Monday, March 17, 2008

New Stagflation, New Perils

Let me be clear here. I do not understand Wall Street or the world of high finance well enough to venture even an Enlightened Layperson's guess as to what is going on. The most I can do is look at the elementary macroeconomics of our situation, and they are not encouraging.

For the first time since the 1970's, we appear to be suffering from stagflation, and for similar reasons. In both cases, the United States overtaxed the economy by attempting to fight an expensive war overseas without sacrificing domestic consumption, and in both cases a dramatic increase in oil prices has put the squeeze on the world economy. So far, stagflation is mild compared to the heights it reached in the '70's. But the accepted remedy is not encouraging.
Following the first oil shock in 1973, the Federal Reserve tried to head off a recession by expanding the money supply. Instead, it merely increased the rate of inflation with only a modest stimulation of the economy. After the second oil shock in 1979, Fed Chairman Paul Volcker reigned in the money supply hard. This threw the economy into a severe recession and raised interest rates to unprecedented highs. But it did squeeze inflation out of the system, and once the economy recovered from the recession, it enjoyed vigorous growth with low inflation and reduced interest rates -- until now. So the answer would appear to be to clamp down on the money supply to squeeze out inflation. Since stagflation is in a much earlier stage than it was in 1979, we should be able to sqeeze out the inflation with a much milder recession than it took last time.

The trouble is the clamping down on the money supply also raises interest rates. High interest rates bear hard on debtors. In the 1980's, the most obvious ill effect of high interest rates was on the federal budget. The combination of high deficits and high interest rates meant that more and more of the federal budget was being devoted to debt service, until eventually debt service payments exceeded the total deficit.* In the 2000's we have been able to run high federal deficits without incurring troubling debt service because interest rates have been low. Rising interest rates will revive that old problem.

But if that were the only problem with higher interest rates, squeezing out inflation would be worth the inconvenience. The problem is that this time around we have a huge problem with private debt. I do not pretend to understand the sub-prime mortgage crisis, other than that it is leading to vast numbers of foreclosures and people losing their homes. Imagine, then, how the crisis would be compounded if interest rates went up. Credit card debt is also at record heights. In short, the accepted remedy for stagflation would cause interest rates to go up, and private debt is too high to withstand the increase.

In short, be are between a rock and a hard place. Stay tuned.

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