Stag-hyperinflation?

Philip Brewer — Tue, 24 Mar 2009 16:15:48 +0000

Stagflation, the bane of the 1970s, is pretty much the worst situation for ordinary folks. With the economy depressed, jobs are scarce for workers and profits are scarce for business owners. With entrenched inflation, everyone's savings are constantly eroding. The result is that nowhere is safe for your money: not cash, not your business, not the market. With the latest moves by the Fed, I fear we're facing a repeat--only it'll be worse this time: stag-hyperinflation.

We know what produces inflation: excess growth in the money supply. This was a matter of some dispute back in the 1970s. In those days, many people thought that government deficits were the culprit--that when the government borrowed money and spent it on stuff, the "excess" demand bid up prices. The experience of the 1980s proved otherwise: Strong measures to hold the line on money supply growth by the Federal Reserve under Paul Volker brought inflation under control despite record deficits.

Bringing money supply growth down to the level of economy growth will bring inflation to a stop. However, it will also produce a recession. (This is pretty much inevitable. The inflation, by producing the illusion of growth, will have fooled businesses into making unwise investments. When the growth fails to materialize, businesses that expanded will have to contract--which is exactly what a recession is.)

Just as we understand inflation and recession, we also understand stagflation. You get stagflation when you repeatedly try to bring inflation down, but then keep chickening out at the first whiff of recession.

Unlike in the 1970s, our current spot of trouble was kicked off as an old-fashioned financial panic, which is a deflationary event. A year ago, I was worrying about inflation. (I wrote about How to live with inflation and Budgeting in a time of inflation and Will high inflation persist.)

By October last year, though, I had figured out that the deflationary effects of the financial panic were going to squelch the inflationary effects of Federal Reserve policy. (I wrote a post called Inflation is going away for a while.) With economic activity plummeting, prices of global commodities fell as well. Consumers trying to pay off debts and boost savings kept a lid on prices of consumer goods as well.

(As an aside, it's worth emphasizing that not all price increases are inflation. Inflation is the money becoming less valuable. Sometimes, though, prices go up for other reasons. Resource depletion makes key resources more expensive to produce, pushing up the prices of raw materials, and eventually the prices of everything made with those resources. Globalization pushes down the prices of things available in global trade, making things that are only available on local markets relatively more expensive. People's tastes change, producing changes in relative prices. All of these things can look like inflation, if all you've got to go by is price statistics.)

The Federal Reserve is in a tizzy. They're terrified of deflation--money becoming more valuable--because the experience of the Great Depression shows that a deflationary collapse can not only bring down the whole economy but keep it down for years. Contrariwise, they know how to stop inflation. This asymmetric situation has prompted them to boost the money supply in an effort to create a modest amount of inflation.

Normally, the Fed can create inflation no problem--they create additional bank reserves, the banks lend more money, the money supply goes up, and you've got your inflation. (It shows up in prices when people spend the borrowed money--prices get bid up because there's more money but no more stuff.) Just lately, though, this mechanism hasn't worked well, because the financial crisis has broken the transmission mechanism at the step of "the banks lend more money"--the banks are bust, so they're not lending, consumers are bust so they're not borrowing (and the ones who would borrow are poor risks for paying the money back), and businesses staring into the economic abyss are not borrowing either.

Faced with that problem, the Fed has now brought out the big guns. Last week the Fed announced that it was going to buy "up to $300 billion of longer-term Treasury securities over the next six months." Because here's the thing--there's one entity that can and will do the necessary borrowing and spending to produce inflation: The US Treasury.

That $300 billion, plus another $1.55 trillion spent on US government agency securities, are guaranteed to work their way through the economy and produce some inflation, pretty much ending the risk of deflationary collapse.

The questions then become, "How much inflation?" and "What next after that?"

How much inflation?

Nobody knows. It's impossible to even guess. The Fed's governors and the presidents of the individual reserve banks do make projections (for what they're worth, they recently projected inflation of 0.3% to 1.0% in 2009 and 1.0% to 1.5% for 2010), but their projections are no more accurate than anyone else's--which is to say not accurate at all.

It's easy to say what they're trying to do. They're trying to offset the deflationary impact of the financial crisis. And, because they know how to stop inflation, they're willing to aim a bit high--they want to be sure that they're entirely offsetting the deflationary impact, and they're willing to risk an accidental inflationary surge. They view the downside risk in that direction as much smaller than the downside risk of an accidental deflationary spiral.

The problem is that they could easily overshoot much too high, producing inflation on a scale that trashes the whole economy. (Inflation of just 10% wreaks drastic havoc with a modern economy. It becomes impossible to make any sort of long-term plan, because there's no way to know what the money will be worth a few years down the road.)

What next after that?

Yes, the Federal Reserve knows how to stop inflation--by causing a recession. Of course, we've already got a recession. Unfortunately, the process doesn't work in reverse: Being in a recession doesn't prevent the next round of inflation.

What we're looking at now is ameliorating this recession with a burst of inflation, in the hopes that doing so will keep it from turning into a depression. At that point things can go one of three directions:

The inflationary burst falls short and the deflationary spiral continues in earnest (The Fed's latest move signals that they'll do whatever it takes to prevent this scenario.)
The inflationary burst is "just right," halting the deflationary spiral without pushing inflation up to levels that threaten the economy. (This is what the Fed is trying to do. Let's all wish them luck.)
The inflationary burst is excessive, producing a serious bout of inflation. (There really isn't an upper bound here. Just a few percent does serious harm to the economy, but 10%, 50%, 10,000% and more have all been seen in various places around the world, over and over again since the invention of paper money. In 1979 and 1980 the US saw inflation rates over over 1% per month, which is plenty to wreck individual household budgets.)

If the inflationary burst turns out to be excessive, the Fed will reduce the rate of growth in the money supply to bring it back down, but we know what that does--it produces a recession. Maybe that recession will be different from this one--specifically, maybe it won't come hand-in-hand with a collapsing financial system--in which case maybe the Fed will stick to its guns and grind the inflation rate back down low enough that its economic effects are minor. But I don't see much reason for optimism. First, we'd have to fix the financial system between now and then--and there hasn't been much progress on that front so far. Second, a solid majority of the policy-setting Federal Open Market Committee members would have to grow a pair, and I'm not too hopeful about that either. The upshot is that I foresee inflation followed by a half-hearted attempt to rein in money supply growth, followed by more inflation.

And, to bring things full circle, we know where that leads. If you want stagflation, all you need to do is try to bring down inflation and then cave in at the first signs of recession. Kick the inflation rate up nice and high first and you can legitimately call it stag-hyperinflation.

Written by Philip Brewer and published on Wise Bread. Read more articles from Wise Bread.