sector, social benefits, public pensions and indexed taxes). Market considerations and political considerations compete to drive up prices.

One concept can be borrowed from the Covid pandemic. Each sector and individual within it has an “R” value, the ratio of income recovered to income lost over the course of a year. If collectively half of real income is lost (R = 0.5), prices increase by double the initial inflationary shock. If a third is lost (R = 0.67), the prices triple. If none is lost (R => 1) the ascending spiral becomes exponential. After years of sustained modest inflation globally, the R wage has moderated (stagnating real wages and increasing the profit share) and indexation has become more frequent. The first is subject to change.

A stagflationary spiral needs growing monetary fuel, including the ability of governments to maintain growing deficits with borrowing, otherwise the budget R = 1. Without fuel, inflation freezes in stagnation or slump. The more tax lavishness and low interest rates are maintained, the greater the rise in prices and the more savage the final calculation. As central bankers cling to the idea that price hikes are transient and resist tightening for fear of a financial crisis, they are unsustainably supporting and distorting overvalued stocks, bonds and houses. A crash is now inevitable. The price of the independent central bank is to blame for the withdrawal of the punch bowl. The warning of the 1970s and 1980s is the sooner the better.

Brian Reading was economic adviser to British Prime Minister Edward Heath and the first economic editor of The Economist in 1972. He is a member of the advisory board of OMFIF.

This is the first installment in a two-part series. The second part will be published soon.