THE BLOG
03/28/2008 02:48 am ET | Updated May 25, 2011

Is It Deja Vu All Over Again?

There has been much talk in the papers, of late, that "Stagflation" may be rearing its ugly head in the U.S. economy. For those of you too young to remember, "stagflation" is a particularly nasty economic phenomenon where both recession and inflation occur simultaneously, a phenomenon we have not seen in the U.S since the 1970s.

As the Wall Street Journal's Greg Ip recently pointed out, "stagflation" is a term coined by British economist/policy-maker who, in 1965, noted that Britain's economy suffered from both stagnation and inflation, a condition he termed "stagflation."

"Stagflation" is highly unusual. That's because, historically, a recession (or economic stagnation) weakens consumer demand for goods and services, bringing prices (or inflationary pressures) down. Hence, a recession is rarely accompanied by inflation.

That was the huge conundrum for, not only the British in 1960s, but Americans in the 1970s, who saw their economies suffer multiple recessions even as inflation rose unexpectedly. Remember the soaring cost of oil, gasoline, food 1971 to 1982? Remember the gas lines in 1979?

My first car loan in 1981, for a 4-door tan, 1979 Chevy Nova (yes, it was an incredible chick magnet!) was 20 and ½ percent. By then, inflation had jumped to 13%, unemployment to 9%, as we suffered through the worst recession since the 1930s and the worst inflation in the history of the country.

While it may only be a semantic argument, because there are many similarities to the 1970s when it comes to the economy, I am going to dub the current economic situation "inCESSION," not "stagflation."

That is a condition where we have the cost of goods and services going up, but recession is the bigger problem of the two, unlike the 1970s, where inflation was the more intractable issue.

The real estate recession and the ensuing credit crisis I have been writing about are highly contractionary events. I believe we are already in a recession and it's likely to get noticeably worse before it gets better. I would also suggest that the rest of the world will weaken with us and this myth of "de-coupling," where the world economy grows while we contract, is nonsense. We have had a nearly unprecedented synchronized, worldwide economic expansion from 2002-2007. There is no way the rest of the world doesn't weaken if we stop growing. With America accounting for 1/3 of global GDP, places like Europe (already weakening,) China and India simply cannot grow without our engine firing on all cylinders.

The "de-coupling" argument, by the way, is being made by brokers who want to keep you invested in emerging market mutual funds, where American investors have been pouring tens of billions of dollars over the last 18 months.

As soon as investors realize the rest of the world is in an equally precarious situation, they will sell their overseas stock market holdings and kill the remaining goose that is giving Wall Street its last golden eggs.

With respect to inflation and/or "stagflation," it is true that commodity prices are skyrocketing ... oil at $100 a barrel, gold at $940 an ounce, platinum over $2,000 an ounce (some women I know are already contemplating hocking their platinum wedding rings to cash in! My wife thought about that at $1,000 an ounce, but that's a story for another day!)

Meantime, the cost of wheat, corn, soybeans and other agricultural products are at prices not seen in about 30 years.

But those prices are not rising because domestic demand for gods and services is red hot ... the typical cause for inflation ... they are rising because investors have lost confidence in the U.S. economy and in the U.S. financial system, which has been plagued by extremely heavy losses on a variety of bad investments, from sub-prime real estate loans to risky leveraged buyout loans.

Hundreds of billions of dollars have been written off by big banks and other financial institutions, weakening our financial system and setting the stage for a protracted economic decline in the U.S. Investors, afraid to hold paper assets, are buying hard assets, like commodities, as a safe haven against the destruction of paper wealth and the devaluation of paper money, particularly our own.

The dollar has plunged as a consequence, putting upward pressure on all types of commodities, particularly oil, which is priced in U.S. currency terms. So, as the dollar declines in value, it costs more to buy a barrel of oil, or an ounce of gold or platinum.

This is not the type of inflation that is usually the result of an overheating economy. With the U.S. economy slowing at a rapid pace (pardon the oxymoron), demand is falling for everything from homes, to home furnishings to vacation houses and consumer goods.

Indeed, if we look ahead at the financial landscape, I believe that we face many more financial shocks in coming months, from the municipal bond market to the commercial real estate market and on to even more arcane corners of the financial markets, all of which will weaken the economy further.

But as a consequence of these competing economic forces, our Federal Reserve, and other central banks around the world, finds themselves in a box.

Because rising commodity prices have long been a leading indicator of inflation, these central banks may not cut interest rates quickly or deeply enough to keep the recession from getting worse.

Conversely, lower rates have continued to weaken the dollar, making commodity prices rise even faster. It is new conundrum for the Fed, and other policy-makers. They can't fight recession and inflation simultaneously. A recession requires lower interest rates. Inflation requires higher rates to cool off rising prices.

As I said before, this will be an "inCESSION," not "stagflation." The recession will be worse than inflation. The problem for policy-makers is that there is no easy solution to fixing either, which means we may suffer through this experience much longer than usual as the Fed fights a two-front war that could take a very long time to win.