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Stagflation Returning to the US Economy after 30 years

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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, and 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) 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."

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A political blogger for the International Business Times, Steve Leser is a hot national political pundit. He has appeared on MSNBC's Coundown with Keith Olbermann, Comedy Central's Daily Show with Jon Stewart and Russia Today's (RT) Crosstalk with (more...)
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