Stagflation Watch

Tim Duy is grim, over at Mark Thoma's Economist's View:

Economist's View: Fed Watch: Inching Closer to the Reality of Stagflation: It is increasingly obvious that the Fed is in a no-win situation. The best case scenario for the Fed is that nominal wage growth is kept in check by a deteriorating labor market. This will help contain inflation expectations and prevent a more serious 1970s type of environment. But overall, Jim Hamilton is correct; they are unable to both contain inflation and prevent a significant economic downturn:

In any case, the tightrope analogy seems a misleading way to frame the issue, in that it presupposes that there exists a choice for the fed funds rate that would somehow contain both the solvency and the inflation problems. In my opinion, there is no such ideal target rate, and the notion that we can address the difficulties with a sagely chosen combination of monetary and fiscal stimulus and regulatory workout is in my mind doing more harm than good. Better for everyone to admit up front just how bad the problem is, and acknowledge that there is no cheap way out.

The nuance I would add to Hamilton's position is... the additional problem of a fundamental imbalance between production and consumption in the US.... Global financial markets... increasingly find it difficult to sustain this imbalance. Brad Delong hit the nail on the head in 2004:

That's the thing about accounting identities like S - D - I = NX. Either you craft economic policies that make them hold at full employment, or the market takes care of making sure that they hold for you--but usually not at full employment. Stagnant or falling wages that boost corporate profits could boost savings S by boosting retained earnings. A Bush administration serious about cutting the deficit could provide financing for investment and keep interest rates from rising. Big booms abroad could raise U.S. exports and reduce investment as the Fed took steps to shrink investment to avoid inflationary overheating. Otherwise, it is indeed hard to argue with Barry just across the north wall of this office: the dollar falls; has the fall produced enough inflationary pressure to lead the Fed to raise interest rates and so reduce investment and the current account deficit? no? then repeat.

The Fed is currently in the "then repeat" stage, although driving down the Dollar appears to have accelerated the surge in commodity prices, while the near term impact on export growth will be hindered by the need for structural adjustment (if only we could export vacant houses). At this point, more policy thrown at impeding this adjustment will only yield more inflation....

The inflation, of course, serves a purpose -- it is a market response to excessive consumption. Policymakers who want to pretend that the fundamental economic problem is insufficient demand rather than excessive demand will find the market yields a solution -- higher inflation to depress consumption via declining real incomes and wealth. Not a pretty solution, but a solution. Perhaps we are well past any other solution.

Bottom Line: I stick with the 50bp call because it is the most rational of the Fed's likely options....

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Update: Greg Ip at the Wall Street Journal also covers the stagflation story this morning. This passage, which I agree is an accurate assessment of Fed policy, is both enlightening and scary:

Core inflation rose and fell with energy inflation between early 2006 and mid-2007, and the Fed thinks the same thing is probably happening now. If energy and food prices stop rising -- they don't have to actually fall -- both overall and core inflation should recede.

So far, they're still rising: wheat, oil and gold hit nominal records last week. But Fed officials don't think the latest jump can be justified by fundamental supply and demand. U.S. inventories of crude oil and gasoline are plentiful. Strong demand from China isn't new and should have been factored into prices long ago. A more likely explanation: investors, perhaps alarmed by the Fed's dovish stance, are pouring money into commodity funds and foreign currencies as a hedge against inflation.

Such fears can be self-fulfilling as higher food, energy and import costs work their way into consumer prices. But speculative price gains can't be sustained if the fundamentals don't support them. If the Fed and the futures markets are right, prices will be lower, not higher, a year from now.

The learning curve on Constitution Ave. is remarkably convoluted. The Fed wasn't willing to describe either the tech or the housing markets as a bubble since it is not their job to define fundamental values, but apparently is eager to define the "fundamental" value of commodities, and quick to dismiss current valuations as a bubble.

What is clear is that the Fed remains eager to dismiss any inconvenient information. And, remarkably, a basic lesson that should have sunk in over the past decade is that even if you believe an asset bubble exists, it can continue for much longer than "fundamentals" would justify. Moreover, this piece reads as if there is no fundamental reason for the Dollar to be falling; instead, we are witnessing a bubble in all other currencies. Yet if I pull any international finance book off my shelf, I am pretty sure I can find some reference that the "fundamental" value of a currency has something to do with interest rate differentials. Not to mention the yawning current account deficit.

I hope the Fed is correct, and I will be the first to admit error, but for now I am not willing to dismiss the signals commodity prices, or the Dollar, are sending.

Comments

[Neal]

The real problem that the Fed is struggling with is to keep the financial sector solvent.

Cutting interest rates and accepting worthless credit "innovations" as collateral are just some of the gyrations.

The dollar be damned. The ordinary guy be damned. The man in the tophat must be saved at any cost. After all, doesn't the future economy of the US rest with the fianancial institutions and the innovations that inflated the economy in this administration?

Can the Fed explain away hundreds or even a thousand or so failed financial institutions?

The Fed is buying time--a month or two at a time at a very high price.

[Donald A. Coffin]

Or, as Keynes once wrote (I don't vouch for the exact language), markets can be irrational for longer than you can remain solvent.

[G.]

The stagflation and mortgage crisis was created by an administration that supports corporatism and greedy investment companies looking for ways to cover there bad bets, assess more fees and commissions in the quest for huge annual bonus checks.

Think about it... all of America’s assets are on sale (mark down 33%) to the world. Hedge Funds, banks and investment banks receive free money and government bail outs after bidding up the stock market, oil, gold, lumber, building supplies, housing, the “euro” and commercial real estate etc. while leaving a disillusioned consumer up to there eyeballs in debit, without a house, car, access to home financing,college loans and line of credit.

What better way to finish off the consumer, American Economy and pad investment banks bottom line then to have traders intentionally “bid up commodity prices” such as wheat, oil, sugar, corn, beans, carrots, potatoes… maybe even Christmas Trees… and presents.

The words corporatism, price fixing, manipulation of stocks & commodity trades, pyramid scheme, scams, bogus tax laws & courts and conspiracy come to mind when I think of the Bush Administration legacy. They shifted the tax burden from business to the individual while violating America’s Constitution, Bill of Rights, rule of law and stacking the courts.

During Bush’s Presidency the American Economy was debased while our political system went from Democracy to Corporatism.

Nice job George!!!

[christofay]

Define rational.

Well, after waking up with the car in a ditch and a 1,000 mule team Borax headache, more tequila.

Which is the best remedy after learning that Ben Stein was the ghost writer for Greenspan's The Age of Flatulence.

[Ralph]

What are the underlying causes of the inflationary recession we appear to be entering? It is clearly attributable to commodity price rises of the past year especially the price of oil. Bernanke said as much during his recent appearance before the House Banking committee. The economic boom in China and India which shows few signs of moderating have fed into the oil boom. Another cause which few economists have recognized is the Federal mandated requirement that our gasoline must be supplemented by at least 10% ethanol primarily corn-based ethanol. This has caused a boom in farm prices and is largely responsible for the increase in food prices.

[anne]

http://www.nytimes.com/2008/03/04/opinion/04herbert.html

March 4, 2008

The $2 Trillion Nightmare
By BOB HERBERT

We've been hearing a lot about "Saturday Night Live" and the fun it has been having with the presidential race. But hardly a whisper has been heard about a Congressional hearing in Washington last week on a topic that could have been drawn, in all its tragic monstrosity, from the theater of the absurd.

The war in Iraq will ultimately cost U.S. taxpayers not hundreds of billions of dollars, but an astonishing $2 trillion, and perhaps more. There has been very little in the way of public conversation, even in the presidential campaigns, about the consequences of these costs, which are like a cancer inside the American economy.

On Thursday, the Joint Economic Committee, chaired by Senator Chuck Schumer, conducted a public examination of the costs of the war. The witnesses included the Nobel Prize-winning economist, Joseph Stiglitz (who believes the overall costs of the war — not just the cost to taxpayers — will reach $3 trillion), and Robert Hormats, vice chairman of Goldman Sachs International.

Both men talked about large opportunities lost because of the money poured into the war. "For a fraction of the cost of this war," said Mr. Stiglitz, "we could have put Social Security on a sound footing for the next half-century or more."

Mr. Hormats mentioned Social Security and Medicare, saying that both could have been put "on a more sustainable basis." And he cited the committee's own calculations from last fall that showed that the money spent on the war each day is enough to enroll an additional 58,000 children in Head Start for a year, or make a year of college affordable for 160,000 low-income students through Pell Grants, or pay the annual salaries of nearly 11,000 additional border patrol agents or 14,000 more police officers.

What we're getting instead is the stuff of nightmares. Mr. Stiglitz, a professor at Columbia, has been working with a colleague at Harvard, Linda Bilmes, to document, among other things, some of the less obvious costs of the war. These include the obligation to provide health care and disability benefits for returning veterans. Those costs will be with us for decades.

Mr. Stiglitz noted that nearly 40 percent of the 700,000 troops from the first gulf war, which lasted just a month, have become eligible for disability benefits. The current war is approaching five years in duration.

"Imagine then," said Mr. Stiglitz, "what a war — that will almost surely involve more than 2 million troops and will almost surely last more than six or seven years — will cost. Already we are seeing large numbers of returning veterans showing up at V.A. hospitals for treatment, large numbers applying for disability and large numbers with severe psychological problems."

The Bush administration has tried its best to conceal the horrendous costs of the war. It has bypassed the normal budgetary process, financing the war almost entirely through "emergency" appropriations that get far less scrutiny.

Even the most basic wartime information is difficult to come by. Mr. Stiglitz, who has written a new book with Ms. Bilmes called "The Three Trillion Dollar War," said they had to go to veterans' groups, who in turn had to resort to the Freedom of Information Act, just to find out how many Americans had been injured in Iraq.

Mr. Stiglitz and Mr. Hormats both addressed the foolhardiness of waging war at the same time that the government is cutting taxes and sharply increasing non-war-related expenditures....

[anne]

While Joseph Stiglitz is arguing is that a combination of increasing military spending and decreasing taxes meant the government had to borrow. What would have been funds for private investment were being absorbed by the government in financing wars and occupations. The Federal Reserve understanding the liquidity problem that would have resulted as the government borrowed, increase liquidity so that private investment would not be limited. Also, the Fed gave no attention to the nature of private investment that was created ignoring mortgages lending abuses that were discussed even in the New York Times.

Siglitz, as Robert Hormats, argues that the nature and extent of military spending increases financed by borrowing, directly led to excessive credit expansion by the Fed and lacking credit supervision in turn led to the mortgage market abuses underlying our current economic difficulties. Hormats, representing Goldman Sachs should be closely attended to as Goldman understood the credit abuses that were occuring and was highly self-protective where other financial houses seldom were.

[anne]

We had then a combination of increased military spending, lowered taxes, government social spending that was completely controlled and obviously lacking in critical infrastructure building areas as well as in meeting needs even as the needs of health care protection for needy children or infants, and we had private investment that was drawn above all to the domestic housing market much financing excessively expensive mortgages.

Joseph Stiglitz has explained our current economic problems, and in pointing to the astounding costs not only of military spending as such but the costs of destroying wars and occupations and the inevitable effects Stiglitz shows how troublesome the legacy of our wars an occupations will be.

Why then are economists unwilling to discuss the finings or argument of Stiglitz?

[anne]

Asking why economists are unwilling to discuss the findings or argument of Stiglitz or Hormats or Bilmes, beyond a slanderous dismissal by a Wall Street Journal managing editor writing with an academic mask in the Financial Times, is reasonable.

Where is Paul Krugman or Brad DeLong, even if arguing that Stiglitz is wholly foolish? Why can Bob Herbert write of there being hardly a whisper? When in August 2005, Bilmes wrote of a trillion dollar war, while having too little access to costs, the figures were dismissed when any attention was given which was seldom. Cost estimates from Stiglitz and Bilmes rose to $2 trillion and even American Enterprisers were suddenly briefly findings costs at $1 trillion.

However, overwhelmingly the effects of the costs of trillions of dollars for wars and occupations have been ignored by economists and I just do not understand why or wish to be unfair.

What am I missing?

[anne]

I recently noticed an economist's essay titled "Why I am Not a Rawlsian" which has been widely circulated, and which turning the title to a question I was immediately tempted to answer "because you have no conscience." Possibly I have no conscience, but I do wonder why $1 or $2 or $3 trillion in spending on destruction makes no apparent difference to so many economists.

John Rawls and Martin Luther King, who we pretend to honor, on a day, would have understood that $3 trillion in wanton destruction make a difference even economically.

Forgive me if I am being unfair, but thinking I do have a Rawlsian conscience I would wish to be even more unfair.

[anne]

http://www.ft.com/cms/s/07d4beda-e8c3-11dc-913a-0000779fd2ac,dwp_uuid=ebe33f66-57aa-11dc-8c65-0000779fd2ac,print=yes.html

March 3, 2008

A War Appraisal Too Vast to Swallow
By Tunku Varadarajan

Just when the American public, in an inversion of the old saw about economists, was thinking that the Bush administration professes to know the "value" of everything but the "cost" of nothing, along come Joseph Stiglitz and Linda Bilmes - two economists - to restore aphoristic order.

Professors Stiglitz and Bilmes, of Columbia and Harvard respectively, assert knowledge not merely of the cost of the Iraq war but its "true" cost. Of the war's "value", they utter barely a peep: "Our intent is to focus on costs, because they can be measured with some accuracy . . . The benefits are more elusive, but it seems highly unlikely they will be significant."

"By now it is clear," the authors declare in the very first sentence of their pamphlet, "that the US invasion of Iraq was a terrible mistake". A few pages later they make plain that "we both ardently opposed the war and were against it from the start". So theirs is a polemical effort in which they play the role of ideological actuaries in an area where, to the believers in Bushian mismanagement, no real proof is necessary. Yet the faux-precision of the book's title - The Three Trillion Dollar War - is propagandistic. One might aver that the aim of the authors was not so much to write a book as to coin a catchphrase....

The authors have entered into territory where it is fraudulent to offer up the omniscient exactitude of "three trillion". Better to issue a cry from the heart and say: "It's a bad, bad, bad, bad war." That would have been more honest than the wheeling into a political debate of a heavy, but woefully inaccurate, economic blunderbuss.

Tunku Varadarajan is a professor at New York University's Stern School of Business and a research fellow at Stanford's Hoover Institution.

[anne]

Please notice that the Wall Street Journal has not discussed the work of Joseph Stiglitz, but the Financial Times choose to smash the work of Stiglitz using a managing editor of the Wall Street Journal while not mentioning that the basher was indeed a WSJ editor. This is mean-spirited dishonesty for the sole purpose of destroying discussion of the work of a Nobel Prize winning economist who is courageous enough to care to bring attention to the terrible cost of war and occupation.

What does it mean when the Financial Times publishes a column on the work of Joseph Stiglitz by a editor of the Wall Street Journal, while not identifying the columnist as responsible for the WSJ editorials designed expressly to counter the ideas written about by Joseph Stiglitz? There is a dishonesty here that is as tragic as mean-spirited.

[anne]

Ralph:

"What are the underlying causes of the inflationary recession we appear to be entering?"

Joseph Stiglitz has answered the question. Who can hear the aswer?

[anne]

http://www.theaustralian.news.com.au/story/0,25197,23286149-2703,00.html

February 28, 2008

Iraq War 'Caused Slowdown in the US'
By Peter Wilson

THE Iraq war has cost the US 50-60 times more than the Bush administration predicted and was a central cause of the sub-prime banking crisis threatening the world economy, according to Nobel Prize-winning economist Joseph Stiglitz.

The former World Bank vice-president yesterday said the war had, so far, cost the US something like $US3trillion ($3.3 trillion) compared with the $US50-$US60-billion predicted in 2003.

Australia also faced a real bill much greater than the $2.2billion in military spending reported last week by Australian Defence Force chief Angus Houston, Professor Stiglitz said, pointing to higher oil prices and other indirect costs of the wars.

Professor Stiglitz told the Chatham House think tank in London that the Bush White House was currently estimating the cost of the war at about $US500 billion, but that figure massively understated things such as the medical and welfare costs of US military servicemen.

The war was now the second-most expensive in US history after World War II and the second-longest after Vietnam, he said.

The spending on Iraq was a hidden cause of the current credit crunch because the US central bank responded to the massive financial drain of the war by flooding the American economy with cheap credit.

"The regulators were looking the other way and money was being lent to anybody this side of a life-support system," he said.

That led to a housing bubble and a consumption boom, and the fallout was plunging the US economy into recession and saddling the next US president with the biggest budget deficit in history, he said.

Professor Stiglitz, an academic at the Columbia Business School and a former economic adviser to president Bill Clinton, said a further $US500 billion was going to be spent on the fighting in the next two years and that could have been used more effectively to improve the security and quality of life of Americans and the rest of the world.

The money being spent on the war each week would be enough to wipe out illiteracy around the world, he said.

Just a few days' funding would be enough to provide health insurance for US children who were not covered, he said.

The public had been encouraged by the White House to ignore the costs of the war because of the belief that the war would somehow pay for itself or be paid for by Iraqi oil or US allies....

[anne]

Not to worry though:

http://www.nytimes.com/2008/03/04/world/africa/04somalia.html

March 4, 2008

Americans Fire Missiles into Somalia
By JEFFREY GETTLEMAN and ERIC SCHMITT

NAIROBI, Kenya — American naval forces fired missiles into southern Somalia on Monday, aiming at what the Defense Department called terrorist targets....

[anne]

We are financing a forever war and occupations in a way wholly different than ever before, and in a way that adds to the destruction, but the mystery is that so sadly many economists are acting as though there is no cost. I do not understand why.

[anne]

http://www.theage.com.au/news/world/economist-says-war-key-to-downturn/2008/03/03/1204402361741.html

March 3, 2008

Economist Says War Key to Downturn

THE Iraq war has contributed to the US economic slowdown and is impeding a recovery, Nobel-winning economist Joseph Stiglitz says.

[anne]

http://www.guardian.co.uk/world/2008/feb/28/iraq.afghanistan/print

February 28, 2008

The True Cost of War: In 2005, a Nobel prize-winning economist began the painstaking process of calculating the true cost of the Iraq war. In his new book, he reveals how short-sighted budget decisions, cover-ups and a war fought in bad faith will affect us all for decades to come.
By Aida Edemariam - Guardian

Fitful spring sunshine is warming the neo-gothic limestone of the Houses of Parliament, and the knots of tourists wandering round them, but in a basement cafe on Millbank it is dark, and quiet, and Joseph Stiglitz is looking as though he hasn't had quite enough sleep. For two days non-stop he has been talking - at the LSE, at Chatham House, to television crews - and then he is flying to Washington to testify before Congress on the subject of his new book. Whatever their reservations - and there will be a few - representatives will have to listen, because not many authors with the authority of Stiglitz, a Nobel prize-winner in economics, an academic tempered by four years on Bill Clinton's Council of Economic Advisers and another three as chief economist at the World Bank (during which time he developed an influential critique of globalisation), will have written a book that so urgently redefines the terms in which to view an ongoing conflict. The Three Trillion Dollar War reveals the extent to which its effects have been, and will be, felt by everyone, from Wall Street to the British high street, from Iraqi civilians to African small traders, for years to come.

Some time in 2005, Stiglitz and Linda Bilmes, who also served as an economic adviser under Clinton, noted that the official Congressional Budget Office estimate for the cost of the war so far was of the order of $500bn. The figure was so low, they didn't believe it, and decided to investigate. The paper they wrote together, and published in January 2006, revised the figure sharply upwards, to between $1 and $2 trillion. Even that, Stiglitz says now, was deliberately conservative: "We didn't want to sound outlandish."

So what did the Republicans say? "They had two reactions," Stiglitz says wearily. "One was Bush saying, 'We don't go to war on the calculations of green eye-shaded accountants or economists.' And our response was, 'No, you don't decide to fight a response to Pearl Harbour on the basis of that, but when there's a war of choice, you at least use it to make sure your timing is right, that you've done the preparation. And you really ought to do the calculations to see if there are alternative ways that are more effective at getting your objectives. The second criticism - which we admit - was that we only look at the costs, not the benefits. Now, we couldn't see any benefits. From our point of view we weren't sure what those were."

Appetites whetted, Stiglitz and Bilmes dug deeper, and what they have discovered, after months of chasing often deliberately obscured accounts, is that in fact Bush's Iraqi adventure will cost America - just America - a conservatively estimated $3 trillion. The rest of the world, including Britain, will probably account for about the same amount again. And in doing so they have achieved something much greater than arriving at an unimaginable figure: by describing the process, by detailing individual costs, by soberly listing the consequences of short-sighted budget decisions, they have produced a picture of comprehensive obfuscation and bad faith whose power comes from its roots in bald fact. Some of their discoveries we have heard before, others we may have had a hunch about, but others are completely new - and together, placed in context, their impact is staggering. There will be few who do not think that whatever the reasons for going to war, its progression has been morally disquieting; following the money turns out to be a brilliant way of getting at exactly why that is....

[Neal]

Want a perfect example of a stagnating (in fact collapsing) market and inflating prices?

I was just informed that the countries largest supplier of roof deck and joists for commercial construction (Vulcraft, division of Nucor) is raisng joist and deck prices by 43%!! Since they typically deliver 6 months after quote, it's a 6 month look-ahead on pricing.

Construction is falling over on it's face and a key component of that is going up!

World commodities-it's the new plastics.
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Mr. McGuire: I want to say one word to you. Just one word.
Benjamin: Yes, sir.
Mr. McGuire: Are you listening?
Benjamin: Yes, I am.
Mr. McGuire: Plastics.
Benjamin: Just how do you mean that, sir?
------

[Knut Wicksell]

For reasons having nothing to do with the present conflict I have been immersing myself in the diplomatic and economic history of the Thirty Years War. Compare and contrast. I will just give you compare. Spain in 1618 was pretty much in the same position as The United States in 2000, an immensely wealthy (by contemporary standards) powerful state. She chose to support her Habsburg brethren in the following years -- at first highly successfully. Things turned a dozen years later when Sweden entered the fray, assisted by France who under Richelieu was doing a balancing act by trying to reduce Spanish power without completely destroying the Austrians. The war went on. By the end Spain was bankrupt. So was Austria, so nearly also was France. As to the German states, they were simply prostrate, a little like Iraq today.

The point is that just as it is for the US in Iraq, so it was for Spain in the Low Countries, Germany and Italy. The financial burden was too heavy. The people revolted. In the end the parties settled out of exhaustion.

[chris]

Spain had all the gold and was left with a penny. This is a story well told in The Power of Gold: History of an Obsession, Peter Bernstein. It's an example of "We think, you sweat," where the sweaters ended up with the money.