International Stagflation and the ‘Locomotive Hypothesis’

Abstract

International Stagflation and the ‘Locomotive Hypothesis’

The second ‘oil shock’ of 1978-1979 made a replay of the economic consequences of the first oil shock of 1973 - 1974 possible, even though it was not possible to predict the exact impact of and reactions to the second oil price hike. It is thus of interest to compare the cyclical conditions of the major Western industrialized countries (plus Japan) at the beginning of the supply shocks and to analyse policies and policy mistakes in the wake of the first external shock. Foremost among the mistaken ideas, which served as guidance to a solution was the locomotive argument’ according to which countries, which were designated as ‘strong’ countries, were expected to solve their own and the weaker contries’ economic woes by engaging in expansionary domestic economic policies. It was argued that expansionary policies in the former group of countries would hardly lead to additional inflation, since, they too, not only the weak countries, operated substantially below capacity levels. After having highlighted the main features of the locomotive argument, this study questions the validity of the theoretical underpinnings of that hypothesis. The theoretical basis of the locomotive argument’ was Keynesian and confidence in fie-tuning economies prevailed. The study investigates whether the premises were justified in light of developments in the real world and economic theories. What happened to the effectiveness of economic policy under different exchange rate regimes, to money illusion, to the unemployment- inflation trade-off, to estimations of unused productive capacity, and to the emphasis on demand rather than supply creation? The determination of whether demand or supply ought to be stimulated has implications on what can be expected to envolve from national and international policy decisions. The locomotive argument paid too little attention to the implicatons of the flexible exchange rate system upon exchange rate effects of domestic policies, capital movements, and the international transmission of domestic economic policies. The basis for country classification into weak and strong ones is of dubious validity, and the J-curve phenomenon further complicates categorization. Current account imbalances may have to be seen in light of stock adjustments. Moreover, exchange-rate and current-account determination are not unidirectional - a fact too easily ignored in balance of payments interpretations.