The Specter of Stagflation
Like clockwork, and as projected by the few good economists who understand the trade cycle, the liquidation phase of the current cycle began — once again, due to a central-bank-induced credit crisis. And yet again the credit crisis began in year 7 of the cycle, after close to 6 years of economic expansion, that is, the artificially pushed money supply boom.
Similar events marked the beginning of the end of the boom during the previous two cycles: "Black Monday," the October 1987 stock market crash, followed by the 1989 savings and loan crisis; and the Asian Credit Crisis that began in the summer of 1997 with the collapse of Thailand's currency, the baht. This time around, however, there seem to be several important differences from the past two cycles, the main one being the rising level of prices, or what mainstream economists call "inflation" (CPI), due mainly to the lowest levels of average interest rates throughout the cycle, as the graph depicts. Additionally, the Bernanke Fed seems more eager to bail out bad investments and pump in more easy money than was the Greenspan Fed. Under this scenario, the specter of stagflation seems ready to show its menacing face for the first time since the '70s.
If mainstream economists and market analysts' predictions (wishes?) come true, and the US Federal Reserve lowers rates several times in the next few months, contrary to popular belief, things in the medium and long term will unequivocally get worse. Lowering rates by pumping fiat-currency liquidity will have the following effects on the US economy:
Credit will not contract as it should have — and might even expand — consequently delaying the necessary liquidation of malinvestments and the cleanup of bad loans.
New easy money will once again flow into stocks and other assets — this has already happened and was the main reason for the recent record highs in the stock market — hence, contributing to further inflation of the stock-market bubble, and creating the conditions for a stronger eventual fall of the market (like the famous October collapses). Moreover, it will provide additional dislocation of the supply chain, as more liquidity and artificial credit are pumped into the higher order, non-consumer-good, initial stages of production. Even more malinvestments will accumulate, setting the stage for ever more bankruptcies.
Prices of these higher-order assets and related goods, wages, and raw materials will keep rising, creating more "inflationary" pressures.
The US greenback will further deteriorate, losing purchasing power for all Americans.
The necessary recession phase of the cycle might be delayed for a few quarters, but its presence will be unavoidable; and due to the factors just depicted, it will be longer and deeper than it should have been.
The artificial monetary injections by the Fed will, like a shot of adrenalin to a sick patient, generate an apparent revival, just to have the patient collapse as soon as the injection wears off. Paraphrasing former Fed chairman, Paul Volcker, "once you have a little [monetary] inflation, you need a little more"; as with any medicine, its effects wear off and are less potent the more "injections" are received.
Let's examine the previous two cycles and contrast them to the current cycle in order to understand why the end of this one will be worse.
The beginning of the 1982–90 cycle came right after the deepest US recession of the past 7 decades, thanks to a tight monetary stance by the Federal Reserve, which raised the federal funds rate to 14.94% in April of 1982. This deep double-dip recession finally cleaned up the 1970s' enormous monetary mess, which generated a decade-long period of stagflation: extremely high price "inflation" and 4 recessions (1970, 1973, 1974–75, 1979–80). After clearing the stage of most of the 1970s' malinvestments, the economy grew more steadily until 1990.
Similarly, the 1991–2001 cycle began with a deeper recession than the 2000–2001 recession that marked the start of the current cycle. Unemployment reached nearly 8% in 1992, the highest level of the past 25 years. In addition, the money supply (M2) contracted by $11.2 billion between March and June of 1992, the first time since 1970, which obviously helped clean up the malinvestments and noncompetitive firms, many from the industrial heartland. The Consumer Price Index was also significantly lower; it had reached 1.6% during the 1998 liquidation phase. Compare that to the current almost-double Consumer Price Index of nearly 3% during this similar stage.
Here lie the two key factors that make the current cycle different than the past 2 cycles:
The 2000–01 recession was not allowed to run its course unhampered, due to excessive Fed pumping in response to 9/11. The recession was not a deep one — unemployment barely rose above 6% — and therefore the cleanup process was not completed. Unprofitable firms and projects (malinvestments) that should have gone under did not, and are still lingering today (these will have to be cleaned up soon in the coming recession).
Unemployment at Beginning
Fed Funds Rate
Change in CPI Inflation
Fed Stance at Beginning of Liquidation Phase
Raw material or commodity price levels (a good measure of the effect of the Fed's easing policies) are significantly higher this time around and rising. As an example, oil prices, in 2006 dollars, are above $88/barrel during the current stage of the cycle; however, the price for a barrel of oil was $28 and $23, respectively, in 1987 and 1997, during similar stages of the business cycle.
In conclusion, the upcoming events and the current Fed seem to be reminiscent of the early 1970s, where the Fed continuously "inflated" the money supply to fend off recession, therefore creating stagflation. A rising level of CPI "inflation" and higher unemployment — the so-called "misery index" — is quite possible. Unfortunately, in this centrally planned monetary system, only the Fed can know if stagflation will be allowed to show its ugly face again, wreaking the havoc it did in the awful 1970s.
David Saied is Commissioner of Panama's Securities and Exchange Commission, and was one of the key players responsible for Panama's recent miraculous economic revival. Send him mail. Comment on the blog.