We’re More Optimistic, if Not Better Off, Than in ’79
A stagflation scenario: After a sustained recovery from a deep recession, the U.S. economy is close to full employment. Indeed, many economists worry that the underlying rate of inflation is creeping up. Then a disruption of oil supplies in the Persian Gulf leads to a sudden inflationary shock to the economy. The direct impact of oil prices is multipled as workers, frustrated over how inflation has eaten away at real wages, demand wage increases. To control the wage-price spiral, the Federal Reserve sharply raises interest rates, leading to a severe recession.
A forecast for 1991? No, it is a description of what happened in 1979 and 1980. The similarity between the current situation and 1979 is almost eerie. As one of my colleagues put it, “We all knew that something would put an end to the expansion, but nobody thought that it would be exactly the same thing as last time.”
Yet most people think that there is only a surface parallel--that 1990 will not, unlike 1979, mark the beginning of a wrenching recession, with an accompanying financial crisis. The general expectation is instead for a mild recession, with recovery well in time for the 1992 election.
But are we really in better shape than we were in 1979? Let’s first look at the similarities.
In 1979 and today, the oil shock struck economies that had emerged from a recession that reduced inflation and in which inflation was showing some signs of accelerating again. The unemployment rate in 1979, 5.8%, is almost the same as the current rate.
Arguably, changes in the structure of the labor market now allow the economy to run with slightly lower unemployment without accelerating inflation. But nobody would have argued in 1979 that the economy was drastically overheating, and few would argue that the economy now has lots of excess capacity (except in some regions; but that was true for the Rust Belt in 1979 too). Overall, the situation in terms of capacity utilization and labor market tightness is similar.
In 1979, the effects of oil crisis were magnified by shortages. Price controls prevented the market from working properly, and panic buying turned minor shortfalls into long lines at gas stations. We don’t have price controls or panic. But look at the public and political reaction to the modest gasoline price hikes that have occurred and ask yourself what would happen if crude oil were to double in price.
Why, then, should we be optimistic? The answer is that in 1979 we came into the crisis with an inflation problem, while this time we do not. But that is only partially true. In 1978, the inflation rate, excluding volatile items such as food, energy and shelter--the so-called core inflation rate--was 6.4%. In 1989, it was 4.1%. We are indeed in better shape on inflation than we were 11 years ago, but the perception that we do not have an inflation problem now is as much a matter of our desensitization after a generation of persistent inflation as it is a statement about reality.
Nor are we in better shape on the energy front. U.S. dependence on imported oil is, as we are now belatedly noticing, at a record high. Moreover, oil prices have dropped precipitously since the early 1980s, so that in real, inflation-adjusted terms, oil in 1989 cost only about half of what it did in the late 1970s. That means that if a crisis were to drive real prices back up to their previous peak, the effect would be far greater this time.
Admittedly, some things have changed for the better: The world as a whole is much less dependent on Middle East oil. On the other hand, in 1979 nobody thought that physical destruction of some of the major oil fields was a possibility. This time it definitely is.
So why are we optimistic? Ultimately, it comes down to a judgment about our own psychology. In 1979, the inflationary impact of the oil shock was met with panic and outrage. Panic, because of widespread fear that inflation would spiral out of control. Outrage, because Americans wanted to preserve their standard of living and demanded protection from adversity. For both reasons, domestic prices and wages exploded.
This time, the optimists say, things are different. The public has seen inflation brought down and has faith in the anti-inflationary resolve of the Federal Reserve, so even a big oil shock won’t lead to expectations of accelerating inflation. And American workers are less militant now, more willing to accept cuts in living standards. It helps that they now know that the pain is inflicted from abroad. In 1979 almost half of the public did not know that the United States was a petroleum importer, and they viewed price increases purely as profiteering by Big Oil. This time, optimists say, they will respond properly, accepting the necessary real wage cuts--maybe with the help of a modest recession to remind everyone that there is a trade-off between wage demands and employment.
I hope that this is right. But it is possible to make a contrary case. The political flap over gasoline prices does not suggest that the voting public is likely to accept economic logic any better now than in 1979. And although labor has been effectively cowed for much of the past decade, that itself creates some risks of an inflationary explosion. After all, real wages are now about 10% lower than they were in 1978; the typical worker’s take-home pay buys no more now than it did when John F. Kennedy was President. Is there really no lingering resentment, no possibility that, faced with another surge in prices, workers will demand compensation?
Or there is another possibility: that the Federal Reserve will not be as staunch in fighting inflation as everyone now expects. If it all breaks loose in the Persian Gulf, Congress and the Bush Administration may not be ready to listen to explanations about why we need to add a recession to the burdens of war and soaring oil prices. Yet a loose monetary policy could turn the third oil shock into a full-fledged revival of double-digit inflation, which would then require another massive recession to get it controlled.
Nobody expects any of this to happen. For the United States to experience three oil-fueled crises in 17 years, each with the same script, is just too trite to be believable. We aren’t that stupid--are we?
