[Opinion] Stagflation, Understanding and Responding Properly

Seojun Sik, Professor of Economics, Soongsil University

Recent signs of inflation are quite significant. South Korea is also experiencing a consumer price inflation rate in the mid-2% range. With the prolonged COVID-19 situation and rising inflation figures, "Stagflation" has become a hot topic. However, many people cling only to the simplistic definition of stagflation as a situation where "economic recession and inflation occur simultaneously," and express opinions different from mine. Such misguided solutions include delaying interest rate hikes because the economy is still weak or slowing wage increases to control inflation.

I define inflation as "the total price burden of all goods that consumers need throughout their lifetime." And I define stagflation as "1. a situation where the inflation rate rises more steeply than income growth, causing 2. a decrease in effective demand (money connected to consumption), which 3. worsens the recession." For example, during the representative stagflation era of the 1970s, the oil shock, i.e., the sharp rise in oil prices, was the main cause that eroded effective demand and led to a prolonged recession. Stagflation is not simply a phenomenon where inflation and recession occur simultaneously, but a causal relationship where inflation causes recession as a result.

The difficulty for consumers to increase their income as much as the price burden of goods pouring in like a flood has always heightened the instability of capitalist economies since the era of mass production. When income growth is insufficient and concerns about recession grow, central banks of various countries expand the money supply through methods such as interest rate cuts. And the expansion of the money supply inevitably leads to an increase in debt. Although not obvious, one hidden reason for expanding the money supply is to allow consumers to manage the consumption of goods flooding in through cheap household loans or installment financing.

However, if the central bank’s expansion of the money supply leads to a sharp rise in real estate prices, it becomes a case of adding insult to injury. If income remains the same but the price of housing, a kind of essential consumer good, rises, the money available for other goods consumption, i.e., effective demand, significantly decreases after allocating funds to pay for housing. This is also why the economic recovery prospects of Japan and Europe, which maintained zero interest rates for a long time, are considered to be even lower. The possibility of recession expanding into a panic also increases. We already know why private debt and real estate bubbles have become hallmarks of major crises such as the Great Depression, the Japanese bubble collapse, and the global financial crisis.

Trend of Consumer Price Index Growth Rate Over the Past Year

Diagnostically, we have already entered the process of stagflation. Unfortunately, in recent years, inflation has risen much faster than income growth. Although one might question this given that the consumer price inflation rate was in the 1% range from 2016 to 2018 and around 0% from 2019 to 2020, in my view, the Consumer Price Index from Statistics Korea now diverges too much from reality to be reliably used for important economic diagnoses or decision-making.

Just by looking at local housing prices and meal costs, one can immediately see many problems with the inflation index statistics. It is regrettable that the Bank of Korea, as the pilot, still heavily relies on this faulty gauge. The price burden of goods that the young people of this land will have to consume throughout their lives has risen tremendously over the past few years. Under these circumstances, a rapid recovery of effective demand is difficult.

Stagflation is not a future concern but a current ongoing issue. Therefore, policy prescriptions should not be about prevention but about suppressing and excising the cancerous growth already present. This means that the money supply must be absorbed again. Fortunately, the Governor of the Bank of Korea recently hinted at an interest rate hike within the year, expressing concerns about inflation.

The sooner, the better. Starting early allows for gradual implementation, minimizing shocks to the market and economy. Meanwhile, the government must invest more boldly to raise consumers’ incomes, which have lagged behind the pace of inflation.

From an investor’s perspective, it is time to consider the high likelihood that the money supply will be absorbed again. Asset prices that rose significantly due to the power of money tend to fall easily when that power weakens. Asset prices that are reasonably linked to performance do not fall easily just because the power of money weakens. Remember Warren Buffett’s famous saying, "Only when the tide goes out do you discover who’s been swimming naked." It is time to find and invest in assets that are properly "clothed."