Stagflation Returning to the US Economy after 30 years

http://www.opednews.com/articles/opedne_steven_l_080118_stagflation_returnin.htm
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January 18, 2008

By Steven Leser

Stagflation, the combination of a stagnant economy with rising unemployment and sluggish or negative GDP growth and high inflation has returned to the United States. This isn't your typical recession. In a typical recession, you have rising unemployment and negative GDP growth but prices stay constant at first, then go lower. The lower prices come about because of goods that pile up from not being sold (higher supply combined with lower demand). With stagflation, you have a combination of factors that results in an overall lower supply (also known as a supply shock) of critical goods like fuel, and this lower supply causes rising prices also known as inflation. The rise of the price of oil has constituted a serious supply shock to the US economy. Not as well known to most people but just as serious is that food prices have arced up sharply in the last year as well as healthcare, housing and education. According to these two recent CBS reports, http://www.cbsnews.com/stories/2008/01/16/business/main3720731.shtml and http://www.cbsnews.com/stories/2008/01/16/national/main3720221.shtml consumer prices were up 4.1% in 2007, the sharpest increase in prices in 17 years (since 1990). As a comparison, prices rose in 2006 by a modest 2.5%. Inflation can also happen in a country because of currency devaluation. More simply put, the government prints more money than the economy has goods and services to back it up. We have also had that here in the US over the past eight years and this is something about which no one other than Ron Paul, who I otherwise don't like, is talking.

It is important to recognize whether a recession is a typical one and when it is stagflation. The remedies for each are completely different and utilizing the wrong remedy will have disastrous consequences. In addition, the public have a need to know which is happening because stagflation is a much longer lasting downturn and the remedies result in a huge bottoming out of the economy for several years before conditions can be improved. People have a right to know this is coming and if they are thus educated, they can attempt to do whatever they can to prepare.

What are the remedies for each of the two main kinds of Recessions?

In a typical recession, the best remedy is demand stimulation combined with a lowering of interest rates. Demand stimulation can constitute many things. The Federal government can decide to hire unemployed workers like was done in the FDR administration with the various alphabet programs. Their earned wages are used to purchase goods, pumping the economy up with added cash and demand. This has the added benefit of going to the people that need it the most at a time when they are hurting the most. Republicans prefer things like tax cuts, but the problem with tax cuts is that they not only go to people who aren't hurting, as people who are paying taxes are employed, but the cuts tend to go to the highest earners. This is called supply side economics. The theory is that the highest earners will invest some of that money, companies will use that investment to create more jobs and this will result in higher employment and additional wages being spent in the economy fueling growth. The problem with this aspect of supply side economics is that in the modern economy, it isn't uncommon for people to invest their money overseas. It isn't going to help the US economy if the high wage earners invest their new cash in EU or Asian securities. The other problem is that the market is typically trending downward in a recession so even if the tax cut money is invested in the US market, the decreasing stock prices will lower the impact of that money dramatically. This is what happened with the Bush tax cuts of 2001. Much of that money went overseas and was also lost in the sinking US securities markets and as a result, recovery from this recession took a lot longer than was necessary and the economy that came out of that recession was vulnerable to additional problems, which we are now seeing. The only tried and true methods that will always work to combat a typical recession are demand side stimulation combined with a lowering of interest rates.

Stagflation is a much more complicated and serious situation because you have to worry that whatever you do to attempt to get the economy going again is going to fuel additional inflation. Consider an example where the inflation component of stagflation resulted from too high of a money supply. If you give tax cuts, you are again increasing the amount of money being circulated and that will immediately result in additional inflation, which will zero out any effects from the tax cut. If the Federal Reserve cuts interest rates, that encourages people and businesses to borrow money. Imagine the effects of this in a shaky economy with high inflation. Again, you are increasing the money supply, you are increasing the amount of risk held by financial institutions and these loans would go to either buying real property in a terrible environment for real property, or would go to fund commercial ventures in an economy where buying is down and prices are up. That is a bad time to start a new business and results in a high amount of commercial failures and defaulted loans.
Consider the other possibility that the inflation component in stagflation resulted from supply shocks. This means that prices are high because goods are scarce. Well, if you stimulate additional demand by employing more people or giving the wealthy tax cuts, you aren't increasing the supply of goods. People are going to compete for the still scarce goods with more money, driving prices/inflation even higher and putting you back in the same or position you were in before the stimulus or worse.

So what IS to be done in a situation of stagflation? We have to look back to 1970s, to the last instance of stagflation to see what was done to bring the economy to recovery. When you do that research, you immediately come upon one Paul Volcker. Volcker was chairman of the Federal Reserve from 1979 to 1987. Volcker correctly deduced in 1979 that the remedy was to limit the growth of the money supply and allow interest rates to rise. This solution, which is the only one that will work in a serious stagflation situation, will result in several years of massive unemployment and even deeper negative GDP growth. It takes money out of people's hands causing both of the things that you need to happen to effect recovery. It causes the supply of goods to rise because people don't have the money to buy them and as a result start to conserve resources, and the reduction in money supply bolsters the value of the nation's currency. These twin powerful effects drive prices down and create the conditions where recovery can happen, but as I said above, it takes several years for this to work. When they read this, I am sure many people will think of the saying "The cure is worse than the disease" and it almost is. It is also the only thing that will work and the sooner it is applied the shorter the duration of the stagflation.

What we are seeing now is about what I expected 13 months ago when I penned this article, "Election 2006 Continued Wrap up – The Coming Economic Swoon and Did Republicans Throw the Election?" (I still smile when I look at the conspiracy theory I mused about at the time. I don't think the GOP threw the election, but I believe I was right when I said the idea should be considered because I saw what was coming in the economy and wondered if they did too) http://www.opednews.com/articles/opedne_steven_l_061208_election_2006_contin.htm As I mentioned previously, the stagflation we have now is the result of both a devaluation of our currency and supply shocks. The Bush administration and the Federal Reserve are treating this stagflation like a typical recession and are applying the wrong remedies. I expect the result of the Bush stimulus package to be a 2-5 month temporary and modest improvement in GDP growth combined with additional sharp increases in inflation. The economy will then swoon into more severe negative GDP growth within 3-7 months combined with even more inflation. By that time, everyone will recognize and be talking about stagflation. Fortunately for Bush and unfortunately for his successor, the worst of what we are going to see from this downturn isn't going to hit until close to the election. As I said at the end of my December 8 2006 article, "My readers, the economy is about to take a nosedive. Make whatever preparations you can."

kept on hearing it was impossible on finance shows.
also have been saying depression.
and i am an art major. i don't know jack about finance. but i have been paying attention.

not require the tripling of the National Debt.

So the higher interest rate scenario does not result in massive unemployment or stopped GDP growth.

But the fellow is correct that if we are into Stag-flation, Bush is doing the exact wrong moves (with Dem help). Let's hope it is not stag-flation.

Remember that stagflation was not caused by the Carter Administration, but was rather the effect of years of overspending in Vietnam. Just like we've now done in Iraq.

There was universal agreement among my sources, for instance

http://en.wikipedia.org/wiki/Paul_Volcker

http://www.britannica.com/bps/topic/632207/Paul-Volcker#tab=active~checked%2Citems~checked%3E%2Fbps%2Ftopic%2F632207%2FPaul-Volcker&title=Paul%20Volcker%20--%20Britannica%20Online%20Encyclopedia

and finally here where Volcker himself says the short term result of his policies was a more severe recession http://www.pbs.org/wgbh/commandingheights/shared/minitextlo/int_paulvolcker.html

recession did not occur during Reagan's first year - which is why he got the August 1981 Budget bill through that destroyed mental health care in the US - (just as he had destroyed it in CA by not building the centers called for with the closing of the CA warehouse hell holes) - by changing health care monies into grants "so the states had more flexibility". - It was a good economic time and the Dems rolled over for that "grants equal flexibility idea and for those tax cuts (half of those tax cuts were removed in 82, 84, and 86 in the largest tax increases in our history - the 81 tax cut being the largest tax cut in our history).

The recession hit after Volker started bringing down those interest rates and after those tax cuts - indeed that is where we got the silly idea from the GOP that there was a 3 to 4 year lag between government spending /taxing and its effects on the economy - they had to blame Carter someway. So the 81 tax cuts gave us the 83 expansion (despite the massive 82 tax hike called TEFFRA and the slightly less massive 84 tax hike called DEFRA).

Basic econ does agree with your sources that Volker's interest rates both cured the stagflation - and that they made the recession a bit worse - but getting rid of 8% inflation (we had 12% individual mortgages and 15% commercial mortgages and 22% annualized overnight rates for stock market margin loans) causes disruptions -

Volker forgets that Carter was handling the largest oil shocks to hit the US ever (our current increase from 25 to 100 dollar oil is nothing compared to the situation under Carter - and that was a time when we were much more dependent on oil for every dollar of GDP).

The oil shock had as much to do with our economy slowing as did his interest rate hikes (the money supply numbers also don't make a lot of sense in terms of Volkers ideas).

It is only an urban myth that Reagan had this great economy and Carter was a disaster - Carter's GDP growth after inflation numbers are not shabby at all and close to Reagan - and Reagan had to buy his numbers via a Keynesian debt increase from 1 trillion of debt to 2.7 trillion of debt.

Even if this were a typical recession, tax cuts for rich people won't help the economy much these days, if they ever did. In the global economy and its accompanying offshoring of US jobs, most of the capital was invested elsewhere - with a negative impact on domestic job growth. All we were left with was more mansions and yachts for the wealthiest 5%, higher unemployment than we otherwise might have had, and massive debt.

The article in the OP is a good summary of what's going on. I fully expect a massive stimulus package to be more of the same that brought us to this point. We might actually see some of the money go to the middle class this time but I will be shocked if Junior doesn't direct all he can to his wealthy elite cronies. It's simply what he does.

We'll probably see a short term superficial improvement, maybe even taking us close to November as Republicans hope. But we'll then be left with a worse problem than before. Junior will leave a big mess for others to clean up. That's another thing he does.

"Brought down by insurance companies, oil companies, and a war in a tiny desert country"

:sarcasm:

I have a plan. Let's redistribute the wealth! Just take their money and divide it up.

What about doing a sock the rich with taxes move (75% top marginal tax rate on income over 1.5mil, boosted estate tax, dividend income above 45K treated as normal income, not at low 15% rate, etc) balance the buget and start paying down the deficit. That will pull plenty of money out of circulation, screw the rich (given what they have done to us over the last 30 years they deserve it). Combine it with substution in the energy sector (start pushing mass transit projects that are low fossil fuel usage (light rail, streetcar, heavy electric passenger/freight rail, express passenger train, subway, etc). That would take the edge off oil usage (but boost copper consumption). Would that help?

TANSTAAFL

The problem is, who owns (or perhaps a better way of saying it is, to whom is owed) the deficit. It turns out that wealthy Americans along with foreign investors and governments are those to whom the lions share of thedebt is owed. If we pay down the debt, part of the payoffs will go to wealthy Americans, again putting more money back in circulation and contributing to the spiraling out of control inflation.

We could soak the rich and then not spend the proceeds, hold onto them until they could be safely applied to the deficit.

Also by paying down the deficit, it will reduce interest payments and wouldn't that reduce the amount of money in circulation?, or would that pale in comparison to the billions of paid off debit now floating around?

The wealth of a country is based on manufacturing. This is why Japan, South Korea, and Taiwan have a high standard of living even though they have few natural resources. They import materials and manufacture more goods than they need within the country. Therefore they sell those goods abroad earning cash or credit with which to import goods from other countries.

At one time, the US was a creditor nation that manufactured more goods than it needed internally, and sold those goods abroad. This wonderful situation turned sour when corporations decided to send manufacturing overseas to cheap labor countries. It increased corporate profits, but the US became a debtor nation with effectively high unemployment. The REAL unemployment in the US is much higher than the meaningless unemployment figures given out by the government.

Another reason for the current economic crisis is due to the high oil prices and excessive demand for oil in the US. American auto companies, in collusion with their buddies and fellow investors in Big Oil, have insisted on producing gas guzzlers long after the technology has allowed for the development of vehicles with much better gas mileage. In the 1970's, after the so-called Arab oil embargo (which the American oil companies enabled), the government mandated corporate average fuel efficiency standards (CAFE) which spurred the auto companies to introduce technology that increased gasoline mileage. This fuel efficiency reduced oil consumption, reduced oil imports significantly, and stabilized oil prices for several years.

At the same time, manufacturing was shipped overseas creating a huge trade deficit, the Bush government dropped taxes for the rich and started the Iraq war/occupation on borrowed money. This debt is financed by borrowing money at high interest rates from the only people who have any, the rich people. And they get to keep all the profits since they already have had their taxes lowered. What a system, hey.

So what is the solution? Actually quite simple. Forget about tax cuts and forget about juggling the interest rates. It is too late for any of that stuff to work. That is putting a band aid on a gaping wound. We need some serious suturing here.

First, we need to act to bring manufacturing and jobs back to America. If the goods that we buy are manufactured here, then the money spent on them will stay in the US and allow us to get out of debt. No waiting for this new technology baloney to take hold. Get rid of NAFTA, the WTO, the IMF, the World Bank, and all of the other trade groups that make us dependent on the multinational corporations.

These agreements and trade groups are designed to stifle competition from small businesses who would hire and employ Americans. Bring back jobs in clothing manufacturing, shoe manufacturing, furniture manufacturing, electronics manufacturing, toy manufacturing, tools, appliances, and on and on.

This will have several effects, all good for Americans. One, it will provide jobs for Americans. Two, it will reduce foreign debt and increase the value of the dollar. Three, it will NOT increase costs to consumers for two reasons: One is that the lower labor costs have NOT been passed to the consumer as lower prices, but have been retained as extra profits by the corporations. Two, the reduced foreign debt will stabilize the value of the dollar. Four, newer businesses that will finally be able to compete with the multinational corporations and will help keep prices from rising.

Working Americans will pay income taxes reducing the need for the government to borrow money which will help reduce the national debt.

Some other policies that will help. Get rid of ethanol made from corn. It doesn't save oil since gas mileage suffers. Turning corn into ethanol reduces corn supply for food which causes a rise in food prices like for milk and other dairy products. It is only used because it increases profits for agribusiness corporations without reducing oil consumption or oil company profits.

Stop wasting money on developing hydrogen fuel for autos. That still provides complete control over energy usage in the US to the oil companies, and will not save any money for consumers. The way to go is pluggable and/or hybrid electric vehicles. The reasons are many why this is the fastest and least expensive way to rid ourselves of dependence on foreign oil. The technology already exists and overall costs are the least for the consumer.

Develop universal health care programs NOT tied to employment. This will allow smaller companies to compete by taking away a cost burden to them, and allow smaller companies to compete for the best workers, since labor will be able to seek better jobs if they don't have to depend on any given employer for health insurance.