The "Continuing Cost Pressure" Theory of Stagflation

From Investopedia, Inflation vs. Stagflation: What's the difference? by Tony Daltorio:

There are two main theories about what causes stagflation. One theory states that this economic phenomenon is caused when a sudden increase in the cost of oil reduces an economy's productive capacity. Because transportation costs rise, producing products and getting them to shelves gets more expensive, and prices rise even as people get laid off.

Another theory posits that inflation is simply the result of poorly conceived economic policy. Simply allowing inflation to go rampant, and then suddenly snapping the reins, is one example of a poor policy that some have argued can contribute to stagflation. Others point to the harsh regulation of markets, goods, and labor combined with allowing central banks to print unlimited amounts of money.

Oddly, Simplicable offers the same two theories:

Stagflation is caused by shocks to an economy such as a sudden price increase in energy. It can also be caused by economic mismanagement such as an overly aggressive expansion of money supply.

Good grief! So does Wikipedia. And Proshare. The same two theories.

The one theory says a supply shock (like "a sudden increase in the cost of oil") can lead to higher manufacturing and distribution costs, and to higher prices which reduce demand and slow the economy. The other theory says bad policy is the cause.

It seems to me that stagflation could arise either way. Surely there is more than one way it might happen. And yet, neither theory is completely satisfactory. The theory of bad policy is not specific. The "supply shock" theory is too specific: A sudden increase in the cost of oil is not the only thing that can create a negative supply shock. Given the right circumstances, any rising cost could lead to stagflation. It wouldn't even have to be sudden.

What circumstances? The rising cost would have to create long-term, continuing cost pressure, pressure that even if resolved today returns tomorrow. Not one or two oil shocks fifty years ago, but something that happens repeatedly or continuously.

People who say "there's no such thing as cost-push inflation" often point out that if not for monetary "accommodation" by the central bank, cost-push pressure would only create a change in "relative" prices: If the price of oil went up, other prices would go down until balance was restored. I can see that. But if it's a repeating or continuing cost increase, it's a different ball game.

If the cost of oil doubled every year, for example, all other prices would soon "relative" themselves down to zero. In that situation, I don't think even monetary accommodation could help. If it was only a 20% increase each year we'd last longer, but still the cost of oil would kill off our civilization, probably before we found some other way to do ourselves in.

What would be the properties of a cost that creates long-term, continuing cost pressure?

• It could be a slow-growing cost, not necessarily a sudden shock like oil in the 1970s.
  
• It would have to be a massive cost, massive enough to impact our massive economy. And
  
• It might be a cost we don't see as a problem: continuing cost growth that, for some reason, doesn't much concern us.

The only cost I know that has these properties is the cost of finance.

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Surely there are more than two ways stagflation could arise. Allow me to offer a third theory of the cause of stagflation: Continuing Cost Pressure.

Rising cost squeezes profit. Producers increase prices to restore profit. To the extent that the monetary authority "accommodates" higher prices by increasing the quantity of money, the result is inflation. To the extent that the monetary authority refuses to accommodate higher prices, the result is slowing growth. Producers are left to cope with their reduced profit as best they can, but low profit is an impediment to growth, and unprofitable business is unsustainable.

If the cost was a temporary, one-time shock to the economic system, this wouldn't be a new theory. But if the cost creates repeating or continuing long-term cost pressure, the story is entirely new. For as long as this cost pressure continues, the relative adjustment of prices can never come to an end. And all the while, the price trend is always "up" for the pressurized cost, and always "down" for everything else.

Again, I am describing the cost of finance.

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Why is it that finance creates continuing cost pressure? Surely it's not because of the rate of interest. That rate goes up sometimes, and down sometimes. And lately it has spent a lot of time at "the lower bound". Surely the problem is not the rate of interest.

That's correct. The problem is not the rate of interest. The problem is the cost of interest. Five percent interest is a rate, not a cost in dollars. If you pay five percent interest, you pay five cents for every dollar you owe. It isn't a lot because it's five percent. It's a lot because we owe so many dollars. Dunno how that gets overlooked all the time, but it does -- except when we're talking government debt.

The problem is the cost of interest, and all the other fees and charges that go along with it. And the debt, the principal that must be repaid, that's part of the cost problem, too. And the cost always increases, because debt is always growing. Finance is always growing. And finance is always growing, because policymakers think that's good for the economy.

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People sometimes figure the size of finance by considering employment in finance as a share of total employment. I can see that. Those people actually are working, same as the people who don't work in finance. They receive income, and the cost of it adds something to the price of output.

But all those people who work in finance only add up to around seven or eight or nine percent of the workforce. If you count just interest paid in the US, it came to 9% of GDP back in 1962. It was 31% of GDP during the 1982 recession, 32% before the 1991 recession, 27.9% before the 2001 recession, and 31% again in 2007, shortly before the "Great" recession. The average cost, for the years 1980 thru 2009, was 26% percent of GDP.

It is true that all the money that's interest cost to us is interest income to somebody. But we still have to pay it, you know? It's still a cost. We don't get to use that money to buy other stuff. And the people who receive that interest as income, they're not likely to spend it. I know, because aggregate demand is down. They put most of the interest with the money they earn interest on, and earn more interest. 

And the money in finance doesn't come back into the economy unless we borrow it, which increases the number of dollars we owe and pay interest on. Or unless the saver spends, of course, but that's anathema to the saver.

Then too, they don't get their interest income in exchange for work. They didn't make something and get paid for it. They just made money. So income increased, and output didn't. People were paid, like, output plus finance, to produce output. So the purchase price of output is the cost of output plus the cost of finance. And every time the size of finance gains on the size of GDP, the purchase price of GDP increases again. Just by growing, finance exerts continuing upward pressure on prices.

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Employment in finance adds to the cost of output, pushing prices up. Interest paid reduces profit and subtracts from aggregate demand, slowing economic growth. The cost of finance contributes to both sides of stagflation: to rising prices and to slowing growth.

If the cost of finance was a one-shot cost, like an oil crisis, maybe we wouldn't even notice a problem. But finance as a rule grows faster than GDP, so it creates continuing cost pressure.

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Finance grows faster than GDP. Therefore, financial cost grows faster than GDP. It's like a slow-moving version of an oil crisis where our use of oil increases every day. Even without an embargo, the cost of it eventually becomes a killer. Oh, and the credit crisis of 2007-08 was the embargo.

Back at the end of World War Two, finance wasn't yet big. Not by today's standard. People had little debt, and interest rates were low. Our lovely little finance, back then, had a lovely little financial cost that didn't much interfere with economic growth. Benefit outweighed cost. And finance, I'll venture, actually helped the economy grow.

But as we enjoyed the fruits of finance, finance grew. And financial cost grew. And there came a moment when the benefit of finance and the cost of finance were equal. That moment, I'll venture, was the end of the golden age. And finance continued to grow.

Back in the 1970s, we were already in the habit of using credit and accumulating debt. Back in the 1960s, policymakers discovered that the benefits of finance far outweighed the cost. They have busied themselves ever since, putting policies in place to expand the availability and use of credit, policies that encourage the growth of finance. And finance continued to grow.

Since the end of the golden age, for the economy as a whole, finance has been a losing proposition. At first, only a little. It was hard to see, because for a long time we thought finance was always good for the economy. But finance continued to grow.

Having grown faster than the economy for generations, finance became massive enough to influence our massive economy. And because of its massive size, the cost of finance came to outweigh the benefit. Finance started to harm to the economy. And still, finance continued to grow.

We still need finance. God knows, we need it. Somehow, we need finance more now than we did when it was little. And yes, that's part of the harm done by finance.

And finance continues to grow.