[Cross posted at
Bopnews.com]
The New York Times mentions the "S" word, one that strikes fear into the heart of investors: Stagflation. Paul Krugman said a bit over a week ago that there was a "whisper of stagflation".
What is stagflation? And why is it such a cause for concern on Wall Street and other places?
[I should note that Barry Ritholtz, chief strategist for the Maxim Group and out of the closet liberal is going to be on NBC's Powerlunch from 1 until 2 today talking about his bearish call on US equities just before the market tumble started. His thinking, while rooted in different numbers and models from mine, is along the same lines. He's going to be the next investment guru - having made two very good calls in the last 12 months when other people were throwing darts at the board.]
And why have I been saying for the last year that it is a potential problem. The technical definition of stagflation is when there is high inflation and low economic growth/high unemployment. The reason this is of particular concern to economists, and others who play them on television, is that in economic theory, increases in the general price level are supposed to create more growth. Basically, inflation prods people to spend more and work more, because it erodes away savings, and makes fixed incomes devalue. It was particularly important to the formulations of Keynesian economics current in the 1970's - which saw the possibility of trading a slightly higher level of inflation for more growth in employment, the "Phillips Effect".
High inflation combined with low growth is a problem, then, because the tool to fight inflation, namely, raising interest rates, lowers growth. If growth is already low to begin with, it means that the cost of stopping stagflation is a "disinflationary" policy, which will generate a very large recession. This is indeed how the stagflation of the 1970's was solved: Carter appointed an anti-inflation economic team, including Paul Volcker at the Federal Reserve. The result of this monetary policy shift, which manifested itself strongly in Q3 of 1979, was a pair of recessions which taken together where the sharpest downturn of the Post-World War II era, and which sent unemployment spiralling up to post war highs in the United States.
Hence, stagflation is considered a bad thing, because the only cure for it we know is a very, very deep recession.
But we aren't seeing double digit inflation rates, we aren't seeing the kind of rapid translation of energy inflation into consumer inflation that we saw in the 1970's. And why is a matter of some discussion, the answer is that people are looking in the wrong place.
Right now we have raging inflation: in houses. In the 1970's, inflation produced rapid inflation in the price of goods, because a great deal of the energy we used as gasoline was involved in manufacturing. Thus, increases in oil prices rapidly produced very direct pressures on the economy as a whole: on factories, on electricity prices and the like. Thus, if businesses had pricing power, they used it to raise prices. If workers had pricing power, they used it to demand higher wages. The reality of the 1970's is that while some have thought that it was "wage push" inflation, the level of real wages dropped consistently after 1974 - one can't have wage push inflation when real wages are dropping.
The real push side of the inflation picture in the 1970's was that energy costs went in two dramatic jumps, the first in 1973, the second with the Persian gulf crisis that was touched off by the Iranian revolution and pushed into higher gear by the Iran-Iraq war.
In the present, far less of our manufacturing capacity and electrical generation is based on oil. Instead, it is spent on transportation, and much of that is personal transportation. Since 1980 there has been a continuous shift away from using oil to run industry. Instead of oil fired electrical plants, we use coal, which now supplies 50% of our electricity. This means that increases in energy prices do not hit manufacturing anywhere near as hard. Also, a great deal of the growth in manufacturing has been overseas, where workers are paid less, and there is, consquently, lower consumption per worker of oil. That means that there is less "demand push" inflation in energy prices.
But higher energy prices do hit home: because energy now makes up a much larger fraction of household consumption. Gasoline was cheaper than the alternatives, and so people used more gasoline to get other things. The two things that they use more gasoline for in particular are driving to work, and driving to get the best shopping bargains. Thus, where we see the effects of inflation is on two areas. One is that housing prices are going up. This is why demand for gasoline seems to be so inelastic: while energy prices are going up, the value of houses is going up as well. As housing prices have gone up, people have drawn equity out of them for their large consumption, and this has meant that more of their wage income could be eaten up by nondurable consumption, particularly gasoline.
The result is that people have much lower discretionary incomes, because debt service is higher. This pattern first emerged in the early 1980's, when the mortgage interest deduction first gave people an incentive to borrow against home value: the percentage of equity owned by homeowners slid dramatically. Much of the "Reaganomic boom" was, effectively, the Federal government picking up the tab for consumption. But note who that helps: those with home equity to borrow against, or those that can buy a home.
Thus our stagflationary pressure is different from the 1970's when higher energy prices rapidly lead to higher consumer prices. Instead what we are seeing is a rapid drop in wages with respect to home prices, one that is now becoming a rapid drop in real wages. This pressure has been building for some time, and seems set to increase. The real stagflationary pressure is that since gasoline prices are not related to the general economy closely, that energy prices will keep rising - which the Department of Energy predicts will happen after a predicted sharp drop later this year - and that the economy will continue to be stripped bare by increased energy prices. The same effect that made stagflation so deadly to economic growth in the 1970's: as it wore on, businesses invested less, and therefore grew less.
In short, last time we had the inflation first, and this lead to lower investment, crowding out improvements in production. It was this effect that lead the right to argue that we had to have "supply side" policies in order to promote investment and therefore growth. The reality is that these supply side policies had little to no effect on business investment, but instead generated more paper to sell for oil. That is, the only thing the supply siders supplied, was asset prices.
This time we are seeing a progressive squeeze on investment and wages, and it "feels" like stagflation, in that each round of belt tightening in other sectors of the economy simply translates into more pricing power for a very few sectors. And that is the ultimate reality behind stagflation and similar economic traps: a few sectors have tremendous pricing power, and use it aggressively. In effect, if someone earns more, the few sectors with pricing power simply raise prices, generating no new economic activity.
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So why is this bearish? Because, of course, it is the stock market that is getting squeezed. Consider that after the rapid rally of relief after the invasion of Iraq, the stock market, measured against Euros, Pounds or Swiss Francs - has been flat. Consider that while corporate profits are very high, there is much less business investment going on - money is being saved for mergers and acquisitions, or going into development overseas.
That is, the same bottom line of stagflation in the 1970's is hitting us today, playing out in a different form, since the economy and monetary system are structured differently. And this is why fear is rattling through Wall Street, because at the end of the last bout of stagflation, the S&P 500 had suffered the longest bear market since the Great Depression, and traded at 8 times earnings. If the S&P were to fall to 8 times earnings today, it would stand at around 400, and the Dow would stand at around 3800.
We are a long way from such an ugly eventuality - however, the concern is that there is no clear direction from the White House, or any place else, as to how the current pressures that are piling up on the US economy are to be abated. Investors and traders are herd creatures, they hate uncertainty and lack of leadership more than anything else. The question that is sitting on everyone's minds is "where to put money"? What, exactly, is going to produce growth without driving inflation?
Right now the stock market is worried about a more close at hand problem: how high will Uncle Alan raise interest rates in order to choke off energy inflation before it becomes general consumer inflation? The higher the rates go, the more likely it is that corporate profits will suffer, as borrowing costs go up, and consumers have less money to spend. The want to see an end to interest rate increases, before we get the dreaded inverted yield curve. This concern is not directly related to the stagflation scenario, but, instead, is being worsened by it - they realize that given a choice, the Fed must fight inflation first, regardless of the consequences to economic growth in the short term.
In short, the economy has to thread a needle between stalling and contracting, and having real inflation ignite. The fears on Wall Street and elsewhere are that we might fall into inflation, and then have economic growth choked off by rising energy prices - there are some signs in the Beige Book that this is already happening. Now, economists are professional worriers, and Wall Street "climbs a wall of worry". The present period of worry could be like the landings in 1995, 1986 and 1966, when there was a return to growth and profits - even if only for a short time in the last two cases. It is possible that the present needle will be threaded and there is a continued expansion on the other side. It is possible, once the current market correction finishes, that it will be a time to buy stocks in preparation for a period of strong growth and low inflation. In hte very short term there are going to bounces up in what is a bear cycle to this market - there is money "on the sidelines" wanting to come in to the market, and right now, short term, the market is "over sold".
It is also possible that the US will join Europe and Japan in an economic slowdown - one that in the case of Europe may well already be recession, merely not declared yet. Investors worry that if Uncle Alan acts too quickly, it will prematurely stiffle the economy - producing a recession - or if he acts too slowly, we will get inflation, which will then choke off growth and profits, and then have to have a recession later, only without any period of profitability in the middle.
And investors don't like the uncertainty of that.