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Five Things You Need to Know: Not Your Father's Stagflation


At the end of the day it doesn't matter how much credit is made available; it matters how many people are willing to take it.


Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

This morning the Wall Street Journal is trumpeting Stagflation fears on the front page, what it calls a combination of inflation and slowing growth, something we first covered in Five Things back in June, 2006. The Financial Times uses Stagflation on its cover today as well, "Data Fuels Fears of Stagflation." Even the New York Times is in on the gag with a piece titled "That '70s Look: Stagflation."

The last perceived bout with Stagflation occurred in the 1970s. Have we now come full circle from ultra-slim slacks back to bell bottoms? Is this our fathers' Stagflation, or something different?

Our view is that this bout with "Stagflation" is simply part of an ongoing transition from cyclical inflation to deflation. Let us explain.

Stagflation Defined

The word "stagflation" was first coined by British Tory MP Iain MacLeod in a 1965 speech to Parliament. "We now have the worst of both worlds - not just inflation on the one side or stagnation on the other. We have a sort of 'stagflation' situation," he said.

In simplest terms, stagflation is inflation + recession... at the same time!

"That's impossible," claimed Keynesian theorists who in the 1970s comprised the dominant force in economic theory and practice. According to Keynes, recessions are solved by one thing: inflation. But what, according to Keynes, solves inflation? One thing: recession.

In a brief period during the 1970s the United States economy experienced simultaneous inflation and high unemployment. The confluence of events leading up to this developed like a perfect storm.

First, the U.S. was at war in Vietnam, and because wars are expensive and require public financing, money supply was increased. As one would expect, the increase in dollars (the supply of money) led to inflation.

In fact, inflation became so entrenched during the 1970s that people began to anticipate higher prices and therefore did something any rational actor would do: they purchased more goods ahead of time, increasing demand.

Toss in the 1973 Oil Embargo, the collapse of Bretton Woods, and the U.S. economy experienced a perfect storm of inflation and slowing growth. Many people think of Bretton Woods as The Gold Standard. But the difference between the Bretton Woods Agreement and a "real gold standard" with fixed parity, is that under Bretton Woods, while currencies were convertible into gold, countries retained the right to change par values. Keynes actually described Bretton Woods as the opposite of the gold standard.

Anyway, as these factors circulated and combined, the result for the U.S. was very high inflation expectations combined with diminished output, high inflation and very high interest rates.

Enter, The Monetarists

The best known of all Monetarists was Milton Friedman, of course, who was awarded the Nobel Prize in 1976 "for his achievement in the fields of consumption analysis, monetary history and theory and for his demonstration of the complexity of stabilization policy."

In Friedman's book, Monetary History of the United States 1867-1960, he popularized the monetarist mantra that, "inflation is always and everywhere a monetary phenomenon." Therefore, according to Friedman, the "trick" to maintaining an acceptable rate of inflation was simply for the central bank to closely monitor the economy and use central bank policy tools to keep the supply and demand for money at equilibrium.

Monetarists, as you can see, have no problem with fiat currency. Instead, monetarists view an artificial inflation of the money supply as "ok" as long as it does not become excessive. In other words, pumping up the money supply is fine, as long as you do it slowly... perhaps so slowly that people don't notice.

Thanks to stagflation, The Monetarist school of thought, and Friedman in particular, developed the "Expectations-Augmented Phillips Curve."

Professor A.W. Phillips "discovered" the Phillips Curve, which, ahem, "simply" shows the relationship between unemployment and inflation.

Phillips found that there appeared to be a necessary and fixed trade-off between unemployment and inflation. Any attempt by a government to reduce unemployment would lead to increased inflation. Keynesian's loved this, of course... until stagflation arrived, breaking the unemployment-inflation relationship.

Friedman, in order to "save" the Phillips Curve, showed how it could be "adapted" to inflation expectations.

1980: Let's get high on our own supply!

The 80s were known for one thing. No, not that thing, Senor Escobar. That other thing. Supply-side economics.

Supply-side economics is grounded in Jean-Baptiste Say's Law of Markets: There can be no demand without supply. Supply-side economics holds that the key to economic growth is a combination of low marginal tax rates with monetary policy directed at maintaining price stability. But it's central tenet might be better expressed as the gold-price rule. In order to maintain price stability, the dollar must be anchored to gold. If the price of gold falls below the specified gold price, then there must be a growing demand for money. If it rises above it, then demand for money has decreased.

President Reagan's economic policy (which many attribute to the successful conclusion of the stagflation and/or inflation of the 1970s) is often equated with supply-side economics and a true "free-market" spirit. However, economic policy under the Reagan administration was clearly only partially grounded in true supply-side theory and Frank Shostak argued several years ago that supply-side economics is not really a free market approach at all:

"In fact, they are very much like the rest of mainstream economics. While mainstream economists advocate the management of demand, supply-siders advocate the management of supply." he wrote. "In the free-market economy, neither demand nor supply is managed. Both consumption and production are equally important in the fulfillment of people's ultimate goal, which is the maintenance of life and well-being. In short, consumption is dependent on production, while production is dependent on consumption. The loose monetary policy of the central bank breaks this unity by creating an environment where it appears that it is possible to consume without production. This unity can be restored by bringing back the market-selected money: gold."

Not Your Father's Stagflation

So where are we today? Is this the return of stagflation? Are "inflation expectations" creeping higher?

Yesterday's release of the Consumer Price Index showed a year-over-year increase of 4.3% in the headline number while the core year-over-year rate, which excludes food and energy, edged higher to 2.5%.

Meanwhile, the minutes of the Federal Reserve Open Market Committee revealed that the central bank's forecast for Gross Domestic Product growth was trimmed to a range of 1.3% to 2%, down from the 1,8% to 2.5% the Fed estimated at its October FOMC meeting, while their core inflation forecast edged higher to the 2% to 2.2% range from October's previously estimated 1.7% to 1.9% range.

As the 70s proved, an increase in inflation expectations can produce a cycle of demand that feeds on itself, despite rising unemployment and slower growth. But in the recent hysteria to label this cycle Stagflation some critical differences exist that will make all the difference in the world. This is most decidedly not our fathers' Stagflation.

In 2006 when we first wrote about Stagflation we asked the following questions:

  • What if the familiar 1970s cycle of increasing inflation expectations doesn't repeat itself because of where we are in the credit-cycle?
  • What if there is no longer the same appetite for credit expansion now as there was between 1980 and 2005?
  • What if the consumer no longer has the same appetite for risk?
  • What if the consumer is in cut back mode in response to even the slightest whiff of inflation; i.e. food and energy?

The answer is that if any of those conditions are present, then what may look like Stagflation now would simply be the transition, the tip of the iceberg so to speak, between excessive risk-seeking behavior, a seemingly endless appetite for credit, and a correction to the Federal Reserve's long-term credit expansion.

In 2006 we noted that as long as appetites for credit remain healthy, we can continue to happily teeter between inflation and stagflation. Today, there is no question that appetite for credit has turned decidedly unhealthy.

After more than two decades of credit expansion the limits have been met. The debt in the economy is no longer sustainable without an expansion of credit and we are now seeing reductions in lending, reductions in spending and reductions in production, all of which are conspiring to slow the velocity of money necessary to sustain economic growth. The Federal Reserve's ability to "engineer" the economy out of deflation is entirely dependent on expanding appetites for credit, an increase in the velocity of money.

A general decline in the ability and, more importantly, the desire to lend and borrow acts is showing up virtually everywhere we look:

  • Sharper Image (SHRP) and Lillian Vernon (LVC) filed for Chapter 11 bankruptcy protection this week, both citing an inability to access sufficient credit to sustain operations.
  • JC Penney (JCP) reported a nearly 10% decline in profits due to a combination of slower demand and promotional price cutting.
  • Delphi has been unable to secure $6.1 billion in financing from banks and is being forced to seek help from its parent company, General Motors (GM).
  • GMAC is closing a majority of its auto-financing offices in the U.S. and Canada.
  • Since 2006 more than 200 major U.S. lending operations have shut down.

Meanwhile, the shut-down in Auction Rate Securities markets forcing some companies to re categorize short-term securities as long-term holdings. A survey of 126 U.S. employers, by consulting firm Mercer, shows that 33% of U.S. companies may implement hiring freezes or downsize staffs as a result of the changing economic environment.

And ironically, government intervention and regulation, everything from splitting up the bond insurers to expanding the roles played by Fannie Mae (FNM) and Freddie Mac (FRE), will have the perverse effect of slowing the velocity of money.

Take for example the Office of Thrift Supervision proposal outlined yesterday of issuing "negative equity certificates" to homeowners that are redeemable at a later date if the home is sold at a higher price; part of a plan to prevent homeowners from walking away from their mortgages.

Although foreclosures make up a fraction of the total housing market, it would be a mistake to underestimate the socionomic significance of the repudiation of debt and credit manifest in homeowners voluntarily choosing to walk away from their mortgages. The fact people are walking away from their mortgages is not a moral failure, but a warning sign that this type of credit unwind is extraordinarily deflationary. The fact an increasing number of people are not interested in protecting their ability to access credit, their credit rating, is a harbinger of how bad things have yet to get. That means, socionomically, that people have already repudiated credit and are no longer interested in accessing it.

That is bad news for the Federal Reserve because at the end of the day it doesn't matter how much credit is made available; it matters how many people are willing to take it.

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