Jayati Ghosh*


There is no doubt about it: the US
financial structure is crumbling, possibly even collapsing. The
collapse of a major Wall Street bank and the enormous bailouts that
are being offered to financial institutions in the US by the US
Federal Reserve are only symptomatic of the wider crisis created by
the unravelling of the real estate boom based on dodgy lending


Everyone knows that what has already
come out is only the tip of the iceberg. The financial crisis has
clearly spread quite dramatically: from "sub-prime"
borrowers to "prime" borrowers; from bad mortgage debt to
bad credit card debt; and from banks to hedge funds to insurance
companies. There is no doubt that there is much more bad news to come
within US markets. And most certainly, given the sheer size of the US
system and the complex forms of financial pyramiding and entanglement
with other financial structures in different countries, the global
financial system will feel the impact.


There is also little doubt that the US
economy is heading into, if not already in, a major economic
recession. The economic data from the last two quarters is poor, and
the prognosis is worse. In the last quarter of 2007, the US economy
grew at only 0.6 per cent, and much of that increase was due to
higher exports rather than domestic demand. Retail sales have
declined in the first two months of 2008 compared to the previous


The most recent employment data show
that the US lost 63,000 jobs in February 2008, following a fall of
22,000 in January. Initial claims for unemployment have been rising
and have already reached levels associated with previous recessions
in 1990 and 2001.


Indeed, such figures suggest not a mere
recession but even a more substantial depression is in the offing for
the US. This is likely to intensify as the effects of the housing
foreclosures and worsening financial position of households combine
with rising unemployment to create significantly reduced consumption
demand. Investment will suffer not only because of the reduced
assessments of future market demand but also as the financial crisis
makes it harder to access finance for new investment. And so the
elements of the downward spiral are all in place.


And here too, the rest of the world
will feel the impact, as the large economy whose voracious demand for
imports had fuelled the most recent global economic expansion stops
being an engine of growth. So there is no doubt that world output
growth will be adversely affected, particularly in those countries
(such as China) that had been growing rapidly on the basis of rapid
increases in exports to the US.


The collapse of the US dollar vis-à-vis
other major currencies is not only related to these troubles; it also
reinforces them, while simultaneously generating cost-push
inflationary pressures within the US by making imports more
expensive. Import prices have increased by nearly 14 per cent in the
year to January 2008, which is the fastest increase since such data
began to be published in the early 1980s. As a result, there is
evidence of greater inflationary pressure already at work. The
year-on-year producer price index in February rose by 7.4 per cent,
making it the biggest increase in more than 26 years. In the past
three months, the consumer price index increased at an annual rate of
6.8 per cent.


This combination of stagnant or falling
output and rising prices is why more and more economists and analysts
in the US have started using the dreaded S-word – stagflation –
to forecast the immediate future of the US economy as well as the
world economy. This immediately brings to mind analogies with the
period of the 1970s, when not only the US but the entire world
economy suffered a prolonged period of income stagnation and even
decline and increased unemployment, accompanied by rising price
levels. At that time, the rise in oil and other commodity prices
combined with attempts by workers in developed countries to maintain
their real wages in the face of rising costs of living generated
inflationary spirals, and economic volatility and depressed investor
expectations caused real output and employment to stagnate.


The stagflation hypothesis appears to
be reinforced because the current period is also a time when global
commodity markets are experiencing some of the highest prices ever.
Crude oil prices, at more than $111 a barrel in the middle of March,
are higher in real terms than they were at the height of the oil
shock of the 1970s. Other commodities such as metals have been
showing very high and rising prices for the past year. World wheat
prices are also at record highs, hit by falling output (because of
acreage shifts in the US to biofuels, along with bad weather
conditions in major exporting countries like Australia and Canada).


And now gold prices have hit record
highs, crossing $1000 per ounce in early March. This is something
that typically happens when inflationary expectations are high, as
investors seek safety in real assets rather than financial assets,
and gold remains the most convenient of such commodities.


So does all this suggest that not only
the US but the entire world economy is heading towards stagflation?
The answer may well be yes, but not for the reasons that are
generally being offered by many analysts. Several economists have
offered an essentially monetarist analysis of stagflation, whereby it
is brought about by central banks trying too hard to prevent
recession, and thereby keeping interest rates too low and monetary
policy too loose. According to them, this creates an excess of money
supply, which then generates higher inflation. Instead, they argue
that if the Fed holds its nerve and simply tightens its monetary
policy in the face of rising price levels, then inflation will be
brought down even at the cost of some temporary pain in the form of a


Remember that the essence of
stagflation is a prolonged combination of stagnant income and rising
prices, rather than a stagnation that has a temporary rise in
inflation followed by a more widespread deflation. While there is no
question that aggregate world incomes will grow more slowly than they
have in the recent past, whether or not there will also be rising
inflation depends not upon monetary policies and the attempt to
control money supply, but on the ability of different groups in the
economy to maintain their distributive shares.


That is because inflation in modern
economies is essentially about two forces: the fight over
distributive shares in national income by different groups, and the
role of expectations about inflation. Thus, if there is a rise in
commodity prices (that would increase the relative income share of
commodity producers) then this will only lead to a rise in the
general price level if capitalists insist on maintaining their
margins over costs at the same level. If they are unable to do so for
any reason, then the rise in commodity prices need not translate into
a generalised inflation.


Similarly, if the initial rise in
prices pushes down real wages and workers are not in a position to
demand increases in nominal wages that would maintain their real
wages, then the inflation is controlled. Tight monetary policies are
usually a way of enforcing this by allowing greater unemployment, so
they work indirectly rather than directly to control inflation. So
inflation reflects a wider fight over income distribution.


Expectations add another dimension to
this, by making different agents behave in ways that are determined
by their anticipation of future inflation. If higher prices are
anticipated, producers and retailers will set their prices higher to
absorb such expected effects, and workers will scale up their demand
for nominal wages. In this way, the expectations become
self-fulfilling and create an inflationary spiral that becomes hard
to break.


Therefore, whether or not there will be
stagflation depends ultimately on international political economy and
the relative strength of different groups in the world economy. It
may be argued that working classes and peasants have been so weakened
by the onslaught of neoliberal policies of the past two decades that
they are in no position to fight to maintain even their already
significantly diminished shares of income. If this is true, then the
likelihood for the immediate future is an economic recession with
worsened conditions of living and higher unemployment across the
world, albeit with lower rates of aggregate inflation.


But if the world has changed in other
ways that make further attacks on people's livelihood more difficult
in most countries, then the current crisis may well become an
opportunity. A period of stagflation and generalised capitalist
crisis could augur a different global political economy and more
creative approach to economic policy making, in which rapacious
profit making is restrained and ensuring better material conditions
for the majority becomes instead the basic policy priority.


This is not as far-fetched as it may
sound. The 1970s may be remembered with fear and loathing by finance
capital, but they were also a period in which several developing
countries began the industrialisation process that culminated in the
"success stories" of east Asia and elsewhere. And surely
the destructive tendencies of the most recent phase of capitalism
require a shift in economic strategy in a more democratic direction,
which can only be enabled by the clear collapse of the existing


* Jayati Ghosh is Professor of
Economics at the Centre for Economic Studies and Planning, Jawaharlal
Nehru University, in New Delhi, India. She is on the executive
committee of the International Development Economics Associates
(IDEAS), a network of economists critical of the mainstream economic
paradigm of neo-liberalism.

April 8, 2008. © International
Development Economics Associates 2008