A remedy for the new stagflation Until two years ago economists could boast that they knew "how to use monetary and fiscal policy to keep any reces- sions that might break out from snowballing- into chronic slumps ". Now, however, they appear puzzled by the intract- ability of the current recession, which is paradoxically accom- panied by a persistent inflation, and they find themselves poised on the horns of a dilemma. They wonder whether they should advise their governments -as most of* the American eco- nomists did in the middle of last year-to give priority to the fight against inflatiori through a restrictive monetary and fiscal policy, at the risk of aggravating unemployment and recession, or whether they should advise them-as the American President's Council *of Economic Advisers did at the beginning of this year-to cut taxes and increase expenditure, in order to stimulate the economy, at. the risk of rekind- ling inflation. I dare suggest that at the root of this puzzle is the lack of a correct diagnosis of the current world economic crisis, which would show the way to the solution of the crisis., Despite the complexity and intricacy of the problem,' I would venture to outline here a simplified diagnosis and' solu- tion. It seems to me that what'the western world economy is now afflicted with is not simply-as is usually assumed-a cyclical recession combined with an inertial inflation, both of which are in fact the aftermath of the 1972-73 " boomflation "; it is rather a. complication of that recession and inflation-which I would call "petrostagflation " -brought about by the oil price explosion since the end of 1973 and, what is more important, by the inability of the petroleum exporting countries (Opec) to absorb goods and services equivalent to their huge oil earnings. Following the oil price ex- plosion the Opec countries in- creased their exports in 1974, compared with 1973, by about $90,000m, whereas they could. increase their imports of goods and services by only $25,000m. Thus, they increased their current balance of payments (BOP) surplus in 1974 from $5,000m to $70,000m. However, because of a time-lag between the export of the oil and its importation to, and payment by, the petroleum importing coun- tries (PIC), the Opec surplus funds in 1974 were estimated at As international trade is a kind of zero-sum game, that surplus has necessarily created an equivalent deficit in the com- bined balance of payments current account of the PIC. It has generally been thought that the main problem which that deficit created was the for. eign exchange one. In 1974 the PIC managed to solve that prob- lem in recycling the petro- dollars through the Eurodollar markets, the IMF and the American money market, by bilateral loans from' the Opec and, in some cases, by scaling down their foreign reserves. In fact, however, that was not the only problem. The oil BOP deficits have created at the same time two further problems in the domestic economies of all PIC. First, the business sector found itself unable to sell goods and services of- a total value equal to their countries' deficits ($56,000m). With such stocks of unsold goods in hand, the business sector was faced with a liquidity crisis, and, in order to improve its liquidity, was compelled to reduce,.its stocks and cut back further produc- tion and new investment. Of course, such cutbacks to- gether with their multiplier effects, created widespread un- employment and recession. The latter situation has been aggra- vated further by the consequent fall in the personal sector's de- niand for durable goods and new housing. That is what I would call "petrostagnation". Second, as the increased cost of oil raised the cost of living and the cost of production of domestic goods and services, Chris Economides argues that oil deficits are at the root of the West's present difficulties and suggests ways of countering their effects Second, by increasing these ex- port prices the commodity. importing countries seek to reverse the terms of trade in their favour; such a reversal is usually facilitated by the fact that the higher commodity prices stimulate higher produc. tion of commodities which leads to a fall in their prices in the following years. Lastly, the reversal of the terms of trade in their favour' and the growth in their produc- tivity through higher exports enable the commodity-import- ing countries to raise the level of their real incomes, thus put. ting an end to domestic infla- tion. By contrast, petroinflation does not serve the above useful economic purpose save to the very limited extent that the Opec now absorb more goods and services than in 1973; to price index and by reducing VAT and other indirect taxation. At the same time, prices and incomes policy measures should have been taken to ensure that the subsidies and indirect tax cuts were effective in breaking the vicious spiral of inflation. If petrostagflation had thus been forestalled, it would, -I believe, not have been too diffi- cult to tackle the residual cyclical recession through the conventional monetary and fis- cal policy. Since, however, such forestalling measures have not been taken in time and all PIC -are now plunged into the petrostagflation, the question now is how to arrest it. Of course, the correction of any evil is much more difficult than its prevention, especially when its continuation has created a lot of complications. In this case, the well-knoin the real incomes of all income- earners (workers, employers and others) in the PIC fell by an amount roughly equivalent to the increase in their coun- tries' oil bills. In other words, and assuming that there were no changes in the production and productivity in those coun- tries between 1973 and 1974, goods and services valued in 1974 at about $56,000m, which the income-earners had con- sumed in 1973, were in 1974 beyond their reach because of their increased prices. , In the circumstances, all Income-earners tried to regain their previous real-income levels through increases in their money incomes. That attempt, however, was self-defeating, as it created a vicious spiral of wage-cost-price inflation. How- ever high their incomes might rise, -they could not buy the goods and services valued at $56,000m, which they were miss- ing, because the higher their incomes rose, the higher the cost of production and, conse- quently, the prices of all domes- tic goods and services became. Although the initial impact of the oil price rise in the PIC domestic prices was only 2 to 3 per cent, the consequent vicious spiral, intensified in some cases (like that of Bri- tain) by the depreciation of their currencies, has created a double-digit inflation. This is what I would call "petro- inflation ". The crucial differences be- tween an ordinary commodity- cost inflation and petroinfla- tion are these: In the former case, the com- modity exporters use their higher earnings in importing equivalent go6ds and services from the commodity-importing countries; so the latter have the opportunity to recoup the increased prices of commodities they paid for, by raising the prices of their exports. In this way, the ordinary commodity-cost inflation serves, I dare say, a useful economic purpose: first, domestic infla- tion releases goods for export in order to pay for the higher cost of imported commodities. the larger extent that they amass financial assets rather than goods, and so long as they continue to do so, the PIC are, and will continue to be, liable to petrostagflation. None the less, this bizarre affair has a comforting aspect which is also crucial. to the solution of the problem: the redundant goods and services, the unsalability of which, is provoking petrostagnation, are equivalent to those that have been cut from the real incomes of the income-earners in the PIC, whose vain attempt to regain them is creating the vicious spiral of petroinflation. So, here we have two com. plementar_ problems which could be solved by making available to the income-earners the goods and services which they are missing and which the business sector wants to sell. How to do it? The reason why these redun- dant goods and services could not be bought by the income- earners was that the purchasing power for them was theoretic- ally held by the Opec who had supplied the high-priced oil. After. the recycling 'of the petrodollars, however, that pur- chasing power reverted to the governments of the PIC which undertook to pay these dollars directly or indirectly to the Opec (together with interest) sometime in the future. So, just before petrostagfla- tion started, the public sector was in possession of the pur- chasing power which the income-earners had lost through the rise in the cost of living and for which the business sector wvanted to exchange its unsalable goods and services. Therefore, the petrostagfla- tion could have been forestalled if, parallel to the recycling of the foreign exchange, the gov- ernments of the petroleum im- porting countries had recycled the equivalent purchasing power back to the income-earn- ers of their countries not by increasing their incomes but by reducing their cost of living. This could have been done by subsidizing food and: other essential items of the retail complications have been high worldwide unemployment, very low productive capacity utiliza- tion, a substantial fall in the volurne of international trade, vast government budget deficits and high inflation. All these evils interact on one another in a vicious circle which has to be broken. The overall balance of pay- ments' current surplus of the Opec and the corresponding combined deficit of the PIC are expected to be reduced in 1975 to $35-40,000rn, owing partly to the Opec's increased imports from the industrial countries-a large part of which ominously consists of modern arms-and partly to the lower volunfe'of their oil exports due mainlv to the worldwide recession. Fur- ther reductions are also ex- pected in the coming years as Opec's absorbing capacity for goods and services will be in- creasing. In spite of such reductions however, it looks rather unlikely that the Opec's current balance of payments surpluses will be reversed into deficits-in which case the PIC will have corre- sponding combined' su'rpluses- before the early 1980s, because ill the meantime Opec's revenues will be increasing by their in- comes from their cumulative surpluses, and because the worldwide recession will hope- fully come to an end and the demand for oil will increase. It therefore looks as if the PIC economies on the whole will continue, to be afflicted with petrostagflation for several more years. It may be argued that the major industrial countries have already managed to either get rid of, or reduce their oil BOP deficits. In the context-of the zero-sum game of international trade, however, the improve- me4t in the current BOP of some is being achieved only at the expense of their weaker fellows, and more particularly, the non-Opec developing coun- tries, whose BOP deficits and predicaments are thus being correspondingly aggravated. -: MIoreover, this aggravation is backfiring against the industrial countries themselves, as it re- duces their export chances, on which the recovery of their economies so much depends. - Nevertheless, in spite of all these aggravating develop'i ments, I believe that the remedy for the current complicated pet- rostagflation should still be on the, lines outlined abore, namely: 1. All petroleum impbrting countries should spend amounts equivalent to the oil BOP defi- cits which they would have under conditions of full employ, ment, in the form of subsidies and indirect-tax cuts with a view to stabilizing their cost of liv- ing index. At the same time prices and incomes policy mea- sures should be taken to ensure that these subsidies and taX cuts are effective in breaking the wage-cost-price -vicious spiral. 2. Parallel to the above, ex- pansionary monetary and fiscal measures should be taken to stimulate the economies of all PIC. The fundamental difference between the measures suggested here and the conventional ones is that inflation is to be cor- bated through a reduction -in the supply price -of conisumer goods and not through the cut- ting back of general demafid by restrictive monetary and fis- cal measures, which is at cross purposes with the reflationary measures needed to combat the current disorder of recession. This, I dare suggest, is the way to get off the horns of the dilemma referred to at the be- ginning of this article. - . -The autlor is an economist from Cyprus who is at present a Visiting Research Fellow at the Queen Elizabeth House, Oxford. He is the author of Earned International Reserve -Units: the Catalyst of two complemen- tary World Problems-the Monetary and Development. - A remedy for the new stalfl2tin .