It's Contraction - Not Stagflation

Includes: DIA, IVV, SPY
by: Stockerati

Let’s first define what stagflation means:

Stagflation is the state of an economy where inflation combined with stagnation locks a society into slow-to-negative economic growth and rising unemployment, invariably including recession. 

Policies which promote growth in the money supply to allow consumers to afford higher priced oil contribute as a cause for runaway inflation, even if implemented to fight stagnation or recessions. Stagflation is, thus, a super-set of recession. And we are not there yet!

The global stagflation of the 1970s is often blamed on both causes: it was started by a huge rise in oil prices, but then continued as central banks used excessively stimulative monetary policy to try to avoid the resulting recession and stagnation, causing a runaway wage-price spiral. Déjà vu, isn’t it?

Let’s explain stagflation through an easy examples:

Say, you have only two car companies A and B in a country. A and B each have 100 employees, 2 manufacturing facilities and produce 100 cars.The facilities and engineers represent the supply of the country. The cars represent the demand for goods. The price of cars is determined by the market.

A and B can increase profits in 3 ways:

  1. They can build more facilities and hire more engineers so that they can push in more cars for the market price. This will give them “average” returns.
  2. They can reduce the costs to produce the same number of cars for the market price by making its existing facilities and engineers more efficient This also gives them only an average return on investment.
  3. They can decide to be better than average by reducing competition and costs so that thy can provide fewer cars but charge more per car. As prices are determined by the market, they have to change the market to do better than average

Now, lets say that A wants to take option 3 above. So, instead of investing in more facilities, it decides to merge or acquire B.

After A and B become one, there is less competition. A then cuts costs (option 2) by shutting down 2 (of 4) facilities and lays-off 100 engineers. Then A decides to raise the cost/car as there is no competition now. As a result A sees a temporary increase in profits because two things have occurred:

  • A has reduced costs (and increased the profit = revenue - cost)
  • A can raise prices because there’s no competition

However, the country now gets only 100 cars instead of 200 before and there are 100 unemployed engineers. With the reduced capacity, A can’t respond quickly to rising demands.

The results are:

  1. Higher unemployment and fewer cars (recession);
  2. Higher rates/car  (inflation)
  3. Lower  productivity (cost per unit of work).

And as a result, we see stagflation in the country. If the government expands the money supply as a means of fighting the recession by lowering interest rates, the economy borrows more money to pay the higher cost/car but because there are fewer facilities and only one company [A] prices rise still further in the short-term. Long term, other companies see an opportunity to make money in this market by building new cars. This then increase production, employment and decrease prices and ends the recession and inflation. This cycle then continues.

Our unemployment rate is on the rise (albeit not at concerning levels). However, productivity still remains high, see graphs below. The charts below give the interest rates and the productivity during the recessions in the past.

click to enlarge

Fred Graph

Fred Graph

 So what does this data mean?

  1. We know there’s inflation. Oil prices today are indicative of rampant inflation
  2. We know unemployment is only slightly on the rise.
  3. Productivity across all sectors (manufacturing, business, non-farm etc.) is strong.

However, as I mentioned in my earlier post, an immediate increase in interest rates will help control this situation. Otherwise we will end up in jaws of stagflation. I prefer a recession to an stagflation has a longer cycle and requires a much longer recovery time.

The solution to stagflation is to restore the supply. In the case of a physical scarcity, stagflation is addressed either by finding a replacement for the limited goods or by developing ways to increase economic productivity and energy efficiency—to do more with less. In the late 1970s and early 1980s the U.S. responded to the scarcity of oil by both increasing energy efficiency and by driving up oil production domestically and worldwide. These factors along with adjustments in monetary policies of Paul Volcker (who was the then Chair of the Federal Reserves). FYI,  Paul’s an economic advisor to Democratic presidential candidate Barack Obama today.

Volcker’s is widely credited with ending the United States’ stagflation crisis of the 1970s by limiting the growth of the money supply by increasing interest rates. Inflation, which peaked at 13.5% in 1981, was successfully lowered to 3.2% by 1983. Does history indeed repeat itself?

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