Back in Time: Second Regime

1970-1985 

The economy fully embraced the period of global co-operation during the Bretton Woods agreement, with growth increasing an average of 6% to 8% between 1950 and 1970. As foreshadowed by the economic cycle, a period of expansion is often followed by a slowdown in activity that marks the beginning of an economic contraction. This is precisely what happened in the 2nd Regime. The defining macroeconomic events that plagued these years were high inflation and a tough oil crisis (although these factors spanned across the entire world, this segment specifically points to the U.S. and U.K. economies).

Central Banks’ objectives set in place for their monetary policy differ from country to country, although reducing unemployment and curtailing inflation are everyone’s main priorities. As the U.S. noticed their Dollar value depreciate, coupled with unemployment and GDP taking a sudden turn for the worse, they enacted a new monetary policy to revive the economy. A similar approach was taken by BOE when attempting to contain a similar crisis in the UK. In both cases, Central Banks responded by increasing interest rates in an effort to spur economic growth and reduce unemployment. A natural effect of an expanding economy is higher inflation because aggregate demand rises faster than supply, forcing prices up. Ironically, the pursuit of full employment was the seed that led to the downfall of their policies. Central Banks, mistakingly, took for granted the stable relationship between unemployment and inflation. In other words, they firmly believed in the Phillips curve: an idea that represented an inverse relationship between unemployment and inflation, whereby inflation rises as unemployment decreases. The Governments were so focused on reaching full employment that they were willing to accept higher inflation, to the extent that it started rising disproportionally to unemployment. The stability of the curve was a fatal assumption and definitely not a good bargain to take.

The second disruptive force to plague the 1970s was the oil crisis. OPEC members, previously side-line players just looking to increase their market share, began exercising considerable economic and political strength. Oil turned into a weapon used by OPEC members to force the U.S. and U.K. into becoming more pro-Arab. In 1973 they imposed an oil embargo,  production was cut by 5% month-on-month and the price per barrel was raised significantly. Countries who were still reaping the benefits of the post-war period relied on cheap oil to run their businesses; keeping their activities running was not a luxury they could give up. Immediately after oil production slowed down, the short-term demand proved to be inelastic even though prices skyrocketed to $12 per barrel to account for the lower level of supply. The impact of the oil crisis was so tremendous it gave rise to a new concept called cost-push inflation. This type of inflation is a result of disruptions in the supply chain that cause the increase in production prices to be passed on to the end consumer, resulting in higher retail prices.

Inflation and rising oil prices nurtured Stagnation, an economic situation caused by a prolonged period of no growth paired with extremely high prices. The global repercussions are noticeable in the below chart.

World GDP

The two dips, first one in 1975 due to the oil crisis, and the second in 1980 caused by a global recession, forced global GDP to drop significantly. Interestingly, these two dips were the lowest in history, except for the financial crisis of 2008 that sunk the GDP line below the horizontal axis into negative territory.

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