Stagflation

(Commentary by Jack Wakeland)

The Fed's "QE2" is driving gold and commodities toward historic highs. A full 70s flashback—stagflation—is under way

We're seeing economic stagnation, 1.5–2% growth in the second quarter of this year and predicted as far forward as the eye can see. And now we're seeing rising prices in all asset classes. A general rise in prices and wages cannot be far behind. All this is being driven by the Fed's desire for a second round of "quantitative easing," "QE2."

In the first round of "quantitative easing," the Fed increased its "balance sheet" from $0.9 trillion to $2.3 trillion during the crisis (September 2008-March 2010); the majority of this was done by printing paper money to buy mortgage-backed securities. This was viewed as a short term expansion of the money supply intended to take the edge off the collapse in private credit, the credit and liquidity produced by the banking system. (Some estimates have put the third quarter 2008 pull-back in privately produced credit at one-third of all credit, or $15 trillion, globally.)

After the short-term crisis was over, the Fed noticed that its balance sheet had naturally shrunk to $2.0 trillion as the private mortgage-backed securities, Treasury bonds, and federal government agency debt it held reached maturity. Afraid that the long term effect of the shrinking balance sheet would end up producing a recession (it would have, and it will), the Fed vowed in June to buy US Treasuries in sufficient quantity to maintain a $2.0 trillion balance sheet from now on.

Projections of 1.5–2% growth that stretched out to the fourth quarter of 2011 implied that the unemployment rate (U1) would probably remain above 9% for 18 more months. Worse, with such weak growth, any significant economic shock could trip the US system into a second recession. So in mid-September, the Fed's Open Market Committee announced plans to further expand its purchase of US treasuries and begin expanding its balance sheet again. The FOMC said that at 1.1%, the rate of inflation was "too low." Thus, with QE2, the goal of the FOMC is to produce a higher rate of inflation.

This sets back Fed policy to the 1970s, when the independent agency decided that its primary mission in life was to restore "full employment" by inflating the currency, a result they expected would occur as a result of Keynesian economic theories. In a reaction against this economic policy of never-ending stagflation, the American political culture turned to the right. "Demand side" Keynesian economists were swept from the stage and replaced with monetarists and supply-siders, a (relatively) stable-currency policy was instituted by Fed Chairman Paul Volker, and during Ronald Reagan's tenure top income tax rates were dropped from 70% to 28% and the top tax rate on capital gains was dropped from 35% to 14%.

This much improved cultural-political regime was in place through the 1990s. In the past ten years, however, the culture has back-slid. All economists—advocates of free markets and advocates of activist government intervention alike—have recently been looking around at their peers and realizing that nearly all of them did not permanently change their root economic philosophy as a result of all those years of experience. They began to comment, as if it were a joke, that they have come to realize that "we're all Keynesians now."

A handful of economists out there have not joined the new crop of understated Keynesians. But it appears that none of them made it to the Fed. Only Keynesians man the FOMC.

The Fed's plan, over the past two months, to launch QE2 has begun driving gold and commodities towards their historic all-time highs. The editors of Investor's Business Daily sum up the situation:

The good news is that even as the recovery has foundered, gold and oil have made impressive gains over the last year. The bad news is that when these two go up in tandem, it can mean big trouble—as it did in the stagflationary 1970s.

During that troubled decade, huge amounts of money moved from productive assets into inflationary hedges such as gold and oil to protect investors' capital. Central banks printed money like mad. The result was raging inflation, shortages, and lower standards of living. Not to mention disco....

Now...the Fed wants another round of quantitative easing—QE2—to print another $1 trillion and buy even more bonds.

The US does not live in isolation, and the rest of the world is reacting. Central banks in some otherwise reputable countries, like Japan, are following the Fed's lead, and the central banks in the world's disreputable countries, like China, have always devalued their currencies as a way to give their politically connected businesses a competitive advantage in the export trade.

Before adjourning for the midterm election, Congress has reacted to China's continuing cheap yuan policy by raising tariffs on Chinese goods. The vote in the House was bipartisan. A majority of the Republicans in the body voted for higher tariffs. The populist element in the Tea Party movement makes its otherwise free-market candidates vulnerable to protectionism's false appeal to national economic "self-interest."

While I would not join Robert Reich in predicting a second catastrophic worldwide trade war with results similar to Smoot-Hawley, we may be in for a few years of protectionist rhetoric and modest protectionist measures—measures that will suppress the growth of what would have otherwise been the fastest growing sector of the US economy: import/export.

Just like in the period 1976–1983, persistent unemployment is stoking protectionist measures which serve only to make things worse.

And that makes our 70s flashback to stagflation complete.—Jack Wakeland

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