To his credit, Todd Harrison at Minyanville.com has been talking about stagflation for a while. After the Hurricane disasters, it’s finally becoming a reality. The government has truly lost control over its finances since it’s now fighting battles stateside (Katrina and Rita damage) and abroad (Iraq, Afghanistan and the 100 other nations in which the US has a military presence). The huge overspending by the government will lead to monetary inflation. But higher interest rates combined with high debt levels and high energy prices will slow the economy.
So here are some terms to know from my favorite source, www.wikipedia.com…
Stagflation is a term in macroeconomics used to describe a period of characteristic high inflation combined with economic stagnation, unemployment, or economic recession.
Stagflation is thought to occur when there is an adverse shock (a sudden increase, say in the price of oil) in a country’s aggregate supply curve. The effects of rising inflation and unemployment is especially hard to counteract for the central bank. The bank has one of two choices to make, each with negative outcomes. First, the bank can choose to pursue a loose money policy to stimulate the economy and create jobs by increasing the money supply (by lowering interest rates) and exacerbate the inflation problem further. Or second, pursue a tight money policy (by increasing interest rates) to try and rein in inflation at the cost of perhaps increasing unemployment further.
In the 1960s it was thought that the Phillips curve, which was associated with Keynesian economics suggested that stagflation is impossible because high unemployment lowers demand for goods and services which lowers prices. This results in low or no inflation. However, in the 1970s and 1980s, when presented with actual stagflation, it was realized that the relationship between inflation and employment levels was not a constant, but could be shifted, and that the Phillips relationship was better seen through payroll surveys (Current Employment Statistics) of employment rather than household surveys (Current Population Survey) ([1]).
By contrast, quantity theories of inflation, such as monetarism, argue that inflation is due to the money supply rather than demand and predict that inflation can occur with high unemployment if the government increases the money supply in a period of rising prices.
Stagflation occurred in the economies of the United Kingdom in the 1960s and 1970s and the United States in the Nixon administration of the early 1970s as reported by various news and financial sites. The difficulty in fitting its existence within a Keynesian framework led to a greater acceptance of monetarist theories in the 1970s and 1980s. The pendulum has, to some extent, swung back in the other direction as monetarism had increasing difficulty predicting the demand for money and the long period of low inflation and high employment of the 1990s – a kind of reverse of stagflation.
As of 2004 global stagflation is making a comeback with the price of oil over $40 a barrel, the US government slowly increasing interest rates, and employment rates stagnant. Monetarists and Keynesian economics continue to have difficulty explaining the phenomena.
Supply-side economics emerged as a response to US stagflation in the 1970s. It largely attributed inflation to the ending of the Bretton Woods system gold standard in 1971 and the lack of a specific price reference in the subsequent monetary policies (Keynesian and Monetarism). As a response most governments today compile consumer price indexes as part of their monetary policy.
Supply-side economics asserts that the contraction component of stagflation was caused by the inflation induced rise in real tax rates (see bracket creep). In addition certain states in the USA had laws against nominal interest rates being above a certain level and in the midst of inflation this forced real interest rates to be negative. In some places this caused a collapse in finance for business.
The coinage of the term, which is a portmanteau of stagnation and inflation, has been claimed for the UK Chancellor of the Exchequer Iain Macleod who died in 1970.
And a small excerpt from the Bretton-Woods System entry on www.wikkipedia.com – Does this sound familiar?
"Closing the gold window"
President Nixon announces that the U.S. will stop redeeming dollars for gold.By the early 1970s, as the Vietnam War accelerated inflation, the United States was running not just a balance of payments deficit but also a trade deficit (for the first time in the twentieth century). The crucial turning point was 1970, which saw U.S. gold coverage deteriorate from 55% to 22%. This, in the view of neoclassical economists, represented the point where holders of the dollar had lost faith in the U.S. ability to cut its budget and trade deficits.
In 1971 more and more dollars were being printed in Washington, then being pumped overseas, to pay for the nation’s military expenditures and private investments. In the first six months of 1971, assets for $22 billion fled the United States. In response, on August 15, 1971, without consulting members of the international monetary system or his own State Department, Nixon unilaterally imposed 90-day wage and price controls, a 10% import surcharge, and most importantly "closed(ing) the gold window," making the dollar inconvertible to gold directly, except on the open market.
The surcharge was dropped in December 1971 as part of a general revaluation of major currencies, which were henceforth allowed 2.25 percent devaluations from the agreed exchange rate. But even the more flexible official rates could not be defended against the speculators. By March 1976, all the world’s major currencies were floating—in other words, exchange rates were no longer the principal target used by governments to administer monetary policy.
The Smithsonian Agreement
The shock of August 15 was followed by efforts under U.S. leadership to develop a new system of international monetary management. Throughout the fall of 1971, there was a series of multilateral and bilateral negotiations of the Group of Ten seeking to develop a new multilateral monetary system.
In December of 1971, on the 17th and 18th, the Group of Ten, meeting in the Smithsonian Institute in Washington, created the Smithsonian Agreement which devalued the dollar to $38 dollars an ounce, with 2.25% trading bands, and attempted to balance the world financial system using SDRs alone. It was criticized at the time, and was by design a "temporary" agreement. It failed to impose discipline on the US government, and with no other credibility mechanism in place, the pressure against the dollar in gold continued.
This resulted in gold becoming a floating asset, and in 1971 it reached $44.20/ounce, in 1972 $70.30/ounce and still climbing. By 1972, currencies began abandoning even this devalued peg against the dollar, though it would take a decade for all of the industrialized nations to do so. In February of 1973, the Bretton Woods currency exchange markets would close, after a last gasp devaluation of the dollar to $44/ounce, and only would reopen in March in a floating currency regime.
Conclusions
The collapse of the Bretton Woods system is a subject of intense debate. There are a variety of theories as to why it did so, ranging from the budget deficit problems, to blaming the Vietnam War, to marginal tax rates. The fundamental point of agreement is that the United States ran an increasing balance of trade deficit, and that, in the end, it could not establish credibility on reining this deficit in. This would lead to the study in economics of credibility as a separate field, and to the prominence of "open" macroeconomic models, such as the Mundell-Fleming model.
But lest you go and sell everything and hide in the mountains, remember, the 1970s were a great trading environment for stocks. As long as you sold hope and bought despair, you did OK (1974 notwithstanding).
