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Suddenly, everything seems familiar again: Commodities are hitting new highs for the year, the world seems to be a dangerous place again, protectionism is on the rise, business spending and investment has turned negative while productivity is waning, yet core inflation remains elevated. Meet "Stagflation":
We first wrote about stagflation here last June. Below is an updated overview of what "stagflation" is in general, as well as updated comments on how this bout with "stagflation" is simply a component of the larger transition to deflation. In fact, we are experiencing a stealth deflation already, which partly explains why consumers found it necessary to borrow against their homes last year to the tune of more than $300 billion.
1. Stagflation Defined
- The word "stagflation" was reportedly 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!
- "Impossible," said 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 solves inflation, according to Keynes? One thing: recession.
2. Ah, General Malaise, I knew him well.
- The 1970s saw the United States economy experience simultaneous inflation and high unemployment. The confluence of events leading up to this developed like a perfect storm.
- The U.S. was at war in Vietnam at the time 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.
- 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 now we have a situation on our hands.
- 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 many 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.
3. Enter, The Monetarists
- The best known of all Monetarists is 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 his book, Monetary History of the United States 1867-1960, Friedman popularized the monetarist mantra that, "inflation is always and everywhere a monetary phenomenon."
- Therefore, the "trick" to maintaining an acceptable rate of inflation is simply for the central bank to closely monitor the economy (hmmm, sounds familiar) and use central bank policy 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.
4. Hey, it's the early 80s! 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."
5. 1970s vs. Today
- So where are we today? Is this the return of stagflation? Are "inflation expectations" creeping higher?
- First, the economy and inflation expectations. One of the key thematic elements in virtually all pricing data at the producer level is the "inability to pass through increases in raw materials costs."
- In the 1970s, it was common to see a minimum of 20 commodities in short supply in any given month.
- According to this morning's just-released ISM report on business, care to guess how many commodities are reportedly in short supply?
- Yet we have commodity indexes that look like this (Chart courtesy Thechartstore.com):
- Second, unemployment. Whether or not one believes unemployment figures understate the rate of unemployment, it is true that job growth remains weak while wage growth is stagnant at best.
- As the 70s proved, an increase in inflation expectations can produce a cycle of demand that feeds on itself... despite rising unemployment.
- But, what if that cycle may not repeat itself because of where we are in the credit-cycle which brought us to this point?
- What if the consumer no longer has the the appetite for risk?
- What if the consumer is in "cut back" mode in response to even the slightest whiff of inflation?
- Then what may look like stagflation now might simply be this very transition, the tip of the iceberg so to speak, between excessive risk-seeking behavior a seemingly endless appetite for credit, and the correction to the Federal Reserve-engineered credit expansion.
- What we see as stagflation looming on the horizon in our side-view mirror today, may be full-blown deflation up close as dollars are hoarded to pay down excessive debt and reduce, reduce, reduce.
- As long as appetites for credit remain healthy, we can continue to happily teeter between inflation and stagflation.
- The Fed's ability to "engineer" the economy out of deflation, however, is dependent on that appetite for credit.