Tuesday, October 5, 2010

I'll Take Stagflation for $100, er $150, er $200, er . . .

With the Federal Reserve maintaining its zero interest rate policy (ZIRP) and promising more quantitative easing (QE), I'm beginning to fear that we will see stagflation in the United States over the next several years.  Here's why.

The Fed has proven that the combination of ZIRP and QE can't spur borrowing by an already overleveraged consumer.  The housing market is dead, and the foreclosure mess is likely keep it dead for awhile longer.  And it's not like there are any jobs out there, and there's a downward pressure on wages, so we won't be seeing price inflation due to wage inflation.

This puts the Fed into quite a pinch.  It can't rely on the consumer increasing demand for either goods or debt, so there's no inflation to be found there.  Non-financial businesses aren't borrowing, either, certainly not at their traditional levels (yes, there was an increase in borrowing by the non-financial business sector in the last two quarters, but the increase was paltry and nowhere near normal).  So, no inflation there, either.  And financial businesses have been leading the way in deleveraging.

The banks are in their own pickle.  They need to rollover debt by getting new borrowing ASAP.  In spite of the continuous backdoor bailouts (e.g., getting paid 3% to hole onto reserves) and "record" profits, some of them have already frozen hiring and are signalling that there may be layoffs.

If only there were a way for the banks to help themselves and the Fed.  But wait, there is! Debt-financed speculation in the commodity markets would be a perfect solution!  The banks get to extend new debt to financial speculators, who use the leverage to drive up the prices of consumer staples like sugar, wheat and corn, and industrial metals like copper, gold and aluminum.  Voila!  You have rolled over debt, created inflation for consumers and industry, and you get to make a tidy profit, all in one fell swoop.

Increased speculation in commodities has already driven their prices up by a multiple of 1.5-2x compared to the drop in the value of the dollar, while stock prices have pretty much gone up by as much as the dollar has gone down.

The only question is whether this is a temporary aberration or the new normal.  Given the greed of the FIRE sector, I'm betting that this is the new normal, that the financial speculators are going to ravage our economy just as they did in the 1970s.  Things will play out differently, however, in part because we no longer have a vibrant manufacturing sector, and in part because various laws and regulations shape the decisionmaking in a different way than it was done in the 70s.  I need to put some more thought into how things play out.