Stagflation Redux

It's like a bad '70s flashback. Oil at $100 per barrel, and now stagflation. The unhappy coincidence of sluggish growth and rising inflation, stagflation is economic poison. (Read my colleague Robert Samuelson's excellent primer on it) It is the opposite of the economic idyll of the last quarter century, an era of relatively low inflation and relatively rapid growth.

The stag? Gross domestic product rose at an annual rate of only 0.6 percent in the fourth quarter of 2007, and likely isn't doing much better today. The flation? The Consumer Price Index rose 4.3 percent between January 2007 to January 2008.

The numbers seem positively buoyant compared to our last serious bout of stagflation in the late 1970s, when inflation rates spiked to double-digit levels and mortgage rates were in the high teens. Compared to the mountain of economic woe in the late Carter years, the economic woes of the late Bush years are a mole hill. But that doesn't mean those fretting about stagflation are crying wolf. Here's why.

In his smart new entry in the behavioral economics genre, Predictably Irrational, Dan Ariely writes about the importance of context: People routinely make business decisions and judgments by comparing them to recent events rather than the distant past. Your relative happiness with your salary and bonus doesn't rest on comparing it with what you made 10 years ago; it rests on comparing it with what you made last year, and with what the people sitting next to you are making this year. Yes, consumers today aren't being ravaged by inflation, high interest rates, and slow growth as they were in the late 1970s. But that's of little solace. Consumers compare their purchasing power and job prospects today with their purchasing power and job prospects of a year ago, or a few months ago. And that's why the sudden decline in growth late last year and the persistent rise in prices are a slap in the face. This case of stagflation may be mild by historical standards. But since we haven't experienced it in decades, our coping mechanisms are weak. That's why consumer confidence has fallen of a cliff in the last several months.

There's another aspect of this context argument. Inflation is generally on the rise throughout the world, and the rate of inflation is higher in many parts of the world than it is in the U.S. But Americans may feel they're getting hurt more by the current outbreak of inflation than many of our trading partners. Inflation is being driven by rising energy and food prices. Commodities-wheat, gold, oil, you name it-are getting more expensive. Another way of thinking about it, however, is that the dollar is losing ground against wheat, gold, oil, and other commodities. As the U.S. has pursued fiscal and monetary policies that debase the currency, the dollar has weakened significantly against many of the world's currencies. Consequently, when a commodity that is priced on a global basis in dollars, like oil, goes ballistic, the chumps who have all their assets in dollars will get hurt disproportionately. Americans today pay about $100 for a barrel of oil. But if you're French, and you're buying oil with the Euro, which has increased by about 16 percent against the dollar in the past year, the blow has been substantially cushioned. What's more, many of the countries that have pegged their own currencies to the dollar, including China and the Persian Gulf states, either subsidize gas or use price controls. American consumers and businesses are, in some ways, uniquely exposed to the twin ravages of a weak dollar and expensive oil.

We also import much more oil today than we did in the 1970s. According to the Department of Energy, U.S. net daily imports have risen from 6.4 million in 1980 to 12.4 million in 2006. Meanwhile, annual U.S. production has fallen from 3.2 billion barrels in 1980 to 1.9 billion barrels in 2006. When the U.S. largely fed its own addiction, the high prices Americans paid at the pump were generally recycled into the domestic economy. Today, the payments are more likely to wind up in government coffers in Venezuela, the Persian Gulf, and Russia.

There's a final reason even a mild case of stagflation can prove fatal: leverage. Stagflation implies a rise in fixed costs and inputs (food, energy, the price of money itself) coupled with slowing growth in sales and revenues. This dynamic of a rising bottom line and a stagnant top line shrinks profit margins. If you have a lot of debt, and if a lot of that debt is floating-rate or short-term debt, that combination is horrible. If your entire business model consists of borrowing huge sums of floating-rate or short-term debt and using it to buy other assets or debt instruments that tend to decline in value when inflation rises and growth stalls, then it's a killer. Unfortunately, that's exactly what the financial services sector and the American homeowner have been doing for the last several years.