Posted by: Bruce Allen | June 25, 2008

One Foot on the Brake and One on the Gas

Sure the economy is different than in 1978.  More dependent than ever on oil.

“One foot on the brake and one on the gas, hey!
–Sammy Hagar       “I Can’t Drive 55”

It is the summer of 2008.  A significant recession appears imminent, and a debate rages as to the likelihood that it will be accompanied by high inflation, producing the condition known as stagflation.  Most respected economists insist the inflation risk is small; a number of others, including myself, think the risks are high.  Here we examine the arguments, dividing them into Things We Know and Things We Suspect.

Things We Know

  • Commodity prices, notably oil, are at all time high.    Global demand is growing.
  • The Fed Funds rate currently stands at 2%.
  • Consumer prices in May rose at an annual rate of 7.2%.
  • The unemployment rate in May moved from 5.0% to 5.5%.
  • The dollar has declined an average of 30% against major Western currencies since 2003.
  • Households are spending more of their budgets on food and gasoline.
  • In 2007 the average American home lost 10% of its value.
  • The housing, banking and automobile sectors of the economy are in distress.
  • The Federal deficit last fiscal year was over $500 billion.
  • The trade deficit was over $700 billion last year and is rising this year.
  • The U.S. economy is notably different than it was in 1978 – see graph.
  • There will be a new president in the White House in January.

Things We Suspect

  • There is evidence of some speculation at work in commodity markets.  Hedge funds at work.
  • The people who invented, packaged and sold CMOs for subprime mortgages successfully pulled off the largest “pump and dump” scheme in history–maybe $2 trillion in vanished wealth.  The results are spilling over into commercial and consumer banking.
  • Inflation has yet to fully arrive in the economy.  It is en route.
  • In response to higher costs, businesses will have to raise prices or lay people off.  Lack of pricing leverage is likely to favor layoffs.  Unemployment will likely rise sharply.
  • If Israel bombs Iran a barrel of oil will jump $30 in one day, and the Dow will drop 1000 points.
  • A recession in the US is unlikely to slow the increases in world commodity prices.
  • The Fed will want to choke inflation by raising short term interest rates.
  • The new Congress and president will not stand idly by and watch the economy stall.

Conventional economics dictates that you fight recession by lowering interest rates and applying a Federal stimulus to the economy.  To combat inflation, raise interest rates and reduce Federal spending.  If you have both recession and inflation concurrently, addressing one causes further damage on the other, limiting the available policy alternatives.  Although there is plenty of room to raise interest rates, there is virtually no room to lower them.  With the deficit running at $500 billion, it is difficult to imagine significant additional Federal spending to stimulate the economy.  Nor is it easy to envision Washington suddenly reigning in spending in order to restore some fiscal balance anytime soon.

The recession is here.  The debate is over inflation–will we see it, or will it wilt in the face of a serious reduction in demand caused by a domestic recession and accompanying unemployment?  Will businesses be able to raise prices and increase the pay of workers whose real incomes are declining?  Or does the global economy make pricing power a thing of the past, forcing businesses to cut labor in favor of higher energy bills?  Does the government attempt to intervene by way of a fiscal stimulus?

Global demand for commodities is a direct function of global GDP.  For a moment, consider the net effect on global demand given 1) a serious deep recession in the U.S.–negative 4% growth, worst in a generation–coupled with 2) a global growth rate down from its ten year average of 4+%, to 2%.  (US demand declines by 4% and the rest of the world grows by 2%.)

US GDP 2007   -4%                          $13 TRILLION X 0.96 = $12.48 TRILLION
REST OF WORLD GDP 2007 +2%    $52 TRILLION X 1.02 = $53.04 TRILLION
_____________________________$65 TRILLION              $65.52 TRILLION

Net aggregate global demand increases, placing additional pressure on prices.  Not good for an American government trying hard to control inflation.

The Federal Reserve is poised to begin raising interest rates to combat inflation.  (At the Fed, Inflation is Job #1.)    Last time around they had to take the Fed Funds rate up to 14% to get on top of inflation.  The result was a serious recession in the early 1980s. The alternative is unimaginable, that the Fed would ignore inflation and allow the administration to go to war against the recession unrestrained by higher interest rates.  Such a policy would increase federal and trade deficits, further reduce the value of the dollar, and shatter the bond market.

The concern here is that the domestic economy will respond to higher interest rates with a deepening recession, but the global economy will continue to hum merrily along, driving commodity demand across the board and providing no inflation relief for American consumers.

The worst of both worlds.  One foot on the brake, and one on the gas.

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