How bad will it get? 

iangunn May 3rd, 2022

One way or another, life seems to mimic the computer game, Mario Kart, with banana skins being flung willy-nilly into our paths. Naturally, nobody knows how bad things will actually get, but there are some pointers from history that might provide a few clues.

There seems to be growing fear of ‘stagflation’. The expression refers to the evil twins of high inflation and a stagnant economy, something which conventional economic theory denied could happen – unemployment was thought to be the ‘safety valve’ in the economy, so that rising unemployment was expected to be deflationary.

However, during the 1970’s, which happens to coincide with the time when I was studying economics (yes I know that was fifty years ago, but I am that old, really), three conditions persisted at the same time – high inflation, high unemployment and a stagnant economy – thus challenging thinking and policy making, and the derivation of ‘stagflation’. The only way out was a recession.

Back then, it was steep rises in the price of oil that were the trigger for severe negative economic consequences (other than for the oil producers of course). At that time, before North Sea oil, imports represented a high proportion of GDP, so the price of crude was critical.

Between 1974 and 1978, the average crude oil price was in the range US$10-15 per barrel (IMF data). That represented approximately a five-fold increase in the prices observed between January 1971 and September 1973. This was the first oil price shock.

In mid-1979, the price of a barrel of crude oil first exceeded US$30, reaching almost US$40 by early 1981. As a result, between 1979 and 1983, the average price was almost three times higher than it had been between 1974 and 1978.

Now, it is the wholesale price of gas which has provided a series of external shocks to the UK economy. Adding to the misery, Brexit, the Russian invasion of Ukraine and the restarting of the global economy after lockdowns during the Covid-19 pandemic, have triggered a series of supply chain shocks.

For the time being, unemployment remains relatively low, but inflation is racing away and growth has all-but stalled. The current conditions do not therefore meet the traditional definition of stagflation.

Whatever you want to call it though, there can be little doubt that there are going to be even tougher times ahead, with huge pressure on real earnings which, for many people, have either fallen or barely risen since the great financial crash of 2008. There will also undoubtedly be pressure on corporate earnings too – rising energy and food costs will leave consumers with less to spend elsewhere.

For example, Netflix has recently reported losing subscribers for the first time in a decade and predicted further losses in the second quarter of the year, causing its share price to plummet. This is one of many alarming signals.

Furthermore, the extent to which an already massively indebted state can intervene to stave off the worst effects of a cost of living crisis and/or a recession, particularly when interest rates are rising (raising the cost of government borrowing) is limited without the political will to do otherwise. It seems a general election may now happen before 2024, if recent speculation is to be believed.

Investors therefore have a lot to worry about, and little idea of the true range of outcomes in such uncertain conditions.

Of course, more could happen than will happen, and worries about what is around the corner are nothing new. But, there’s no escaping the bumpy road ahead we all face. It feels to me that now, more than ever, a guiding hand is going to be vital.