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Tuesday, June 20, 2006 11:27 AM

Flationed Out

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I have been pondering the word "stagflation". Judging from the stock boards I post on, a vast majority seems to think we are in it or headed for it. What exactly does stagflation mean anyway?

Let's take a look at two definitions and a comment from dictionary.com.

  1. "Sluggish economic growth coupled with a high rate of inflation and unemployment."
  2. "A condition of slow economic growth and relatively high unemployment - a time of stagnation - accompanied by a rise in prices, or inflation."
  3. "Investopedia Commentary: Stagflation occurs when the economy isn't growing but prices are - not a good situation for a country to be in. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fueling sharp inflation in developed countries. For these countries, including the U.S., the effects of inflation were considerably made worse because of this stagnation."
From above context, stagflation seems to be based on rising prices (instead of an expansion of credit), and furthermore the term seems to imply that rising prices are bad only in context of the "stag".

An Austrian View of "Flation"

Inflation - Expansion of money and credit
Deflation - Contraction of money and credit
Disinflation - Expansion of money and credit but at a declining pace
Hyperinflation - Rapid rise in inflation accompanied by a complete loss of confidence in currency

In Austrian terms I find little use for such a term.
Where exactly does it fit in?

Several days ago I sent an article that called for "stagflation" to a good friend of mine who posts under the name "Trotsky" on Kitco. We had not discussed that term before but knowing his Austrian leanings, his answer did not surprise me at all. It is as follows. Note: he does not capitalize his sentences and this is a verbatim quote.
what immediately comes to mind is that the term was coined with a Keynesian mindset - as if it were a new phenomenon that sort of 'just happens' without a sensible explanation at hand. at the time of the 1970's K-summer economists had been conditioned to associate economic downturns with deflation - the inflationary recession of the early 1920's was long forgotten. when suddenly recession coincided with the effects of the concurrent inflationary monetary policy becoming highly visible something happened that wasn't supposed to happen. so they thought it required a new term - 'stagflation' equaling recession cum inflation, the supposedly 'unnatural' state of affairs. obviously once you define inflation correctly (expansion of the fiat money supply) such a term makes no sense. especially considering that the Keynesian (as well as monetarist i might add) recipe for 'combating economic downturns' consists of deficit spending cum monetization, i.e. printing lots of money, as a matter of course!. perversely, application of this recipe leads only to bigger failures (proven by EVERY major application of it, including imo the most recent one, which only created yet another surge in malinvestment, namely the housing bubble).

the only reason why at times the inflation seemingly 'works' and at other times doesn't, is that the initial conditions, as defined by the K-seasons vary. imo there are two aspects that play a role - the state of the pool of real funding (if it is shrinking, no amount of monetary pumping can even create the illusion of a new boom - that's Japan from '89 onward) and the size of the private sector debt extant at the conclusion of the last boom.

note that the term 'boom' is actually a negative term, or should be. during the boom, which is itself a result of lax monetary policy , capital is malinvested and the economy's production structure damaged/distorted. the bust is the economy's attempt at RECTIFYING the mistakes of the boom by liquidating malinvested capital and redirecting those resources to their optimal use (usually that entails the realization that assumptions about future demand were simply wrong, as they are based on the illusion created by the credit expansion).

anyway, the rarer condition of deflation as we understand it in the context of the fiat system is simply a credit contraction so massive that it overwhelms the countervailing attempts of the CB to inflate. one must not forget the credit was largely created from thin air - in a deflation it simply goes back there.

in any event, ultimately 'stagflation' does not describe anything really...even though we know what it is meant to describe. simply put, it's the type of bust where the usual inflationary policy is noticed by everybody because prices and wages start to rise everywhere (because the debtberg is still able to expand further).
An Austrian Debate

Actually I think the origin is probably far simpler. Someone wanted to talk about "stagnation" and accidentally said "stagflation" or perhaps said "stagflation" purposely trying to be cute. In any case, the word stuck but as Trotsky pointed out, the word makes no real sense from an Austrian point of view, yet it is only from the Austrian point of view that I wish to debate anyone on inflation.

That last sentence is key and it has caused a lot of frustration recently. In addition, I keep responding to the same questions over and over again from emails and replies to blogs, many from people that do not know (or refuse to accept) what inflation is. In other cases people are just now finding my blog and just happen to be asking a question I have addressed elsewhere a dozen times. Here are some of the typical questions:

"Mish doesn't the rise in the price of oil prove you are wrong?"
"Mish you still haven't explained how we can have a falling US$ and deflation"
"Mish the US is not Japan"
"Mish how is your favorable view of gold consistent with deflation"?
"Mish isn't it about time for you to throw in the towel?"
"Mish inflation is our past present and future"
and so on and so forth with no one adding anything to the debate.

One of the problems I face is that people want to be a part of the debate, even though they refuse to accept the terms of the debate. Austrians in general would accept the "Flation" definitions above (or something reasonably close) others do not. Unless parties agree on definitions, however, there can be no meaningful debate. People keep telling me I am wrong when they do not agree to the terms of the debate.

Following are three people whom I believe do agree with those "Flation" terms as defined above.
  1. Marc Faber
  2. Steve Saville
  3. Robert Blumen
Note that I said they agree with those definitions. All of them disagree with my position. Taking the other side of a debate with Faber is dangerous, but we agree on far more things than we disagree about. Faber also admits deflation is possible (even if unlikely). Most inflationists will not even grant that.

Anyway I want to thank Robert Blumen for his piece MUST BERNANKE CHOOSE DEFLATION? simply because he not only agrees with the terms of debate but he also made a serious effort to understand what I am saying. Hardly anyone else has bothered to try. If you are new to this discussion not only do I ask you to read Blumen's article but to click on all the embedded links in his post and read those too. Unless you do that, you can not understand what I am saying or why.

Blumen disagrees with my position but there is nothing wrong with that. Should unanimous opinion ever form on something economically related I confidently predict we would all be wrong and probably sooner rather than later.

Questions Answered

I will reply later to his rebuttal, but for now I want to address some of those questions above.

Q: "Mish doesn't the dramatic rise in the price of oil prove you are wrong?"
A: No, the price of oil could be rising for many reasons and perhaps much of that price is related to peak oil, dwindling supplies, and geopolitical concerns rather than directly related to monetary expansion. One can not know for sure what causes any price increase and that is a key reason why attempting to define inflation by looking at prices is dead wrong. It simply can not be done. At any rate, prices rise and fall for many reasons so one simply can not look at prices to decide if there is inflation. My views on deflation are forward looking and in response to an expected credit collapse in housing. For now I freely admit there is inflation as credit and money supply are still expanding, but note that it is possible for oil prices to keep rising, perhaps dramatically, even during deflation on account of peak oil.

Q: "Mish you still haven't explained how we can have a falling US$ and deflation"
A: I have not explained how because a falling dollar is not part of the equation. Inflation is an expansion on money and credit. Rest assured there was inflation when the US$ index hit an all time of 120. Rest assured the US dollar can sink even in a contraction of money and credit. I am not saying the dollar will fall I am saying it could fall. More than likely the dollar will at hold its own. If it falls I have many reasons why it is unlikely to crash (any time soon). For starters it has already collapsed in just a few short years. Everyone thought the Euro was trash a few short years ago, now everyone seems to be a euro bull. That said, I do think the dollar could crash much later on down the road after debt is wiped clean. A dollar crash will probably occur after everyone gives up on it. In the meantime I expect savings will rise and in a worldwide economic debacle there will be safety in US treasuries. Note too that many other fiat currencies look just as bad from where we are now. Ideas about hyperinflation with a housing bust and loss of jobs and a worldwide economic bust seem rather silly to me. You are free to disagree of course. For a more complete discussion on the US dollar please consider Is the US dollar toast?

Q: "Mish the US is not Japan and besides Japan really did not have deflation anyway"
A: I never said the U.S. was Japan. And yes, there are big differences. In fact, I have outlined many of those differences between the Japan and the U.S. Some factors, such as demographics, favor the U.S. for avoiding deflation versus Japan. Other factors, most notably consumer debt, are a bigger problem here. Even though we are not Japan, I expect the deflation experience here will be quite similar. Part of that was addressed in Inflation: What the Heck Is It? And as for those who proclaim "Japan is a nation of savers" while the U.S. is not: That fact will actually make the snapback to the mean all the more vicious and the deflation cycle that much worse. The U.S. was once a nation of savers, and will likely be again.

Q: "Mish how is your favorable view of gold consistent with deflation"?
A: This question is really simple. If one view gold as money it will be hoarded in deflationary times. Housing and equities will both plunge relative to gold even if gold just manages to stay flat against the US dollar value. That is the key idea. I believe that gold will more than hold its own but there are no guarantees.

Q: "Mish isn't it about time for you to throw in the deflation towel?"
A: On the verge of victory? No chance. One of the conditions required for my deflation scenario to unfold was a housing bust, a loss of jobs and income, and rising bankruptcies. Housing is just starting to bust and eventually that will affect jobs and income. The scenario is just now finally starting to play out.

Q: "Mish inflation is our past present and future"
A: Spoken like a person that has not studied history. Yes 3/4th of the time those believing in inflation will be correct. K-Cycles are long cycles, lasting up to 80 years in length. By the time a deflationary winter is upon us, most people have known nothing but inflation all their lives. That is why no one sees deflation as a possibility. Memories of 1930 are long, long gone. Note too that length makes timing it a problem. In a 60-80 year cycle pinpointing the start is not that easy to do. If housing is the "bubble of last resort" as I believe it to be, we can be in a world of hurt over the next seven years or more.

Those questions and similar ones keep coming up again and again and again.
I thought I would address them all in one place and of course everyone is free to disagree with my conclusions. That said, one can not have a rational discussion unless one agrees to definitions and I choose to accept Austrian monetary definitions. In that regard, stagflation is simply not the answer to the "Flation" debate. It has too much to do with "stag" and too little to do with “flation” from my point of view.

Mish Addendum:
I started writing the above last Thursday. No sooner do I finish writing the article, (but right before posting it) a good friend of mine going by the name "Chispas" on Silicon Investor sent me a link to a Forbes article entitled It's Not Stagflation...

What are they doing reading my mind? Or can it be vice versa? Regardless, let's briefly consider If It's Not Stagflation...
It's not stagflation, but no one can seem to agree on the new term for an economy in which growth is slowing while inflation is rising, such as it is today.

Could it be "fearflation," a term that means it's all just fear rather than actual inflation that's driving the current economy? Maybe it's "bubblenomics," as the U.S. seems to be stuck in a bubble of higher prices, growing unemployment, high housing prices and a falling dollar. Then again, it could be "transflation," the cycle of high gas prices leading to higher inflation. Or how about "moderflation," a slowing down accompanied by inflation?

Of course if Bernanke is to be believed, it's not inflation we need to fear but expectations of inflation. So maybe we should describe the current economy as "Fedflation."
Eleven terms were submitted to Forbes to describe the current economy. Click on the above link to see them. YES I agree with Forbes that it's NOT stagflation (at least someone agrees with me) but NO we do not need another term for it. With that thought in mind I changed the title of this article from "Stagflation Anyone?" to the above title because quite frankly I am "Flationed Out".

Mike Shedlock / Mish

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