The Deflation/Inflation/Stagnation Debate

Listening to debates about housing, oil and commodity prices is surreal. In the first 3 months of 2008 housing and medical costs represented 33% of personal consumption expenditures, or $3.3 trillion. Across the same three months sky high energy and food costs accounted for 18% of personal consumption expenditure, or $1.8 trillion. Housing and medical costs suffered massive and sustained inflation for years. Housing prices- the single largest cost facing American families- went nuts from 1996-2007.

Not only were there virtually no complaints, every imaginable policy action was taken to extend and increase run-away and unsustainable house price inflation. Speculators drove housing price inflation. Individuals bought more, larger and more expensive homes constantly. How? Why? They got larger and larger loans on easier and easier terms. Lenders could bundle and sell the home mortgages to speculators around the world. The resulting speculator driven asset inflation was celebrated as successful wealth building.

Stagnation

We see the downside now as these speculative investments have already gone bad into the hundreds of billions of dollars. Everyone caught up in this deflation process is writhing in pain. Our response? Let's re-inflate the bubble and/or try to lock in our inflated house prices. We have been failing and trying that for the last year. These attempts to save run-away housing inflation are feeding energy and food costs.

The Fed trotted out their June 25, Statement as though our present inflation, deflation and stagnation are mild, new and already in hand. In fact they sounded close to admitting they have fired all their rounds. The presence of asset price and housing deflation with food, energy and materials inflation is creating stagnation. Fed policy is caught in the quick sand of stagnation. Pressures are mounting for more easing from asset, Dollar and housing deflation. Tightening pressure builds from energy, food, materials inflation. We are stuck in a deflation/inflation/stagnation.

Inflation

Over the past several years oil/gas/energy prices have soared. Prior to that, oil prices were basically flat or declining for more than 10 years. Food prices performed similarly. More recently commodity prices in general have spiked. Energy, food and materials costs are significant. They represent a smaller portion of spending than housing and medical care. Food and energy combined account for about half as many household dollars as housing and medical costs - even now. Why then the vast disconnect in response to inflation? Why is speculator driven hyper inflation in housing the greatest thing ever? Why is speculation influenced inflation in food and energy prices the work of Satan?

US mortgages were sold in an international market place. Chinese, Japanese and other nation's economic growth created vast pools of trade surplus dollars. Trillions of these dollars were recycled back to US homeowners to allow America to keep borrowing and spending- including on foreign exports. Oil export surpluses were stockpiled and recycled into US mortgages as well, to keep America buying and to support the US dollar.

The public neither heard about, nor seemed interested in this from 2001-2007. As of June 30, 2007 [PDF file] foreign holdings of US agency securities stood at $1.4 trillion. Such securities are heavily comprised of bundled American home mortgages. Foreign, particularly Chinese and Middle Eastern, demand growth funded the inflation in housing. No one minded, no one said anything and few paid attention. Suddenly, Chinese demand growth and Middle Eastern policy is decried for causing energy inflation and aggravating food prices. There was no problem when international markets, speculators and financial flows inflated housing. The stories of housing, energy and food are similar and intertwined. The responses are vastly divergent.

We are now stagnating in growth terms. Employment has declined by 880,000 jobs between May 2007 and May 2008. Across the year through May 2008 there was a 39% increase in people unemployed for more than 27 weeks. Home prices, consumer confidence and general assessments are in continual decline. Foreclosures, delinquencies and late payments are on the rise. It has become very clear that we are in a depressed growth environment with deflating housing and assets and inflating materials, energy and food prices. Monetary policy is always a blunt instrument and is uniquely unsuited to the present type of environment. As the force of rising prices batters the general economic weakness, there will be more weeks like the present one and continued difficulty in gauging market reactions and valuations amid deflation/inflation/stagflation.

Disclosure: None

Comments

[20smoney:]

Great article... Totally agree.

2008 Jun 27 09:12 AM

[whidbey:]

Your article is long on explanation, but short on alternatives, if any. Do you mean to imply that there is no policy which will help a recovery to something more functional in the economy? Would you, for example, suggest benign neglect by the Fed while assets are written down? It will result in deflation and that might be the lesser of all evils. Oh yes, doing nothing is a decision.

2008 Jun 27 09:43 AM

[20smoney:]

The fed should allow deflation. It will be painful but better for our country long term.

2008 Jun 27 09:57 AM

[wes mantooth:]

"The fed should allow deflation. It will be painful but better for our country long term."

This is one of the dumbest things I've ever read. Yes, let's cripple our economy for an entire generation. Please go read about the Great Depression or the Japanese econmy from the early 90s to the present day. No winners there sir.

2008 Jun 27 12:18 PM

[Xyrus:]

Mantooth, I think you need to review your economic events.

The "Lost Decade" in Japan was caused by stagflation. You see, back in the late 80's and early 90's, Japan had a massive real-estate boom. Similar to our current situation, lax money standards helped fuel that bubble. When it popped, their central bank tried to inflate their way out of the problem by slashing rates (all the way to zero). It took a decade to recover from that debacle.

We are in a very similar situation. We've had a collapse in the real estate market. We have high inflation and a slow economy (which keeps heading downwards). Cutting rates more isn't going to help, as that just adds to the inflationary fire (and has already failed to do much). Leaving rates alone won't help, since the weak economy only continues to devalue the dollar (as well as our government's fiscal irresponsibility). Increasing rates (which is what the Fed did in the Depression, despite the economic pain it would bring) will at least stem the tide in dollar losses and put a cap on the inflationary spigot.

Choose your enemy. But no matter which road you take there's going to be pain. Perhaps banks may finally learn that greed can and will destroy if left unchecked.

~X~

2008 Jun 27 04:58 PM

[wes mantooth:]

"Mantooth, I think you need to review your economic events."

Thanks for the history lesson and all but Japan's lost decade was a deflationary event...not stagflation.

2008 Jun 27 06:23 PM

[Rhett:]

Duh?

2008 Jun 28 11:02 AM

[carey_jim:]

Most of our economic malaise is due to the old suspects: greed, fear, lack of savings, imprudent and unintelligent spending, etc.

For example,

The United States has/had no intelligent energy policy.

We have/had no intelligent health care policy.

We have/had no intelligent mass transportation policy.

We have/had no intelligent natural resource management and preservation policy.

Etc.

A good metaphor for the mess we are in is:

A 400 pound man who smokes two packs of cigarettes a day, drives an SUV to the 7/11 two blocks away to buy a six pack of beer every night and eats only junk food thinks he needs a double knee replacement surgery because his knees hurt.

America needs to feel the pain of a pretty serious "hangover" from past economic sins.

Whether the pain comes from inflation (confiscation of savings) or deflation (confiscation of assets) is probably irrelevant. The rich and nimble will prosper under either case. The rest will suffer, as usual.

2008 Jun 28 12:26 PM

[JRBH:]

While raising rates directly into a weakening housing sector, Mr Bernanke and the wizards of Wall Street [who got us into the current trap] kept asserting that a housing slowdown would not effect the general economy which is somewhat akin to saying that liver cancer is not a threat to ones general well being. I certainly do not know what, if anything , can be done to escape without some sort of discomfort. But I do know this, homebuilders have been in depression for nearly two years now, homeowners have seen their biggest asset in freefall and all sectors are suffering and will only suffer worse until this condition is corrected. Today, the clear enemy is continuing deflation. Raising the cost of money and reducing its supply in this type of environment was tried once before by Mr. Hoover. The definition of insanity is doing the same thing and expecting different results.

2008 Jun 28 03:22 PM

[User 30121:]

TERRIFIC article!

There are truly some brilliant minds here (commentaries). It WILL be painful to overcome. Many of us are experiencing this debacle again for a second time, and some of us unbelieveably for a third go round. History has a way of repeating itself.

A way to rebound is to take assertive political and economic action to drive out the crazies and fringe thinkers from office. BUY (taking PHYSICAL possession of) and HOLD gold and silver! May God have mercy on us!

2008 Jun 28 03:49 PM

[rbblum:]

Positioned as a superpower, America has had its golden opportunities. It now can only succumb to the current transition of the global economic forces in play.

2008 Jun 28 06:42 PM

[fodi MD.:]

Everyone seems to think we can do somthing to magicaly fix our problems. Well the time to do somthing has long since past. Thank Allen Greenspan! In this country positions are awarded to unfit and unskilled upper class where they get great monitary rewards for doing a disasterous job.The US monitary system is in a dountrend it may never recover from.Buy physical gold!The fed confiscated gold before and they can do it again You will pay for their mistakes .

2008 Jun 29 12:09 AM

[Learning Curve:]

Thank you all. This is a discussion we urgently need. One qualification on the article... Wolff states that, "The public neither heard about, nor seemed interested in this from 2001-2007." Perhaps the public was ignoring the "impending doom". But many many others, including the writers here, did hear about this and & hear & hear.
We saw the statistics about the American personal savings allocation going down. We witnessed that the Japanese personal savings rate was high and that no matter the stimulus, they still would not spend.
We saw the underemployment, the growing disparity of wealth. We heard about the 'new economy' and supply side.
Meanwhile, we voted against our own self interest and that of our children.
It was painful to watch the lack of response by these "wizards of wall street" and certain Administrations back to 1980.
While it may be true that the wealthy feel none of this, who, exactly is going to recharge the stock values in their portfolios once the buying public is completely tapped out and Disney Land, medications, electronic devices, education, Chinese toys for the kiddies, food from south of the equator and shiny new automotive transportation are no longer in the consumer’s budget? Politicians and magnates can’t continually hurt the citizenry with bad policy and expect the US to remain a world power.

2008 Jun 29 11:21 AM

[SW Richmond:]

There is no magic pill, no painless solution. We will have inflation, or deflation, or both. My personal bet is on inflation, followed by currency collapse (too many foreign dollar-holders, debt and intergenerational obligation overhang, world reserve currency and all). Efforts to avert collapse via war are not unthinkable.

There is plenty of blame to go around. It is a simple (and known) fact that people will not pay attention to details when things seem good. When things seem good people want to enjoy themselves and they tend to ignore looming storms. Most people do not understand economics at all, and that serves the interests of the ruling class who can feed the public any line they want to, like for example "evil oil speculators."

But such ignorance is bliss only temporarily. Because economics is based on numbers, and numbers don't lie, reality must intrude every now and again. So here we are.

I wouldn't want to be the next President.

2008 Jun 29 11:40 AM

[ArnoldCountry:]

I agree with the article but think that the Fed could have done things differently that would have made for a softer landing. For example, on housing, they could have provided a homebuyer tax credit if anyone buys a home in the next two years of $10,000 to $15,000.00. This would have brought out buyers. While home prices would continue to decline, the rate would slow with the increased demand. Energy prices could get under better control with an inverted windfall profit tax... the higher the price for fuel, the greater the tax on the oil companies. That would create incentives to try and keep prices down. Oil should also be removed as a comodity in the open market and the Federal government should be the direct purchaser of oil from the suppliers and then reselling it the oil companies for refining and distributing. Now, we have so many middlemen speculating, that is more driving the price then true supply and demand. Finally, we should impose a food/fuel supplement. Food export cost has a percent to percent increase in relation to oil. If oil increases by 25%, all food exports increase by 25%. If the government is the purveyor of oil, the supplement can be be used to offset the rising cost of oil.

2008 Jun 29 12:01 PM

[Jan Rogozinski:]

Housing prices were grossly inflated (or watered, as they used to say in the stock market.)

It was the bubble of all bubbles. So why should anyone want to stop housing pieces from falling back to where they were in 2000? It's not possible so to do, but why would anyone want to do something so dumb.

Folk are losing money because they were greedy. Bears can make money, bulls can make money; in the not so long run, pigs lose and deserve to lose.

The problem is that Americans are dumb enough to think that the House they live in is an "investment." Anyone that has taken either accounting 101 or economics 101 knows that all housing costs, including the initial purchase price and mortgage payments, always are 100% an expense, never an investment. In addition, housing is a totally messed up market. At least with stocks one can sell them at any time. So one can get out with a smaller lose.

2008 Jun 29 05:19 PM

[johngonole:]

I have an idea that might actually work. We can stop the energy and food prices, other goods and services price increases by supporting the dollar. The Federal Government must balance the budget and the FED must go neutral and let the interest rate freely float. These actions will obviously have a deflationary effect. However there is one inflationary force that could balance this. As our goods get cheaper this country could once again become an exporter of goods. Ohio, Michigan, and Indiana could once again flourish. As our prices come down all those dollars that have been sitting over seas could come back into America as the chinese, middle east, and many others decide to actually spend those dollars they've earned on our goods.

We just can't keep inflating our currancy and expect people to want our currency. Its time to get back to work. Let prices move freely. Short pain yes but prices will find a bottom. Unlike the great depression we have trillions of dollars waiting over seas to be spent into the economy.

2008 Jul 05 04:01 AM