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  Two Models of Stagflation, One Useful, One Not

  By James Annable | Jan 15, 2021

  Mainstream FGME Analysis

  Mainstream friction-augmented general-market-equilibrium theory cannot  explain the massive market failure that occurred during the stagflation decade. That episode featured simultaneous high unemployment and a powerful price-wage spiral that broke apart what had been a remarkably stable interindustry wage structure. We know that involuntary job loss was the engine of rising unemployment in the stagflation recessions of 1974-75, 1980, and 1981-82. But, given that forced job loss cannot coherently exist in FGME modeling, the consensus story ignores actual employment behavior that accompanied the persisting instability. It is the familiar macro conundrum produced by market-centric thinking. Wage recontracting must, but cannot, be rationally suppressed. Playing by the rules governing the New Neoclassical Synthesis, modern New Keynesian (NK) theorists have always had less capacity than discredited Early Keynesians (EK) to elucidate, albeit imperfectly, the unemployment part of the stagflation story.

  The second central part of stagflation mechanics, the powerful price-wage-price spiral, is also out-of-reach for market-centric thinking that, by definition, pays no attention to information-challenged workplaces. If we are to understand stagflation, we must first understand how wages adjust for inflation. We must understand that rational workplace behavior mandates the use of catch-up to price change that has already occurred, providing a necessary tool to model the 1970s nominal spiral. Generalized-exchange mechanics, and the nominal persistence they enable, are not available to modern theorists who restrict wage adjustments for inflation to anticipated future price change. The hard fact is that exclusive reliance on rational expectations is irreconcilable with rational behavior.

  Market-centricity denies employees the means to compel employers to increase wages in the circumstances of unemployment that exceeds its natural rate. Stagflation’s characteristic price-wage-price spiral, the nature of which was closely documented in my The Price of Industrial Labor (1984), cannot exist in FGME modeling. Mainstream theorists must disregard the fact that only half of all workers were able to defend their real wages against the 1970s adverse terms-of-trade shifts, that those workers were concentrated in information-challenged...

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