The Road To Stagflation

This is an article I wrote for a newspaper that is a reprise of my reasoning why I think we are headed for stagflation. The article will appear next week, but it will be familiar stuff for Daily Capitalist readers.


The Fed voted two weeks ago to print money as much money as they think is necessary to fight deflation, economic decline, and rising unemployment. It is a major policy change little noticed by the media.

There has been a lot of noise in the media lately about deflation. While a few of us have been forecasting deflation and a decline in the economy for some time (your truly since December, 2009), it is as if most economists had just discovered it.

The reason for all this concern is the weak economic data coming in:

  • Jobless claims jumped to a 9-month high which forecasts rising unemployment.
  • Consumer spending is softening.
  • Disposable income is flattening.
  • New manufacturing orders are declining and inventories are rising.
  • Durable goods orders are falling.
  • Credit continues to shrink, both for consumers and businesses.
  • GDP was revised downward for Q2.
  • The Consumer Confidence Index took a big slide.
  • Commercial and industrial real estate is still declining.
  • Home sales continue to decline.
  • Some of the leading indicator indices are falling, such as the ECRI and the Consumer Metrics institute.

There are two more data points that really have the Fed concerned. One is that the Consumer Price Index is very low. While you would think that low rates of inflation are good, the Fed wants inflation.

The other thing that bothers the Fed is that money supply is declining and has been doing so since last December. They think that we may be heading for deflation.

What does all this mean? It means that everything the Fed and the federal government have done to revive the economy has failed. From massive fiscal stimulus (spending $787 billion on mostly wasteful projects), to the TARP bailouts of Big Money, to zero interest rate policy (“ZIRP”), to gimmicks such as Cash for [your industry here], they have failed to stimulate the economy.

With all the bad data coming in, it is no wonder that the Fed, as reported in the minutes of its June, 2010 meeting, was so pessimistic:

Participants generally anticipated that, in light of the severity of the economic downturn, it would take some time for the economy to converge fully to its longer-run path as characterized by sustainable rates of output growth, unemployment, and inflation consistent with participants’ interpretation of the Federal Reserve’s dual objectives; most expected the convergence process to take no more than five to six years.

They are saying that they think it could take 5 or 6 years from 2008 for things to turn around.

What they overlook is that it is the Fed’s manipulation of the money supply that is the cause of our boom-bust cycles: they are the problem, not the solution. And that is why their policies are failing.

Which gets us back to the inflation-deflation issue. It is an axiom of faith with the economists who control Fed and government policy that the economy needs a little bit of inflation to grow. They think that all the Fed has to do is step on the money pedal and the new money stimulates the economy, money supply grows evidencing healthy business lending, prices rise modestly, employment rises, and the economy grows.

The only problem with that idea is that it isn’t working.

Why have they failed?

It all has to do with the banks, mostly the regional and local banks that finance about one-half of our economy. These banks have two problems. First, as a result of the crash, their balance sheets are clogged up with (mostly) bad commercial real estate loans. Bad loans tie up a lot of capital that banks would otherwise lend out. Second, because of the economic decline, business customers aren’t borrowing. And it’s not just because banks have tightened lending standards; businesses see weak demand plus, with all the new laws passed, they are very uncertain about the future.

The Fed saw the plight of banks and they lowered the interest rate (the Fed Funds rate) to zero on money banks borrow from the Fed to make loans. They have also massively increased the pool of money available to banks to tap into (money base).

But, if banks aren’t lending and borrowers are reluctant to borrow, the new money never gets lent out, and the giant pool of new money just sits at the Fed as banks’ reserves.

Since the money is not being lent out, which is their main tool to increase money supply, money supply is now declining, and that is deflation. This is why the Fed is very concerned with a potential “deflationary spiral,” a phenomenon that occurred during the Great Depression.

What can the Fed do? They can’t lower the Federal Funds rate because it is already as low as it can go. And this hasn’t worked anyway.

This is what the big change in Fed policy was all about.

There was a huge internal fight at the Fed between the anti-deflationists and the anti-inflationists, and the anti-deflationists won. The Fed decided they would fight deflation through “quantitative easing” or “QE.”

With QE, another tool the Fed has to increase money supply, the Fed buys Treasury debt (bills, notes, and bonds) from its primary dealers and prints money to pay for it. This puts money directly into the economy.

It’s not as if this is something new. From last year through April of this year, the Fed bought $1.25 trillion of debt issued by Fannie Mae and Freddie Mac. They also bought about $700 billion of Treasury debt. This put $2 trillion of new money into the economy. This apparently wasn’t enough.

The second important thing they announced is that they will replace their Fannie/Freddie paper with Treasury debt. This seems harmless at first because the Fed is not increasing its total debt holdings—yet.

They announced this with a seemingly innocuous statement: that they would keep their current level of debt at about $2 trillion. In Fed-speak this means they are clearly worried about the sinking economy, and that they will print as much fiat money as they think is necessary to increase the money supply to induce inflation.

In economic terms, buying Treasury debt is called “monetizing” debt. In plain English it means that the government prints money to pay for its debts. This policy has been the downfall of many governments who destroy their currency through hyperinflation.

As soon as unemployment starts to go up again, and I believe it will, the politicians will be all over the Fed to “do something.” That something will be massive QE. I am quite sure that the Fed has not figured out how much QE they will need and that they are unsure of its impact on the economy.

I have a pretty good idea of where it will all end up. Since they are not dealing with the underlying problems, this papering over of the problems will lead to inflation and economic stagnation, a phenomenon we saw in the 1970s called “stagflation.”


52 comments to The Road To Stagflation

  • Brendan


    With regards to my comment above on the current state in the evolution of the market, I said, ‘ this could be we’ll ever see or could be a dead end’. What I meant to say was, ‘this could be best we’ll ever see or it could be supplanted by something very different’.


  • Brendan


    Thanks for your brief reply. There is plenty to work with.

    Biological: I suppose I was looking at things too narrowly, considering random genetic mutations as not infuenced by human thought or choices – biology at it’s most basic.
    Man made extinctions are not a ‘natural’ evolutionary event in themseleves but, you are correct, that the absence of a specie in the ecosystem could lead other evolutionary events.

    Human thoughts and choices are a product of evolution; I agree but only to a point. We all have a brain with some fundamental processes that a universal with the human race but everyone thinks different thoughts and comes to profoundly different conclusions. If evolution was so all powerful and deterministic we wouldn’t have be having this discussion. We all make choices, radically different choices and have very different beliefs. One could say all these different choices are the product of evolution but that doesn’t provide the means for convergence.

    I think I have a much better understanding of your main point: the current state of politics and economics as a combined system and it is this particular way because this combination is the ‘best’ combination to date. This is because this combination has outlasted other combinations. Correct? This is reminiscent of your thoughts on the prevalance of central banks.

    As I pointed out, there is a huge variety of political economic situations in the world right now. Is one ahead and the rest are just catching up? Or are they all, in a sense, the ‘best’ for that place (and time) because that’s what they are right now. If this is the case, then can any one be judged superior? The political and economic situation certainly does ‘evolve’ but an individual can make concious choices and can effect change in the system, the choices are not infinite but they are broad. This evolutionary change of ideas through concious thought is not the same as a species developing legs or binocular vision. If there is a violent revolutionary coup in a country with a democracy and a market economy and is supplanted by a communist dictatorship; is that an example of evolving ideas and the political/economic situation or is just brute thuggishness? Is that an example of the best ideas outlasting the weaker ones?

    The market does not exist in a political vacuum, granted. Are politics essential to the functioning (or existence) of the market? Are politics essential to modern market economy? Is the market more efficient and properous because of the political enviroment that surrounds it? Can the market ‘buffalo’ exist without the political ‘cheetah’? Are they symbiotic? The market has never existed in political vacuum – we don’t know what were missing but we can speculate.

    Cheetah’s and buffaloes do exist in the same enviroment and are subject to the same pressures. Cheetahs and buffalo only know one thing – survival, physical survival. With respect to politics and econmics we are talking about the survival of ideas. You are correct that both politics and the markets exist in the same enviroment but it’s a self made enviroment of ideas, a feed back loop to some degree, and people can choose how they respond to the enviroment. Buffalos and Cheetahs don’t choose, they respond to survive. Peoples’ choices could look like just about anything and can change anytime. I don’t think it’s as deterministic as you think.

    “Politics and the market are in essence fundamentally different so their respective evolutions are distinct.” I don’t think I was clear as I could be with this. Markets are influenced by politics but the characteristics of the thier evolution are distinct from politics. Markets respond to politics and laws all the time (rent seeking, etc) but the evolution within the market is still based on voluntary agreement. Politics is based on coersion. That is distinct.

    I have more questions on the ‘big picture’ direction of things but that’s enough for now.


  • Buck


    People often unknowingly and erroneously believe humankind is somehow separate from ‘nature’. In making this mistake, they ignore not only the fact that man was obviously conceived in, and thus a creature of, nature, but also that he in fact never has and never will escape the protection of her womb. In a similar vein, many are want to argue that something called ‘free markets’ can and should exist as a phenomenon wholly separate from government. As if markets as we know them could just spontaneously exist prior to or in absence of the establishment of something called the Social Contract. As if!!!

    There is nothing whatsoever that man can do that is ‘artificial’ or ‘unnatural’. No matter how seemingly ‘exotic’ his actions or ideas, they are but a product of the behavior and imagination of a being who is in turn a creature of ‘nature’. For better or for worse, let us not ever forget that! In turn, mankind’s myriad social constructs and institutions can never be considered ‘unnatural’. It therefore should never be taken seriously, that a central bank and/or financial regulations be framed as a ‘affront’ to some nebulous concept labeled ‘free markets’, which often enjoy the unspoken presumption of being the ‘natural’ state of affairs.

    I see this is where I erred in my initial question: Why are the markets ‘not free’? Its obvious why they are not ‘free’. What I really meant to ask was: what is unnatural about this? And what is the problem? After some thought, and reviewing the terms, I realize I misused the term ‘free market’, because in my mind, I was looking at it from the standpoint that every manifestation we can witness is ‘freely evolved’. However, in the economic parlance, the term ‘free market’ has already been reserved and imbued with certain connotations (i.e. free = natural).

    Again, to answer some qustions:

    “As a citizen you aren’t free to pick and choose what laws apply to you.” Citizens (human capital) and/or financial capital are, for the most part, free to flee ‘oppressive’ regimes which constitute ‘selective pressures’ upon political systems. Governments adapt accordingly.

    “The market tends to evolve through self interested but voluntary actions of its participants. Politics is about power over others.” It is not a power without limit. See above. Governments that overextend the balance of symbiosis are prone to collapse. See history.

    “The market is bent and mutated around various points of political inflection.” And vice versa. A more common refrain is free market actors bending and mutating politics to their end.

    “I see very little advocacy for the idealized construct of free markets.” This is at the core of lead proponents of Austrian thought. See M. Rothbard.

    “Again, I agree with your last comments on faulty models. But I’m not sure what alternative you are suggesting.” At the moment I am only trying to illustrate that we must strip current models of their heavy reliance on faulty, oft unstated, presumptions.

    “Man made extinctions are not a ‘natural’ evolutionary event in themselves but…” I beg to differ. See ‘man is a creature of nature’.

    “Human thoughts and choices are a product of evolution; I agree but only to a point.” If the thoughts and choices are ‘human’, then they are a product of evolution, unless man is a product of something else.

    “Everyone thinks different thoughts and comes to profoundly different conclusions. If evolution was so all powerful and deterministic we wouldn’t have be having this discussion. One could say all these different choices are the product of evolution but that doesn’t provide the means for convergence.” Evolution is not deterministic. Different thoughts and ideas are absolutely necessary for an evolutionary process to happen. They are the metaphorical ‘random mutations’ that either confer selective advantage or disadvantage. Strong ideas survive and weak ones perish. What is ‘convergence’?

    “The current state of politics and economics as a combined system is this particular way because this combination is the ‘best’ combination to date.” I would be very hesitant to employ the phrase ‘the best’. It is one of many combinations that have survived countless other experiments, which have died out, never to return.

    “There is a huge variety of political economic situations in the world right now. Is one ahead and the rest are just catching up?” It would be folly to argue this, but this is exactly what many ‘schools of thought’ are want to do.

    “If this is the case, then can any one be judged superior?” Again, I’d be hard pressed to declare something as complex as a symbiotic political/economic system ‘superior’. HOWEVER, to the extent that we are talking about a specific technology therein (say, central banking, or cell phones), that ends up being voluntarily adopted, cross-culturally, worldwide, I think a very strong case can be made that said tech is indeed ‘superior’ relative to others existing, and is universally recognized as such. This is how you can have extremely conservative, old world cultures adopting things like cell phones, computers, etc. The pragmatic benefits of certain physical technologies are just too overwhelming to ignore.

    “This evolutionary change of ideas through conscious thought is not the same as a species developing legs or binocular vision.” Sure it is. Random ideas either survive or are discarded. Some of the retained ideas, like telecommunication, become so widespread they become about as ubiquitous among nations as binocular vision becomes amongst species.

    “If there is a violent revolutionary coup is that an example of evolving ideas and the political/economic situation or is just brute thuggishness? I’d say its both at the same time. There is no need to separate them.

    “Is that an example of the best ideas outlasting the weaker ones?” The issues are complex and only history would be able to judge. The trend does not necessarily move in a fine linear path, but the general upward trend holds. See market charts.

    “Are politics essential to the functioning (or existence) of the market?” I will go out on a limb here and say Absolutely. I would use the word ‘government’ in place of ‘politics’ however.

    “Is the market more efficient and properous because of the political enviroment that surrounds it?” More, or less, efficient and prosperous, yes.

    “Are they symbiotic?” Yes, as distinct from the parasite vs. host metaphor which is commonly invoked.

    “With respect to politics and econmics we are talking about the survival of ideas.” Precisely. See ‘memetics’.

    “I don’t think it’s as deterministic as you think.” I do not view evolution as deterministic whatsoever. However, the general meta-trend is towards greater systems of greater complexity.

    Appreciate the conversation,


  • Brendan


    Once again I agree, humankind is part of nature. Our bodies and brains have evolved in nature and we are still immersed in nature. Everything physical in the world is part of nature and we cannot isolate ourselves from it. However, thoughts and ideas are ‘man-made’. You may argue that because man is part of nature his/her ideas must be as well but ideas are not part of nature. Nature is the physical world. Ideas are conceived inside our heads from the organ called the brain but do not have physical properties like a leaf or lake or a mountain or algae or elephants. Ideas can be manifested physically, these physical embodiments are subject the laws of the physical world and are part of nature in the grandest sense of the world. My thoughts are represented on this screen in writing but the little black characters are not actually ‘thoughts’.

    I agree that political and market institutions in the world ‘evolve’ but it’s only an analogy. They do not evolve in the same sense as the human body or dinosaurs or trees. Our manmade institutions evolve because we can make them evolve. It may be a random or coincidental process but it is initiated by people. It may not be designed and deliberate but it is human action that makes it happen. The cheetahs and buffalos can’t wilfully evolve thier enviroment. We can. We are part of nature but our thoughts and ideas can transcend ‘natural’ processes. For better or worse, we can (and do) change our world. This sets humanity apart from the rest of nature. The realm of ideas is not subject to the same rules or limitations of the natural world. Therefore the realm of ideas is not subject the same rules and limitations of evolution, a natural world process.

    I’m not convinced markets can exist without political government. I concede coercion by a privledged few might be the glue to
    hold it all together. But there is plenty of room for debate on the amount of government deemed necessary. An extreme example would be courts and police only and 99.9% of all property is private property including all roads and oceans? Possible? Desirable? Most would say neither but it’s never been tried not even on a limited scale. If I understand you, you would say it’s never happened because it’s a ‘dead end’. Maybe conditions haven’t been quite right. The above unlikely scenario is unlikely but not impossible. It doesn’t violate any natural laws – it’s physically possible. If people chose to orgainize themselves in such a fashion would it be wrong or immoral? We have private property now, why not nearly all private property? Many parts of the world have tried it the other way, 100% collective ownership. It didn’t (and still doesn’t) work out all that well – poverty and human & enviromental degragation are the primary results. Proven dead end.

    You scoff, ‘as if’ but why couldn’t markets exist without ‘The’ Social Contract? Maybe people do have to give up some of their sovereignty in trade for social order but they don’t necessarily have to give it up to the State (again, this could be a matter of degree). People living in a condominium give up some of their freedom (sovereignty) in how they use thier property. It is a legal contract enforced by the State
    but people choose to obligate themselves to the rule of the condo community. They can sell and leave this social contract at any time. Same applies for many a public and private areas of peoples lives – they choose to behave themselves and give up some of thier impulses and freedoms to maintain social order – no government or government coersion required. Government laws may be respond to these social conventions or mirror them but most people follow them anyway without the threat of force itimidating them into compliance. Do you refrain from
     stealing from a store shelf because you might go to jail? Do you refrain from shouting obscenties and threatenting people as you walk down the street because you might be charged with disturbing the peace? Do you honor your contracts only because you might end up being sued in court? Is the threat of the State the reason you behave and honor your ‘social contract’ with your fellow citizens? Maybe I’m wrong but most people behave themselves (in most places) most of the time without ‘The’ Social Contract.

    Maybe a Social Contract with a government is necessary on a very basic level but how long and extensive is the Contract? How onerous are the terms? I only know of Social Contracts where all citizens are bound by the same terms – again, you can’t pick and choose what laws you want to obey. The obligation to the State is to obey ALL the laws. To say if you don’t like it, you can move, side-steps the whole issue. Yes, voting with your feet is one solution but why should you feel obligated to obey the State? What if you don’t like the particular terms of The Contract? Why can’t an individual negotiate separate terms with the State? A contract takes two (or more) consenting parties entering into an agreement. It is a voluntary arrangement. The State only offers one deal to all – take it or take it (or don’t and go to jail). North Korea and Cuba have been offering the same shitty deal to thier citizens for 50 years. The citizens cannot leave or alter the terms. Too bad for them, just stuck on a particular point in ‘evolution’?

    If you finally have had enough of a particular country’s Social Contract and decide to pack your bags, what are your choices? If you find the US ‘oppressive’ what are your options right now? Singapore (no chewing gum)?  Switzerland? Time travel back to pre-handover Hong Kong? The ‘pack your bags’ option is a false choice if you’re even mildly libertarian.

    The problem with the people choosing more State at the expense of less freedom is they choose for all, including the ones that disagree. Even if it’s a minority of 1% who resent the loss of a particular freedom, is it a just imposition by the majority through the means of the State?

    I feel like I’m falling behind; I still want to address more points in your previous email. Enough for today though.