What Are the Prospects for Stagflation?

by: John Mason posted on: July 23, 2008    

There has been a lot of talk recently about the United States economy entering a period of stagflation. Stagflation can be defined as a period of time in which economic growth remains below historical averages while significant inflation is present.

A period like this is looked on as the worst of two worlds: the low economic growth results in a higher ‘natural’ rate of unemployment than in more normal times; and the economy still has to deal with an inflation rate that erodes earnings and causes an allocation of resources favoring wealth protection and not productivity. A period of stagflation tends to be self-perpetuating because the lower productivity results in slower growth and the slower growth exacerbates inflation, which further stymies productivity, and so on.

Stagflation also puts the Federal Reserve System “in a box.” If the Fed attempts to ease during such a period, the argument goes that its efforts will tend to go into further inflation. If the Fed attempts to restrain inflation, it will only worsen the unemployment situation. The monetary authorities are faced with a real dilemma.

One of the problems in understanding how stagflation can occur is that people tend to focus on aggregate demand factors when studying economic fluctuations. If economic shocks come from the demand side, a slowdown in demand translates into slower economic growth, which is accompanied by higher unemployment and lower inflation. However, this is not how we define stagflation.

Instead, stagflation comes about due to a supply side shock, which produces both a slowdown in economic growth and higher rates of inflation (for a given amount of aggregate demand). However, how does this come about?

In terms of economic growth, I would argue that two things contribute to the possibility of a slower expansion. First, there is the restructuring that most financial and non-financial firms are going through right now. When firms are going through the process of restructuring, they lose focus as to what they really should be concentrating on. I know this sounds contradictory, but my business experience points to this very thing happening at a time like this.

When you are restructuring you are concentrating on getting back to basics, eliminating those things that you shouldn’t be involved in and retrenching into those things that you should be involved in. (Should you sell businesses, something that takes time and attention?) In addition, financials need to be cleaned up. (Perhaps new capital needs to be raised, something that takes time and attention.) Furthermore, expenses need to be trimmed, people let go, and superfluous efforts eliminated (all of this takes time and attention).

During such times, executives do not focus on creating or sustaining competitive advantages because their focus lies elsewhere. Achieving and sustaining competitive advantages are what produce exceptional returns over time. However, achieving and sustaining competitive advantages takes time and effort since the primary sources of competitive advantage result from things like barriers to entry and from customer captivity. Barriers to entry come from economies of scale and research programs that create a continuous competitive flow of innovation. Customer captivity comes from building customer relationships through product and service quality and support. A firm generally has to restructure first before it is able to concentrate on these paths to better than average performance. In addition, since building competitive advantage must be intentional, it must be the primary focus of management.

The second factor that contributes to slower economic expansion is the impact that inflation has on economic performance. As we saw very clearly in the 1970s, an inflationary environment results in managements directing attention away from longer-lived investments that are more productive and into shorter-term assets that act like an inflation hedge. Such investment slows down improvements in productivity because productivity improvements tend to be more prevalent in longer-term assets than in short-lived ones. The threat of higher inflation results in lower productivity growth.

Both factors - the loss of focus and reduced productivity growth (each of which tend to reduce innovation), contribute to slower economic growth and a less vibrant business environment. This re-focus also results in a change in business leadership. As the culture of businesses change due to different economic environments, management leadership tends to change as well. Promotions and the responsibilities for hiring employees go to managers that are more risk averse and less dynamic and this contributes to a slower pace of economic expansion.

On the policy side, both monetary and fiscal policies are directed to stimulate aggregate demand. The general prescription for monetary policy is to lower interest rates (or at least not raise them) and speeds up monetary growth. On the fiscal side, a general effort is made to cut taxes and/or increase government expenditures. If the above analysis is correct, both efforts will go to produce more inflation rather than stimulate production, and this, as we have seen, will just contribute to making the situation worse.

If we think we are entering a period of stagflation, then we must be sure that we understand where the economic shock has come from, either the demand side or the supply side. If stagflation results from a supply side shock then pursuing demand side remedies will only make the situation worse. If Stagflation is coming from the supply side then the government must create more appropriate policy responses in order to meet the needs of the times.

If stagflation is a supply side problem then we must look at the behavior described above in order to come up with appropriate actions. First of all, inflation is an enemy and its fire must not be fanned! (This even ignores the impact that inflation potentially has on the value of the dollar.) Any policy actions that encourage inflation only create a cumulative problem that just adds fuel to the fire and makes the inflationary spiral that much more difficult to stop. It is hard for policy makers to fight inflation at a time like this because voters and politicians are clamoring for more economic growth and less unemployment.

The second part of the problem is not only difficult but is also slow to unwind. There are also two components to this second part. The restructuring of businesses, both financial and non-financial, must take place and it must take place in as orderly a fashion as possible. This takes time. It has taken the American economy quite a few years to get into the situation it is now going through and getting out of it will be painful and time consuming. Adding to the normal adjustment process is the added problem that the United States, as well as the world, is also in need of moving away from fossil related energy sources and moving into an age of cleaner and more efficient energy sources that are not fossil related. Therefore, we are going though an adjustment related to the financial excesses of the past decade or so as well as an adjustment related to the absence of a sound energy policy in the developed world.

The other thing that must be avoided at this time is the move to a more inner-directed management. For the economic growth rate to increase and unemployment to drop, managements must strive to create sustainable competitive advantage by focusing on what they do best and innovating in order to keep ahead of their competition. Costs must be contained, not through cutting back on expenses, but through economies of scale achieved in the application of core competencies and increases in productivity. This too will take time and the intentional efforts of business leaders and entrepreneurs.

To combat stagflation we must have monetary policy and fiscal policy working together. Monetary policy must work to keep inflation moderate. Fiscal policy must work to create an environment that encourages the improvement of productivity and risk-taking. Yes, there needs to be a safety net for Americans that are hurt by unemployment and economic dislocation. If stagflation is a supply side problem, then the resolution to the problem must come from stimulus programs that impact the supply side of the economy.

This article has 17 comments! Add yours below...

John M. Mason

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This article has 17 comments:

  •  
    freefall51
    Jul 23 08:51 AM
    So what am I supposed to buy now?
  •  
    CLH
    Jul 23 11:07 AM
    I see little chance of stagflation. This downturn is deflationary --similar to the 1930s and Japan 1990s. Prices are dropping except for energy and food and they seem now to be headed down.
  •  
    Charlie
    Stromeyer Jr
    Jul 23 11:14 AM
    I don't see much chance of sustained stagflation either because the most recent NABE survey shows that businesses are reducing hiring which means that we can't have a wages-prices induced spiral of inflation higher like we did in the 1970s.
  •  
    Tinman
    Jul 23 01:27 PM
    Stagflation risk is not insignificant: we have serious inflation making its way through the system (look at PPI, not CPI) while experiencing near zero growth. The supply-side shocks that are driving inflation make this a different beast than the 70's model.
  •  
    flow5
    Jul 23 04:26 PM
    With a chronically depreciating dollar foreigners will be much less inclined to invest in the U.S. on a creditor ship basis, thus pushing up interest rates. The rising cost and diminishing volume of imports will contribute to an increase in inflation, and the expectation of further inflation will also push up interest rates. This spells permanent stagflation.

    There are extremely large and permanent leakages in the IS-LM model. And stagflation was described and foreseen before it's coinage - in 1958. S never equals I

    Unfortunately, under the influence of the Keynesian dogma, academicians have been trying for too long to analyze interest rates in terms of the supply of and demand for money. A “liquidity preference” curve is presumed to exist which represents the supply of money. In this system interest is the cost which must be paid, if lenders are to forgo the advantages of liquidity.
  •  
    flow5
    Jul 23 04:32 PM
    While interest rates are not determined by the supply of and the demand for money, changes in thee volume of money and monetary flows (MVt), can alter rates of inflation and, therefore, the supply of and the demand for loan-funds.

    The significant effects of these monetary developments are long-term and involve an alteration in inflation expectations. Inflation expectations operate principally through the supply side for loan-funds. Specifically, an expectation of higher rates of inflation will cause the supply schedules of loan funds to decrease. That is to say, lenders will be willing to lend the same amount only at higher rates.
  •  
    Flav
    Jul 23 04:44 PM
    @CLH: where exactly do you live? If you dare to say that only food and energy prices are rising, you must not live in the U.S.
    You don't need to look at a particular sector, just check the core CPI issued last week, which shows a YOY increase of nearly 3%, the fastest since 1995
  •  
    iThinkBig
    Jul 23 05:53 PM
    My Website
    CLH is correct, this is deflation or perhaps Flow5's permanent stagflation terminology applies. BTW, thank you Flow5 for all of your comment contributions. I have learned probably the most here at Seeking Alpha from your comments.

    Probaby too early to have a very strong opinion about this topic in any event, but I stay in the deflation camp for now. I hope I am very, very wrong but as a simple connect the dots thinker that is the way it appears.
  •  
    iThinkBig
    Jul 23 05:57 PM
    My Website
    Flav, how much YOY inflation in the transportation sector? Durables? As mentioned, probably too early to quantify deflation vs XYZ based on two soft quarters and two really weak quarters.
  •  
    flow5
    Jul 24 11:50 AM
    Mason, I look forward to your comments. Your remarks have substance.

    Professional economists have no excuse for misinterpreting the savings-investment process. They are paid to understand and interpret what is happening in the whole economy at any one time.

    For the commercial banking system, this requires constructing a balance sheet for the System, an income and expense statement for the System, and a simultaneous analysis of the flow of funds in the entire economy.

    From a System standpoint, time deposits that represent savings have a velocity of zero. As long as savings are held in the commercial banking System, they are lost to investment. The savings held in the commercial banks, whether in the form of time or demand deposits, can only be spent by their owners; they are not, and cannot, be spent by the banks.

    Savings held in the commercial banks are lost to investment, and deprive the financial intermediaries of loan funds.

    From the standpoint of the economy, the elimination of time deposit banking by the commercial banks will facilitate the orderly and continuous flow of monetary savings into real investment (lowering commercial bank (but not the thrifts) Reg Q ceilings in 1966 brought the U.S. out of a recession and housing crisis. (but the rate was not lowered far enough).

    This "structural" change that you refer to is what I would label disintermediation (as applied only to the non-banks). It is an economist word for going broke. The last period of disintermediation for the commercial banks occured during the Great Depression

    See Banking & Monetary Studies, 1963, Irwin. Dean Carson, ed. Sponsored by the Comptroller of the Currency, pp. 369-386.

    Also, Crutchfield, Henning, & Pigott, Money, Institutions, and the Economy, a Book of Readings 1965, Prentice Hall pp. 125-139 Library of Congress, Catalogue No 65-13574.
  •  
    flow5
    Jul 24 01:44 PM
    How does the FED follow a "tight" money policy and still advance economic growth.? What should be done?

    The commercial banks should get out of the savings business (REG Q in reverse-but leave the non-banks unrestricted).

    What would this do? The commercial banks would be more profitable - if that is desirable.

    Why? Because the source of all time deposits within the commercial banking system, is demand/transaction deposits - directly or indirectly through currency or their undivided profits accounts.

    Money flowing "to" the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know.

    The growth of the intermediaries/non-ban... cannot be at the expense of the com. banks. And why should the banks pay for something they already have? I.e., interest on time deposits.


    SEE: Dr. Leland James Pritchard (MS, statistics - Syracuse, Ph.D, Economics - Chicago, 1933) described stagflation 1958 Money & Banking -- Houghton Mifflin,

    “The Economics of the Commercial Bank Savings-Investment Process in the United States” -- “Estratto dalla Rivista Internazionale di Scienze Econbomiche & Commerciali “ Anno XVI – 1969 – n. 7

    “Profit or Loss from Time Deposit Banking” -- Banking and Monetary Studies, Comptroller of the Currency, United States Treasury Department, Irwin, 1963, pp. 369-386.
  •  
    Flav
    Jul 24 07:27 PM
    @IThinkBig: if you consider this is a deflation period, and the most you've learned from this site is through flow5's comments is maybe beacuse you're absolutely, completely and thoroughly clueless about any subject about finance or economy (as your dumb heatlhcare site suggests).
    As to flow5, who remarks Keynessian economics to be not up to date on their analysis of the interest rate, maybe you should check economy books a little more often. The simple IS-LM model, along with the original Philips curve have been updated to new and more comprehensive frameworks in which interest rates are determined by other factors than just the liquidity preference. I believe that your comments are totally useless and inaccurate. But well, writing (like talking and breathing) is free, so...
  •  
    flow5
    Jul 25 01:44 PM
    If you were correct the FED wouldn't use the FFR as a guide to monetary policy. Quick to point out errors, quick to leave them begging.
  •  
    flow5
    Jul 25 01:46 PM
    What makes you think the economics books are correct? I can both read and interpret.
  •  
    flow5
    Jul 25 02:00 PM
    You didn't even read what I wrote. REPORT ABUSE
  •  
    flow5
    Jul 25 03:03 PM
    william-king.www.drexe...
    This is still operative:

    In the diagram, we show the QUANTITY OF MONEY on the horizontal axis and the INTEREST on the vertical axis. For example, if the rate of INTEREST is Ra, people want to hold Ma of MONEY, where as if the rate of INTEREST were to go down to Rb, people would increase their demand for monetary assets to Mb.
    The FED can use this relationship, in reverse, to influence the INTEREST RATE. Suppose the Fed sets the total QUANITY OF MONEY at Ma. Then people will try to shift their assets out of the less liquid accounts into liquid money accounts as long as the rate of interest is less than Ra, or in reverse, to buy nonliquid assets whenever the rate of interest is greater than Ra. Since they cannot all shift their assets at once -- the total quantity of assets of each kind is known -- their competition for liquid or nonliquid assets will drive the INTEREST RATE to Ra. We may say that Ra is the "equilibrium interest rate" with a MONEY SUPPLY of Ma. If the FED wants to push INTEREST RATES down to Rb, they would increase the MONEY SUPPLY to Mb.

    There are two points of controversy about this:

    There may be a lower limit to how far the Fed can push the INTEREST RATES down. In the diagram, the DEMAND FOR MONEY (improper use - means the opposite of how it is used) DEMAND FOR MONEY increases without any limit as the INTEREST RATE falls toward Rt. Thus, no matter how much the Fed increases the MONEY SUPPLY, it could never push the INTEREST RATE below Rt. Rt is called "liquidity trap." Some economists have questioned the possibility of a "liquidity trap;" but others observe that the Japanese economic system, in the late 1990's, behaved very much like it was at the "liquidity trap" INTEREST RATE level. In any case, INTEREST RATES can never go lower than zero, and Japanese interest rates in the late 1990's were sometimes so low that the zero lower limit would be relevant.
    The FED can use the LIQUIDITY PREFERENCE relationship to influence INTEREST RATES only to the extent that the relationship is stable, or at least predictable. But some economists believe that it is very unstable and unpredictable -- a source of trouble rather than a means of control. In the fall of 1998, with the collapse of a major "hedge fund," and again just before January 1 2000, the FED believed that there would be bid increases in LIQUIDITY PREFERENCE. Indeed, for a short period in 1998, it seemed as if the U. S. economy had a liquidity trap at an INTEREST RATE of several percent. But because they predicted these changes, the Fed adjusted the MONEY SUPPLY to keep the INTEREST RATES more nearly stable, and they were successful on the whole.
  •  
    flow5
    Aug 02 01:38 PM
    A more careful reading of my comments reveals that the liquidity preference curve is not the sole factor determining interest rates. Interest rates are determined by all factors operating through the demand for and supply of LOAN FUNDS.
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