Understanding Stagflation

It's apparent that Dean Baker has never heard of stagflation, Austrian Business Cycle Theory or Zimbabwe.

He writes:

It is worth noting that there is no economic theory that shows quantitative easing (the Fed buying long-term bonds) leads to inflation when the unemployment rate is far above normal levels, as is the case at present.

On stagflation as a monetary phenomena during a downturn see the important paper by Robert Barsky, University of Michigan and NBER, and Lutz Kilian, University of Michigan and CEPR, A Monetary Explanation of the Great Stagflation of the 1970s, where they write:

The data show a rather dramatic expansion in the world money stock (see McKinnon 1982), led by the behavior of the United States and facilitated by the breakdown of the Bretton Woods system. We view this expansion as the initiating cause of the stagflationary episode of 1973-1975. A similar monetary expansion preceded the second stagflationary episode of 1982. The recessionary element is provided by the fact that money-induced booms contain the seeds of their own destruction.

In otherwords, the money printing caused the unemployment.

As for Austrian Theory on unemployment and money printing Murray Rothbard writes:

Every time someone calls for the government to abandon its inflationary policies, establishment economists and politicians warn that the result can only be severe unemployment. We are trapped, therefore, into playing off inflation against high unemployment, and become persuaded that we must therefore accept some of both.

This doctrine is the fallback position for Keynesians. Originally, the Keynesians promised us that by manipulating and fine-tuning deficits and government spending, they could and would bring us permanent prosperity and full employment without inflation. Then, when inflation became chronic and ever-greater, they changed their tune to warn of the alleged tradeoff, so as to weaken any possible pressure upon the government to stop its inflationary creation of new money.

The tradeoff doctrine is based on the alleged "Phillips curve," a curve invented many years ago by the British economist A.W. Phillips. Phillips correlated wage rate increases with unemployment, and claimed that the two move inversely: the higher the increases in wage rates, the lower the unemployment. On its face, this is a peculiar doctrine, since it flies in the face of logical, commonsense theory. Theory tells us that the higher the wage rates, the greater the unemployment, and vice versa. If everyone went to their employer tomorrow and insisted on double or triple the wage rate, many of us would be promptly out of a job. Yet this bizarre finding was accepted as gospel by the Keynesian economic establishment.

By now, it should be clear that this statistical finding violates the facts as well as logical theory. For during the 1950s, inflation was only about one to two percent per year, and unemployment hovered around three or four percent, whereas later unemployment ranged between eight and 11%, and inflation between five and 13 %. In the last two or three decades, in short, both inflation and unemployment have increased sharply and severely. If anything, we have had a reverse Phillips curve. There has been anything but an inflation- unemployment tradeoff.

But ideologues seldom give way to the facts, even as they continually claim to "test" their theories by Facts. To save the concept, they have simply concluded that the Phillips curve still remains as an inflation-unemployment tradeoff, except that the curve has unaccountably "shifted" to a new set of alleged tradeoffs. On this sort of mind-set, of course, no one could ever refute any theory.

In fact, current inflation, even if it reduces unemployment in the short-run by inducing prices to spurt ahead of wage rates (thereby reducing real wage rates), will only create more unemployment in the long run. Eventually, wage rates catch up with inflation, and inflation brings recession and unemployment inevi tably in its wake. After more than two decades of inflation, we are now living in that "long run."

Baker must also be unfamiliar with the real world example of inflation and unemployment climbing in tandem:

...in Robert Mugabe’s Zimbabwe, a country’s whose unimaginable hyper-inflation rate (upwards of 231 million percent by recent accounts) and unemployment rate (as high as 94 percent throughout the country) cause not only economic, but civil and political strife..

Stagflation occurs whenever a central bank prints money, but a sum of money that is not sufficient to re-establish a previous central bank distorted capital structure. I see even Austrians get this wrong sometimes. Fed money printing does not always lead to stagflation. There can be periods when the central bank money printing is sufficient to boost the economy (though in a distorted manner). There can be some short-term stagflation when the Fed stops printing money and the economy starts to readjust toward consumer goods, which results in consumer goods price inflation. But mostly stagflation occurs when the Fed prints money that is not of sufficient quantity to uphold the previously distorted capital structure BUT is enough to add price inflationary fuel to the fire.

The current period is unlikely in the short-term to lead to stagflation, since the Federal Reserve is not printing any money. There may be some inflation, if the desire to hold cash balances diminishes, but it will not be severe. The threat of serious stagflation (double-digit inflation) won't occur until the Fed starts printing huge quantities of new money. There is no indication they are going to do so in the near term (3 months plus).