March 21, 2007

Is Stagflation Making a Come Back?

"Analysts said the central bank (Fed) appeared to acknowledge it is in a bind, caught between an economy being dragged down by troubles in the housing industry and stubbornly high inflationary pressures." - A recent AP article.

Although many people view the U.S. Federal Reserve as being at the center of power, its power has waned over time. What happens when the Fed "turns the knob" to control the economy and nothing happens? Well, first, the mythic power of the Fed is shown to be.... er, mythic. Second, people and institutions get nervous about the economy. And third, these same people and institutions quickly forget about their nervousness and continue to exhibit signs of "irrational exuberance;" they continue to move money around in speculative activities that are disconnected from reality as described in John McMurtry's The Cancer Stage of Capitalism.

It isn't really news that the Fed's breaks and accelerator have gotten mushy lately. In addition to the phrase "irrational exuberance," coined by former Fed Chairman Alan Greenspan, is the word "conundrum," which has meaning in this context. It's a fairly simple concept. (Conundrum1)

When someone invests money to make a profit, say on bonds that pay back at a certain interest rate, their money will be locked up for a period of time (unless they back out and pay a penalty). A thirty-day bond locks up the money for thirty days, and a ten-year bond locks it up for ten years. The longer a person is willing to bear the inconvenience of having their money locked up, the higher the interest needs to be to entice them into such an investment. That is, longer term bonds (10-yr) should pay a higher interest than short term bonds (30-day). The "conundrum" voiced by Greenspan is that the bond yields were reversed fairly often during 2006 (long-period bonds were paying lower interest than short-period bonds). This is also known as an inverted bond yield curve (here's a good site that shows the yield curve changing over time). Despite trying to control this, the Fed seemed powerless.

Now the Fed has another conundrum (Conundrum2). Usually, the Fed "controls" the economy by adding or removing dollars; more available dollars means more economic activity, which in a healthy economy translates into more jobs (but more potential for price inflation, AKA an over-heated economy). If the Fed provides fewer available dollars, it helps to bring down price inflation, but this reduces economic activity. In simple terms, the Fed strives to control interest rates at which money is borrowed; lower interest rates means more money is likely to be borrowed and thus fuel the economy (and inflation); higher interest rates means less money available, and prices should come down.

What happens when the economy is not doing well, but at the same time price inflation is going up? The Fed might be tempted to pull dollars out of the economy (increase interest rates) to control the inflation, but this will also further dampen the economy and put more people out of work. If the Fed tries to do the opposite, put dollars into the economy to stimulate the economy, inflation will go up. This situation is known as "stagflation;" the economy is stagnant, but at the same time there's inflation. It's a counter-intuitive situation in which the Fed has lost control in terms of Conundrum2, even assuming Conundrum1 isn't in effect.

Today, both conundrums seem to be in effect: We are facing stagflation (Conundrum2), and when the Fed turns its control knobs, nothing happens (Conundrum1).

The reason for all of this, I believe, is simple. The economic system isn't healthy, which is different than saying the economy isn't healthy. Our corporate free market system has allowed obscene amounts of wealth to be concentrated into a few hands, and the money is stuck there. In a healthy economy, the money moves around, in and out of every one's hands, even the little people who are not part of the inside crowd. We are witnessing the failure of trickle-down economic theory, or worse, outright corruption among the wealthy political elite. Either way, the signs of failure are emerging.

There's much more to this story, and we will watch it unfold in terms of an unraveling economy starting with subprime mortgage defaults that bring down corporations and institutions that have invested in real estate financial instruments. The challenge of this time will be for society to rise to the occasion and re-define the economic system so that it becomes a healthy one.

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