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Friday, August 19, 2011

What is Stagflation?

Source: Time
Backstory:  Unemployment stubbornly high.  High percentage of unemployed chronically unemployed.  Official numbers underreport extent of unemployment.  Overall Consumer Price Index (CPI) reported at 0.5% - approximately 6% annual rate.

One of my favorite exercises with my macro econ students is to think about how many "inflation" words we can think of, to define them, and to give instances when they occurred.  There is inflation, deflation, disinflation, hyperinflation, and stagflation.  Stagflation is the one DIY investors are hearing more often today.

Stagflation doesn't often raise its ugly head - thankfully.  To understand stagflation, it is useful to understand that macro economic weakness is generally perceived as a problem in inadequate aggregate (total) demand.  In this view, the problem is corrected by increasing aggregate demand using standard monetary policies ( increase the amount of money in the economy, thereby lowering interest rates) or by fiscal policy (lowering taxes and increasing government spending).

There is a bit of a difficulty in this that we are currently facing.  If the Fed supplies excess reserves to the banking system, but the banks don't lend, then we are in a liquidity trap a la the U.S. in the 1930s and Japan in the 1990s.  The banks aren't lending because they need to recapitalize after their bad lending spree of recent years.  Businesses aren't borrowing because demand uncertainty is rising.

As an aside  I know some readers probably flinched at the mention of the typical fiscal and monetary policies because  they are the exact prescription for the mess the global economy finds itself in today. The problem is that, if you lower taxes and increase government spending to combat economic weakness, you commonsensically need to run surpluses, i.e. reverse the policies when the economy is strong.  This is what politicians do not have the stomach for and their economic advisors wimp out and "swallow the whistle," as we say when referees fail to call a blatant foul.

Anyways, with stagflation, the economy experiences weak aggregate demand and inflation pressures. The problem, then, is that the usual policies (which, in truth, are commonly viewed as the proverbial  free lunch) won't work.  Fiscal policy will only exacerbate inflation, and monetary policy that will lower inflation will ramp up unemployment.  This was the situation in the early 1980s.  Then Fed Chairman Volcker (we should have never let him resign!) cracked inflation expectations by letting short-term rates rise to 20%, and the unemployment rate skyrocketed.  In stark terms, stagflation causes the usual macro economic models to break down.  They fail to provide seemingly easy solutions.

After taking Volcker's medicine, the next 20 years produced exceptional economic growth and low inflation.  As a point of history, Volcker was almost tarred and feathered and run out of D.C. before his medicine took hold.

Since the 1980s, the U.S. economy as well as the global economy have become considerably wealthier; and it is probably true that the wealthier an economy becomes, or people for that matter, the more difficult it is to take corrective medicine when necessary.

Stay tuned.

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