Stagflation

By SHLOMO MAITAL
The lifelong mission of U.S. economists is simple to define: We are dedicated to turning good news into bad and bad news into even worse. I have an uneasy feeling that I am rusty at this. Before it is too late, let me get back into practice and show you how it's done. The International Monetary Fund (IMF) is a global institution whose purpose is to help countries that overspend and overborrow by supplying emergency lines of credit. As the world's fireman, IMF experts are tough. They rarely use superlatives. Yet in its annual consultations with Israel, IMF's praise was fulsome, noting Israel's "exceptional economic performance" in 2007, due to its responsible fiscal and budgetary policies and the Bank of Israel's appropriate interest rate policy. Israel's economy grew by 5.3 percent, faster than any Western nation, and drew in $10 billion in foreign investment. Observers noted that the report was probably the best any major international institution had ever written on the Israeli economy. Wow! Yet surely we economists can find a dark cloud behind the IMF silver lining? There is one. It is called "stagflation," a term coined by former British Chancellor of the Exchequer Iain Macleod in 1965. Stagflation is the double-whammy of inflation coupled with stagnation and recession. America has caught a dose of it, even though Federal Reserve Chair Ben Bernanke denies it (he has to - it is an election year). And Israel has early signs of a mild case. In "Alice in Wonderland," the Queen says, "Why, sometimes I've believed as many as six impossible things before breakfast." Stagflation could be one of them. Inflation, after all, is caused by too much demand, too much money and too much spending. Stagnation - recession, unemployment - is caused by too little demand. So, only in Wonderland is there too much demand and too little at the same time. Here is the solution to the riddle: Sometimes, inflation is caused not by too much demand but by too little supply, that is, by cost pressures caused by higher prices of fuel, energy, wheat, steel and other inputs. That, in fact, is what the world is encountering now (as I wrote in this column on February 4). It last happened during the two oil price hikes of the 1970s. Supply-side inflation causes stagnation, unlike demand-side, which spurs growth. The reason? Higher costs cause higher prices, causing lower demand, causing higher unemployment. What evidence is there that Israel has early-stage stagflation? Israel's unemployment rate is 6.6 per cent, the lowest it has been in 13 years. Yet there is no doubt Israel's economy is slowing, like a runaway diesel engine that has exhausted its fuel. The Bank of Israel's "state of the economy" index rose sharply, by 7-8 percent annually, from 2004 through 2007. But, in January 2008, the index rose by only 5.3 percent (annual) and is dropping quickly. A major cause: Services exports dropped by over 7 percent that month, perhaps owing to the sharp fall in the number of shekels you get for a dollar, making export prices expensive. Relative to the shekel, the dollar fell by 4 percent in January alone. So the "stag-" part of stagflation is underway. What about the "-flation"? From November 2007 through January 2008, consumer prices (excluding housing) in Israel rose at an annual rate of 6.8 percent. Compare this with zero inflation from mid-2006 to early 2007. As we measure children's fever with a thermometer, we measure stagflation with the "misery index" - the sum of inflation and unemployment rates. Israel's misery index is now over 13 percent, double what it was a year ago. America's misery index, too, is elevated, at 9 percent, highest it has been since 1993. Israel, America and parts of Europe have both a fever (inflation) and the chills (stagnation). Stagflation is contagious. Is there a remedy? Bank of Israel Governor Stanley Fischer acted with surprising vigor last month, slashing interest rates by fully half a percentage point and surprising the experts. By making money and credit cheaper, he is trying to battle stagnation. But the stock market was not impressed. Tel Aviv stocks fell a steep 3.3 percent in one day, on March 2, reflecting the fighting in Gaza and an earlier steep drop in Wall Street stocks, and then fell another 2.5 percent on March 9. What can we practitioners of the dismal science offer to raise morale? Perhaps this - for a nation with superior resilience in its DNA, dealing with war, rockets and terror, a little stagflation barely registers on its radar. The writer is academic director of the Technion Institute of Management, Tel Aviv.