Stagflation and debt

In the UK and US there is the non-negligible possibility of stagflation - an economic contraction combined with inflation. A plausible mechanism is simple; a cyclical economic decline in these countries is combined with high and rising global oil prices, so they import inflation faster than they deflate their economies by recession.

The reported current economic recession in the US (accurate figures are still pending) was foreshadowed by widespread defaults on debt. The UK, although it does not seem to be presently in recession, is likely to see its growth rates fall and also has had a local debt crisis. The possibility of debt default leading to economic decline is clear - banks lose money, stop lending, so people and companies can't fund their plans for future business projects or their consumption.

The debt crisis was so spectacular, with bankruptcies and liquidity problems among leading US and UK banks, that the question arises whether the debt-recession-imported inflation nexus is more fundamental than the simple analysis just given would have it. Stagflation has received attention in the post-Keynesian literature, but I usually treat it as a curiosity arising from exceptional circumstances, like the OPEC price hikes of the 1970s and the rise of China and India today, leading to high imported inflation. It can be analysed in terms of its separate components, as is done above.

Even if one accepts that the nexus is tightly bound, then it can still be explained in an augmented neo-classical framework, for example if capitalism is viewed as always pushing its growth to the limits of short-term possibilities so that people will keep borrowing to fund projects and expenditure even if they are likely to face bankruptcy in the medium term. Faced with recessionary pressures from rising oil costs which are a cause of imported inflation, the economy keeps straining until the extra tension brought by the oil costs forces the economy into a sharper decline than usual. One can keep adding to the neo-classical framework, and only reject it when its complexity becomes preposterous relative to its non-orthodox competitors.

Non-orthodox theories are generally more sophisticated than neo-classical theory, and many of the competitors to neo-classical theory are probably right in the sense that they describe reality more fully. For example, the post-Keynesian discussion of inside and outside debt probably gives a more complete description than neo-classical financial macrotheory. However, many classical works have the colossal advantage of being so simple that they are empirically testable, even if their proponents do not always test them. The few leading post-Keynesian papers and books I have seen do not test much if at all, and their specifications, whilst plausible, cannot be rejected relative to other theories because they are not readily able to be tested with available data or current econometrics. Increased sophistication is nice, but not worth it if it means taking a theory on trust.