Talk Elections

What were the primary causes of the stagflation of the 1970s.  Explain like I'm five.

I assume my reply to your post was the reason behind you asking this:

"1.Keynesian economics failed to address the problem of inflation of the 1970s (starting in the late 1960s.)  Keynesian theory held that unemployment and inflation could not rise at the same time, they argued that a nation could have a little more inflation for a little less unemployment. 

Essentially the idea behind this was that due to the circulation of money, there was a fiscal multiplier effect to government spending.  The government would put money into the economy and due to it being spent multiple times, jobs would be created.

Monetarists showed that in normal economic times (i.e no recession) new money introduced into the economy without an increase in productive capacity (or output) would just result in inflation: "too much money chasing too few goods."  They showed "in the long run, the fiscal multiplier is zero" (or "dead" in the original quote.)

So, this change in economic theory removed the argument for governments to try to 'fine tune' the economy to reduce unemployment."


I think there are two ways to answer your question: either with an analogy or with a simplified mathematical explanation, unfortunately, I'm not smart or capable enough to come up with either.

If you ask me what you don't understand about my post, I might be able to figure something out.

Prior to then it was believed that unemployment and inflation moved in opposite directions (see Phillips curve), so fiscal and monetary policies were primarily about picking the right mix of unemployment and inflation.

You will obviously get many different arguments for why this no longer held, but one major reason was that a constant inflation of n% just meant the entire economy inflated by n%. Lets say inflation is 5% for the last 5 years. Unions (which had power back then) would negotiate raises and business would plan all expenses assuming a 5% inflation, so in the end result everything just went up 5% without affecting the unemployment rate. Now that everybody expects 5%, they plan on 6% next year and 6% is the new norm. Repeat. In other words, a wage-price spiral, with no changes in the unemployment level.

Thus arose the concept of non-accelerating inflation rate of unemployment (NAIRU).  The argument here went that there is some natural rate of unemployment, and any attempt to push unemployment below that level would just inflate the economy. So, policies shouldn't try to lower unemployment below the NAIRU (some variations wanted to make policies to keep unemployment significantly higher than NAIRU in the belief that hunger feeds innovation). The NAIRU (imprecisely called full employment) was typically taken to be about 5%. The problem with this was of course that unemployment has often been lower than 5% (including in Clinton's second term and since about 2014). And of course there is some intellectual dishonesty, with some redefining the natural rate to be whatever it is right now since they just want tight monetary policies.

TLDR:

OPEC forced oil prices to go up = energy prices go up = harder to produce things = all good prices increase. THIS IS INFLATION.

OPEC forced oil prices to go up = energy prices go up = harder to produce things = people get fired because less people are buying goods, they cost more to produce, and there are less profits. THIS IS UNEMPLOYMENT.

UNEMPLOYMENT + INFLATION = STAGFLATION

Stagflation is the trend when consumable goods, especially necessities, increase in price, while luxuries decrease in price. There are two general reasons for this: either something unusual happens to the supply of consumables, leading to a spike in price, leading to more money spent on consumables & less on luxuries; or economic stagnation results in a growing number of people having their demand for durable luxuries satisfied (imagine if no new cell phones were released for several years).

Re: the 70's, the economy was stressed due to the combination of the Vietnam War & the Great Society. The US went off the gold standard because there just wasn't enough gold around anymore to keep growing. American support for Israel pissed off the Middle Eastern oil producers, which the West was increasingly dependent on. With the gold standard down, those same oil producers were losing revenue fast, & decided to get some back by instituting an oil embargo.

So, while there were many factors involved, the key one was oil. The oil crisis was the main contribution to the stagflation: it increased not only oil prices, but also the cost to transport goods, especially high-volume consumables, including food. Now, Nixon not only mishandled the situation with wage & price controls, but a less major issue too was the economic decline meant that the Silent Generation, who remembered the Great Depression, started cutting back on luxury spending. This was made worse by the response of the Fed (which was led by a highly partisan person who wanted to keep getting Republicans elected) to this: seeing economic trouble, they decided to excessively ease monetary policy to keep unemployment down by lowering interest rates & increasing the amount of money that was available, but both companies & people kept spending on necessities & not much more, making the inflation worse.

The result of all of this simultaneously happening was stagflation, an event that economic theory at the time didn't account for & didn't say anything about how to handle it.

On the inflation part, the main thing was the accommodative monetary policy of the Federal Reserve (at that time, ultimately the policies of Richard Nixon, Gerald Ford and Jimmy Carter since the independence of the Federal Reserve had not fully been established at time time) primarily in terms of printing money:

"Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output." Milton Friedman

Partly it was the odd dogma that inflation and unemployment were inversely linked. (There are some economic factors that do promote both inflation and employment, but they aren't always dominant in the economy.) But it was also a failure to consider the effects of externalities on the economy. It began with the extravagance of funding both the Vietnam War and the Great Society simultaneously and then just as we started cutting back on excessive military spending,we got the oil shocks which beyond the economic effect of increasing energy costs, caused a hunkering down on spending for other things at the worst time. One thing that FDR, Reagan, and Obama all got right was the importance of emphasizing hope over fear. That's essential for a well functioning economy.