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Another Sibling in the Flation Family

Tags Booms and BustsThe FedFinancial MarketsGlobal EconomyU.S. HistoryBusiness CyclesMonetary TheoryMoney and Banking

08/10/2004Sean Corrigan

Just when you thought that threat of DISINflation (a Good Thing, the Fed tells us) turning into DEFlation (A V-E-R-Y Bad Thing) had vanished and that instead we were on the verge of INflation (A Not Quite So Bad Thing), up pops another frightful creature from the Fearsome ‘Flation Family—STAGflation!

For example, Bloomberg News recently ran a story headlined; "Some analysts think stagflation is a new dragon stalking Asia."

"First, there was the fallout from the 1997 and 1998 financial crisis," it began luridly. "Then Japan and China exported deflation around the region. And now, as consumer prices recover, Asia may be facing another threat: stagflation."

The article went on to quote Morgan Stanley’s Man in Asia, Andy Xie, as follows:

"While economies are decelerating quickly, inflation rates are picking up virtually everywhere. Should Asian central banks take stagflation seriously? We think so."

Citing low interest rates and booming property demand, high oil prices and rising wages, Xie worries that, soon, the INflation indices will be rising faster than the GDP, or ‘growth,’ ones.

"The mild stagflation we are experiencing could turn virulent," he warned, darkly.

Not to be outdone, John Parry by-lined a piece for Reuters in New York, entitled: "Hints of stagflation despite growing U.S.economy."

"With oil prices high and the pace of the U.S. economic recovery in question," he wrote with furrowed brow, "some in financial markets are becoming wary of a return to 1970s-style ‘stagflation,’ featuring spiralling prices and faltering growth."

"Just a year ago," he continued, "economists, troubled by a still-sizable surplus of industrial capacity after three years of softness, were pondering the prospect of a deflationary crisis."

Fancy that! Mainstream economists completely at a loss as to what is happening in the world!

"But now," Mr. Parry ploughed on, "some analysts fret that high oil prices might eat up economic resources otherwise earmarked for spending or investment, and warn that stagflation could return to haunt the U.S. economy and the dollar."

"Stagflation worries . . . will become more part of the vocabulary of the market if oil prices remain high," Michael Woolfolk, senior currency strategist with The Bank of New York was quoted.

Well, yes, STAGflation may become a part of the argot of the financial press, but perhaps everyone should pause and, instead of glibly peppering their speech with this latest buzzword, they should take the time to think about what STAGflation actually means. Then we might be able to figure out whether we are likely to experience this blight—essentially an economic malaise which sees prices rise even though unemployment is high and climbing—and how to recognize signs that it might be occurring.

First—and I apologize in advance—a little basic economic reasoning, but, don’t worry, it’s something every business man, or housewife, or school kid saving up his pocket money will readily understand.

This concept is the simple one which says that if you reduce the price of something, more of it will tend to get sold.

Are you a retailer, stuck with too many beach hats in a poor summer? Slash the prices, draw attention to them and maybe you’ll get to shift them all at last.

Maybe you’re a chocolate addict, ever ready to spend your petty cash on another bar of Snickers. If Mars launches a 2-for-1 promotion, happy days, you get to put twice as many calories into your system as you would have.

Now this straightforward bit of logic also applies to the cost of almost all other economic ‘goods’ and though we don’t always think of it in these terms, labor is a good, too.

It’s something that can’t be had for free or in infinite supply. It’s something which commands a value and which must be paid for on a competitive market.

It’s a good.

So, if, for whatever reason—say, because an unsustainable, technology-centred Boom came to a crashing halt—there are temporarily too many workers for employers to hire, cut the price of the goods (lower wages) and more of them will tend to be bought (put back on the payroll).

Now, of course, people aren’t beach hats.

Beach hats don’t have feelings. Beach hats don’t have a large mortgage to support, or a car lease to maintain. Beach hats don’t insist that they’re not getting out of bed for less than $20 an hour, not with a college education behind them. Beach hats don’t scream at the injustices of the capitalist system when the store owner unloads them at a 20% discount.

Thus, it is often difficult to persuade an unemployed man that he should maybe aim a little lower on the wage scale and try to discount himself back into a job, on the reckoning that 90%, say, of his former salary is worth a whole lot more than none.

That same man may be doubly reluctant to compromise if he can rely on a welfare scheme which will pay him a goodly portion of his former wages, even if he does nothing but sit around drinking coffee all day, getting under the feet of his long-suffering spouse.

Even if he would rather work than be idle, it may still prove impossible if there is a minimum wage under which he’s not allowed to offer his services at all.

Nor will the wannabe-working man benefit much from a union policy which insists all jobs at a given company comply with their rules, not the boss’s (unions, you see, maintain their grip not by fighting against the abstraction of "Capital", but by insisting "Capital" enforces a high degree of discrimination against both non-union members and the unemployed).

Finally, our job-seeker might find that though he’s able to offer to work for a low enough pay packet to tempt his boss, that latter can’t afford all the payroll taxes, insurance costs and regulatory burdens imposed upon him by the state, so it’s still no dice.

This is where the evil genius of John Maynard Keynes came in, seventy years or so ago when he saw that, if Mohammed would not go to the mountain for a lower pay check, the mountain must come to Mohammed.

What Keynes realized was that if modern institutional arrangements and political short-termism were going to rule out that wages could fall far enough in the Bust, in terms of the dollars and cents people were paid in (if wages were ‘sticky downwards’ as economists have it), he could achieve the same result by making the dollars and cents themselves worth less!

So, why not just INflate all the troubles away, he pondered from his Ivory Tower at King’s, Cambridge?

That way, though the working man would still be able to pull in the same $550 a week, say, in folding stuff, as he ever did, that $550 would end up buying less at the shops, since the price of goods would have risen.

In other words, suppose it  used to be that a prospective new boss would only be able to sell the goods the worker was able to produce for, perhaps, $900—out of which would come the new hire’s required $550—but that, sadly, at this level, he would not reckon on being able to cover all his other costs, like those  to repair and replace his equipment, to pay his tax bill, his banker and stockholders, and then to have a little left over for his own trouble. So, it would have been a case of, Sorry, Buddy and I can’t spare a dime, either! 

However, thanks to Lord Keynes’s debauching of money itself, that same businessman might see he could now sell the same goods for $1000, instead of $900. All of a sudden, the arithmetic works and, hey, you can start Monday, pal.

With this shallow piece of knavery did Keynes consolidate his overblown reputation and, at the same time, prise open wider the Pandora’s Box of Boom and Bust, of the rise of the Money Trust, of the unceasing encroachment of Big Government into our lives, and of the eventual extinguishing our freedoms, amid the decay of our morals and the erosion of our prosperity.

But the insidious thing about this black magic is that, in the short run, it seems to work, much like, in the short run, the hair of the dog seems to lessen the effects of a hangover. Then again, it was Keynes himself who superciliously remarked that, "in the long run, we are all dead."

This economic history lesson may all be very well, you may be thinking, but how does all this get us to STAGflation, as was promised?

Well, one thing Keynes—ever the patrician—overlooked was that even working men and union leaders can actually read (that is they could read in his time, whereas today, even graduates seem to struggle with this basic task).

Thus, though his own prose can be turgid and his chains of false reasoning tortuous, the message was eventually made clear enough to all: monetary inflation can price people back into work so long as they are under the illusion that they are not suffering a real cut in their wages.

Sooner, rather than later, of course, that illusion was dispelled. Soon, the workers and their representatives, not to mention the pensioners and welfare recipients, began to watch the published price indices very closely and, at the first hint of an uptick, they would all demand to be compensated for the loss to their purchasing power which that increase comprised.

Indeed, before very long, they were making the process pretty much automatic, by building indexation clauses into working agreements and state benefit payments.

So, as more and more money was pumped into the world economy in the 1960s—led by a US trying then, as now, to have both Guns and Butter—and as this INflation pushed prices up ever more rapidly, workers became ever quicker to adapt to the change, making any lessening of their real cost to employers ever more transient and unreliable.

INflation, then, was not reducing unemployment in anything like the manner the Keynesians had predicted, and this was solely because the plumbers had outsmarted the professors and the sausage makers had gotten a jump on the central bankers. 

In due course, this helped hasten the monetary breakdown of the early 70s. Nixon put America into another partial default (FDR having been the first to do so) by closing the gold window. The breakdown of the Bretton Woods system, which Keynes himself had helped to construct before his death, soon followed.

Then, as the dollar—for so long propped up only by the purchases made, largely unwillingly, by all the other central banks—plummeted and as war broke out in the Middle East, the oil producers decided they would not sell their resources artificially cheaply for depreciated paper, an aversion naturally heightened by the fact that some of these same resources were being used to fuel their enemies’ assault tanks and jet fighters.

Here, another blunder was made by unthinking mainstream economists, under pressure from their political masters.

Instead of accepting that oil was henceforth going to cost more dollars than it had before and instead of reigning back on the creation of money, so that the INflation which brought this about might be slowed, energy costs were baldly dropped from the calculations. About this time, the concept of something called ‘core’ consumer prices—a measure excluding firstly energy, but later also food prices—became the vogue.

Now, if you had spent $10 bucks on gas and $5 on groceries yesterday, by rights, when gas went up to $12 overnight—and assuming you would rather be without your shallots than without your Chevy—you should have had only $3 left with which to buy food today—and the price of food should have fallen to reflect this new economic reality.

No extra money (no INflation) and no overall rise in price, only a relative change in these prices would have ensued.

But, no! Most central banks, anxious not to see money diverted from domestic producers to the account of the foreign oil magnates, simply had another $2 printed up so that you now had $17 to spend in place of your original $15, so $12 for oil and $5 for food could be simultaneously accommodated, at least, in accounting terms.

What they failed to notice, of course, was that this did not give full voice to the more urgent requirement for gas, nor did it truly reflect individuals’ lesser relative demand for green beans, and that by "monetizing" the oil price rise, they were only making matters worse!

They also struggled to see that the Sheiks still got more of the pie, both in monetary and in real terms, despite their efforts to confound this shift in free market valuations. 

Remember, too, that while all this was going on, organized labor and the political parties which represented it were perhaps at the zenith of their powers and so, as prices rose, wages and benefits rose just as fast, if not actually faster.

This meant that, rather than becoming cheaper, workers were, in many cases, getting pricier and goods, as we saw, which are more pricey do not tend to sell as readily as those which are not. Unemployment, therefore, rose.

Whereupon there was another reason to INflate again for, once the market adjusts to a given volume of money and a given matrix of prices, to prevent another relapse, the artificial stimulus must be re-applied, and in increasing dosage, to boot.

This process—in another failure of economic vocabulary—became known as "cost-push" inflation, or as the "wage-price spiral." That way, the real culprits—the men whose hands were covered in printers’ ink—could conveniently lay the blame for the woes of the world off onto militant union leaders at home, or onto sinister Arab princes abroad.

At the same time, "fiscal drag"—by which we mean the process wherein tax thresholds and depreciation allowances are not adjusted fully in line with rising prices—was bleeding businesses of internal funds, limiting their ability indirectly to employ others, higher up the Cone of Production, by placing orders for capital equipment and plant via continued investment.

Moreover, with foreign exchange rates going wild, with interest rates more volatile than for many a long year, and with commodity prices soaring alongside labor costs, few businessmen were able to make any meaningful plans for the future.

Indeed, the whole question of what constituted a profit became vexed when historic costs of inventory or equipment, recorded on the books, bore little relation to prices being charged on current markets.

Further, with all this "core" consumer price nonsense and amidst all these ex-food and ex-energy shenanigans, all manner of relative prices were being distorted, too, as our green beans and gas example illustrates. It cannot be over-emphasized that relative prices are the kinds which provide the most important market information of all to any entrepreneur.

This is because, in many ways, the entrepreneur is effectively someone who takes a recipe out to a shop, buys the ingredients listed there, and then bakes a cake to be sold later on his or her market stall. If he can’t accurately price the flour and the sugar, the fruit and the butter, and measure the total against his estimate of what someone is likely to pay for the finished pastry, how can he expect to make a profit by his efforts?

So, in addition to being unable to afford the higher wages arrived at under threat of strikes, or through subjection to government ‘arbitration’ and the forced complicity with national pay-deals, on top of having capital consumed by the interaction of flawed accounting systems and rapacious government revenue departments, company executives and business owners alike found themselves increasingly uncertain as to what it actually was they should be doing if they were to make a profit; even one, at root, which they couldn’t properly quantify if and when they were to make it.

Naturally, then—either voluntarily, or by force of circumstances—they did less of everything. Production was cut back. Joblessness rose and stock prices plunged—though sometimes the extent of their fall was disguised by the coincident steep fall in the value of people’s money.

For a while, as all this went on, the politicians and the central banks fell back on their two most readily utilized means of Depression-busting—a resort to the command economy means of maximum prices, mandatory wage caps and of restrictions on the mobility of capital and, of course, to more INflation to combat the spreading stagnation of output and work.

Ultimately, however, this was recognized as being inherently self-defeating and, clad in the political camouflage of an adherence to the ‘new’ doctrines of monetarism, the Anglo-Saxon central bankers—a distinction we draw because their more conservative Continental counterparts had, as ever, been a deal less susceptible to such follies—began to do what was long overdue: they cut back sharply on the pace of credit creation and let the inevitable bust work itself out at last. For such a belated recognition of economic reality was Paul Volcker apotheosized and allowed to ascend the monetary Mount Olympus from whence he appears occasionally to berate the poor mortals who succeded him! 

And that, Ladies and Gentlemen, was what STAGflation was all about—and a fairly horrid experience it was, too.

Now, it must be admitted that there are a great many uncomfortable parallels with today.

Money is overabundant. Capital is confused. Prices of resources, of assets, of finished goods, are in disarray. Governments have their noses in all affairs and their fingers in every pocket. Oil is getting dear and the mainstream wants to wish it away by putting its fingers in its ears and ignoring it.

Accounting is a mess (though there is a deal more wilfulness at work today, than in the 70s, perhaps). The dollar is being held aloft only by foreign central bankers. The US Administration wants Guns and Butter (around $500 billion a year of them, no less).

There is even a war—and ominous prospects of a yet wider conflict—in the Middle East, while everyone from NeoCon Richard Perle to New Dealer Michael Moore wants to blame the Arabs for our ills (as Mises once said, there are truly few fundamental differences between the socialists who wear brown or black shirts and those who besport the red variety!)

But what is different today—so far—is that the dismantling of many man-made barriers to congress and to trade, such as existed in the Cold War era of the 60s and 70s, has eradicated a good deal of the power of organized labor.

That same liberalization has given business a little more leverage in its negotiations with its workers and a little more clout with politicians anxious that it will simply up sticks and leave, if conditions become too onerous at home.

Therefore, today, we may well see spurts and stalls in "growth" as the intensity and the unexpectedness of the global policy of INflation vary from time to time.

But, what we will not see, as matters rest, are wages rising faster than selling prices and thus, generalized unemployment mounting alongside the cost of things at large.

STAGflation, then—once we bother to educate ourselves as to what constitutes it and what causes it—seems a distant prospect at the minute.

So what does this lead us to conclude? Try the following, for this shows the intent behind what is being practiced, even if it by no means guarantees the desired outcome.

In Alan Greenspan’s wildest fantasies he sees a graph with four lines rising on it from the left, near the origin, on out to the right, as time passes along the bottom axis.    

The lowest of these, in his dreams, is marked, "Interest Rates," and though they, too, increase and demonstrate his "credibility," their slope is a gentle one, such that even a heavily-laden mortgagee would barely break sweat ascending it.

Next higher up and a little steeper comes a line labelled, "Wages," representing all the money earned by all those who work. Money wages per job may not rise much, but money wages times jobs ought to, the Chairman knows.

Third comes a line bearing the legend, "Prices." This must not be too steep, lest it cause alarm, or lest it is too hard for those toiling up it to climb and they fall back to its foot. But—if its gradient can be just so—the rise in money wages will mask a fall in real wages and unemployment will recede. Moreover, because both the price curve and the wage curve rises faster than the interest rate one, debtors can be kept solvent and the banking system made safe—and nothing pleases a central banker more than that last circumstance!

Finally, overarching them all, comes a line proudly flagged as "Money & Credit" and it doesn’t really matter how steep this one is, so long as the other three lie in the necessary relation to it and to one another.

Of course, the more this one exceeds the amount needed to encourage the most fortuitous arrangement of the lower trio, the more there is left over for a little honest financial speculation—and as any would-be Alan Greenspan knows, you can detract attention from a multitude of sins if only the S&P is rising steadily into the empyrean.    



Contact Sean Corrigan

Sean Corrigan is the author of 'Money, Macro & Markets' newsletter & Consultant to Hinde Capital.

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