A Case Of Stagflation

For those of you too young to have been exposed to the economic disease of stagflation, I can confirm this is what an incipient, thus-far mild case looks and feels like. You are not going to enjoy it.

Stagflation is a combination of uncomfortably high inflation and uncomfortably high unemployment. It is not the same as recession, in which economic output actually shrinks, and often so does the total number of people with jobs. The economy can grow during periods of stagflation, but it does not grow fast enough to provide work for nearly all of those who want it, and some of the apparent growth is the illusory result of rising prices rather than rising output.

It has been about 30 years since this country experienced real stagflation. Back then, in the late 1970s and early 1980s, it was not a mild case. Inflation reached 10 to 12 percent a year (briefly peaking a little higher), and unemployment hovered near double digits as well. The “misery index,” which was coined to reflect the combined unemployment and inflation rates, exceeded 20. By comparison, for most of the past two decades, this index has been below 10, and at times has been around 5.

That is not the case any more. The U.S. Labor Department reported Friday that the unemployment rate rose in May to 9.1 percent, the highest level this year, while employers added a net of only 54,000 jobs last month. The job-growth figure was far below economists’ already modest expectations of around 165,000 net new jobs, and even farther below the roughly 250,000 new jobs that we would need to produce to make a significant dent in unemployment.

The most recently reported consumer price inflation statistic, for April, shows a 3.2 percent year-over-year gain, and that figure is probably close to May’s rate, scheduled to be released on June 15. The misery index has therefore climbed above 12, and chances are good that it is going to stay there for awhile. There is some risk it will go higher.

Month-to-month reports on inflation and employment can be volatile, and we should not overreact to the recent bad news. But we should not ignore it, either. Policymakers at the White House and the Federal Reserve assume, or maybe by this point merely hope, that the unsettling recent statistics are transitory. Inflation, in particular, is being blamed on the sharp spike in food and energy costs earlier this year that has since abated. The Fed points to so-called “core” inflation statistics that are running at only around 2 percent, which is close to the central bank’s target. Employment grew at a reasonably decent pace earlier in the year, before disasters in Japan disrupted supply chains and rising gas prices made consumers turn cautious. As these setbacks recede, things may pick up again, they tell us.

Then again, what else could they tell us, except that two years of fire-hose federal spending and rock-bottom interest rates have failed to ignite self-sustaining economic growth, even as they fanned inflationary fires around the world that are now threatening to consume our own front yard?

Stagflation is an economic cul-de-sac that leaves policy makers with few appealing options. The Federal Reserve will conclude its latest round of monetary pump-priming, known as “QE2” (QE stands for “quantitative easing”) later this month, when it finishes a $600 billion binge of buying Treasury debt. QE2 did help the stock market rally by 20 percent over the past year and, by driving down the dollar’s value, gave the U.S. farm and manufacturing sectors a boost. But the crashing dollar helped generate a nasty round of commodity price inflation, including the $4-a-gallon gasoline that is creating so much discomfort. It helped send inflation soaring in other parts of the world, even in Brazil, where an excessively strong currency should be keeping prices down by making imports cheaper.

These unwanted side effects will probably prevent the Fed from launching a QE3 campaign, unless the government’s overspending so terrifies the bond market that the Fed becomes the Treasury’s buyer of last resort. If you see that happen, you should view it as the opening of the gates of inflationary hell.

Meanwhile, consecutive years of deficits measured in the trillions have pushed us to the limit of the government’s $14.2 trillion in authorized borrowing. Last week, Moody’s became the latest credit rating agency to warn of a potential downgrade of Uncle Sam’s debt if a resolution to the debt ceiling issue is not reached, or at least in sight, within a few weeks. But simply raising the debt ceiling does nothing to put the federal government’s budget in order, which is why many Democrats joined every House Republican in rejecting a no-strings-attached debt limit increase two weeks ago.

We have not been able to spend and stimulate our way to sustainable growth, because that is not how sustainable growth is generated. We have not been able to cut interest rates to generate job-producing investment, because people invest in order to earn a return on their money, and the government is intent on keeping such returns as low as possible in order to minimize the cost of that $14 trillion in debt.

Stagflation is more of a chronic disease than a life-threatening one. A lot of societies, notably in Europe, have chosen to live with it for decades rather than take the bitter medicine required to cure it. They avoid the short-term distaste, but they live year after year without a truly healthy economy. The result often is cynicism, corruption and bitterness, especially in the young, who never have the opportunity to build truly prosperous societies and rewarding lives.

We’ve had this illness ourselves and we know what it takes to treat it. You don’t bandage it with more government spending, higher deficits, higher taxes to service the resulting debt, or artificially cheap capital to keep that debt serviceable. You deal with it by letting capital earn a fair rate of return, letting labor find its true value – at the cost of a temporary rise in unemployment – and by having a sustainable tax structure that neither discourages commerce nor drives it elsewhere. The cure is neither fast, nor cheap, nor painless, but when the misery index gets high enough, we’ll finally choose to accept it.

The question at the moment is: How high must the misery index go before it gets high enough?

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About Larry M. Elkin 564 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

Visit: Palisades Hudson

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