07.08.2022
Recent events suggest that the US and the EU are moving towards stagflation, that is, the coexistence of inflation and low economic growth, with adverse effects on unemployment and social cohesion.
In general, governments and central banks have two main tools that allow them to intervene and influence the course of the economy. Both are aimed at expanding or, depending on the circumstances, at curbing the pace of economic growth. These two instruments include fiscal policy, which includes adjustments to government spending and taxation, and monetary policy, which includes changes in base interest rates and effects on the money supply.
Periods of stagflation pose an acute dilemma for the authorities, since, as a rule, policies aimed at curbing inflation have a negative impact on unemployment, and vice versa.
Stagflation is caused by two main factors:
1) Reduced production of basic commodities such as butter, which has an increasing impact on prices and at the same time holds back economic activity as it increases production costs and limits profitability.
2) Simultaneous adoption by the authorities of a macroeconomic policy that limits the production of goods and services while inflating the money supply.
Both factors played a decisive role in the 1970s, when there was stagflation, first in the UK and then around the world, when OPEC quadrupled oil prices in October 1973. The resulting stagnation prompted central banks to pursue an overly expansionary monetary policy, thus triggering a vicious cycle of rising prices and wages.
The theoretical correlation between inflation and unemployment, especially in recent years, has come into question. However, the above factors appear to be leading to a new period of stagflation today. In particular, the combination of an overly long period of interest rate suppression and the expansionary monetary and fiscal policies adopted in response to the pandemic, as well as the adverse effects of the war in Ukraine on energy and food production, have created fertile ground for resurgence of stagflation.
The implications for the economies of smaller countries, including Cyprus, are particularly large given: (a) over-reliance on imported energy and raw materials, (b) the ineffectiveness of strategies to reduce dependence on traditional forms of energy, for example, through the promotion of renewable energy sources and (c) limited scope for fiscal support given that the fiscal framework is largely governed by European rules.
Macroeconomic conditions will be particularly challenging in the coming years. Countries will be encouraged to increase economic prosperity by promoting digital and green growth. At the same time, they will be called upon to provide targeted assistance to vulnerable social groups in difficult financial conditions and with limited fiscal resources at their disposal.
Economic aspects and, in particular, the proposed policy to combat the phenomenon of stagflation, of course, should be among the priorities of the election campaign of the President of the Republic of Cyprus. We all need to carefully consider the positions of the candidates.
Andreas Charalambous is an economist and former director of the Ministry of Finance. Omiros Pissarides is Managing Director of PricewaterhouseCoopers Investment Services.
