first majestic silver

Stagflation 2006 ?

October 18, 2005

It wasn't too long ago that the talking heads of Wall St. and the Media were all worrying that our Goldilocks disinflation economy was turning into Deflation; then suddenly out of the blue we were told that we are now on the verge of Inflation, then almost before we could get used to inflation, up pops -Stagflation!

Bloomberg News "Some analysts think stagflation is a new Ogre stalking Asia."--- "While economies are decelerating quickly, inflation rates are picking up virtually everywhere. Citing low long term interest rates and a world wide booming real estate market, high oil prices and rising wages, Soon, the Inflation indices will be rising faster than GDP. Could the mild stagflation we are experiencing turn virulent," ? Reutershad a piece called Hints of stagflation despite growing U.S. economy. "With oil prices high and the pace of the U.S. economy in question, some economists are wary of a return to 1970s-style "Stagflation", Will Stagflation soon become a part of the lexicon of the financial press?

What does Stagflation actually means?

The basic supply - demand concept says that if you reduce the price of something, more of it will be wanted. A retailer, with too many T-shirts, slashes their prices, and suddenly they are all sold. This straightforward bit of logic also applies to all other economic 'goods' and "services" (computer consultants for example) though we don't always think of it in these terms, Workers are really just another economic good. So, if, for whatever reason-such as an unsustainable, technology-centered Boom comes to a crashing halt-and there are temporarily too many workers for employers to hire, if we would then cut the price of the goods (lower wages) then more goods (labor) will be purchased (Hired). Now, of course, people aren't like t-shirts, which don't have feelings or large mortgages. Nor do T-shirts scream at the injustices of the capitalist system. Most importantly T-shirts don't vote. It is often difficult to persuade the unemployed that they should try to discount themselves back into a job, on the grounds that 75-85% of their former salary is worth a whole lot more than zero, especially once their unemployment benefits run out. The Unionized GM workers have finally begun to figure this out. On the other hand even if they would rather work, there may be a minimum wage under which they cannot work, or there may be a union which insists all jobs comply with their rules, not the boss's. Finally, our job-seekers might find that though their able and willing to work for a lower wage, but due to all the Payroll taxes, Medical insurance costs and Gov. mandated regulatory burdens, the employer decides to outsource the work so that he can reduce the costs of his service or product and stay competitive instead of closing his doors.

This was where the Keynesians came in. Seventy five years ago Keynes realized that, if modern institutional and political arrangements ruled out the possibility that wages could fall far enough during a recession to enable all laid-off workers to be re-hired, he could achieve the same result by making the dollars themselves worth less! Simply inflate all the troubles away? That way, though the worker, for arguments sake, would still take home the same $1000 a week, that $1000 would end up buying less, since price of all goods had risen. With this simple slight of the hand, Keynes seemingly solved the problem and garnered an overblown reputation But alas he also pried open a Pandora's Box of Boom and Bust complete with an ever increasing encroachment by Big Government into our lives and businesses. The insidious thing about this black magic is that, in the short run, it seems to have worked, much like, the hair of the dog seems to lessen the effects of a hangover, but in reality it is definitely not a cure. Very interesting you say but what's all this got to do with Stagflation? Well, the one thing the "Superior" Keynes overlooked was that the Common man was not as ignorant as he had supposed; Monetary inflation can only price people back into work if they are under the illusion that they are not suffering a real cut in their wages. Of course, that illusion was quickly dispelled, as workers, not to mention the pensioners and welfare recipients, all demanded to be compensated for the loss to their purchasing power. It wasn't very long before "COLA" clauses were built into all working agreements and Government benefit programs.

As more and more money was pumped into the world economy in the 1960s-70's plus the fact that then (Viet Nam), as now (Iraq), we were in a "Guns and Butter" economy-workers became ever quicker to adapt to the changes, making any lessening of real cost to employers impossible. Employment and new hirelings naturally slacked off, Instead of reducing unemployment in anything like the manner that the Keynesians had predicted. Then, as the dollar-for so long propped up only by the purchases made by all the other central banks-plummeted, the unthinking economists, under pressure from their political masters; Boldly dropped energy from their CPI calculations. About this time, the concept of something called 'core' consumer prices-a measure excluding first energy and later food prices-became the vogue. Magically we suddenly had No Inflation and no overall rise in price. They then monetized the governments borrowing. Wow No Inflation and relatively flat interest rates. What they failed to notice, of course, was that by "monetizing" government Debt, they were only making matters worse! While all this was going on, organized labor and the political parties which represented them were at the zenith of their political powers and so, as prices rose, wages and benefits rose even faster since they all included COLA Clauses, This meant that, rather than becoming cheaper, workers were getting pricier and goods (workers), which are more pricey do not sell as well. The natural result was that Unemployment rose in conjunction with prices, VOILA, STAGFLATION was invented. It does not take long before the market adjusts to the increased volume of money and prices react accordingly, so in order to prevent another relapse, the artificial stimulus must be continually re-applied but in ever increasing doses. This process (in another failure of economic vocabulary) became known as "cost-push" inflation, or as the "wage-price spiral." That way, the real culprits-the FED and the politicians could conveniently lay the blame for the woes of the world, off onto militant union leaders and Oil companies at home, and sinister Arab princes abroad.

At the same time, other "fiscal drags" such as bracket creep, AMT (alternative minimum tax) and depreciation allowances, which were not fully adjusted in line with rising price, were bleeding businesses dry, limiting their ability to employ workers as well as their ability to invest in new plant and capital equipment. Moreover, with foreign exchange rates going wild, with interest rates more volatile and with commodity prices soaring alongside labor costs, few businessmen were able to make any meaningful plans for the future. The whole question of what constituted a profit became vexed when historic costs of inventory and equipment, recorded on the books, bore little relation to current replacement costs. With all this "core" consumer price nonsense amidst all these ex-food and ex-energy shenanigans, all manner of relative prices were being distorted as well. It cannot be over-emphasized that relative prices (interest rates) are exactly the kind of thing that provides the most important market information of all to entrepreneurs. So, in addition to being unable to afford the higher wages arrived at under threat of strikes, or through subjection to government 'arbitration' and the forced complicity with national pay-deals, and on top of having capital consumed by the interaction of flawed accounting systems and rapacious government revenue departments, company executives and business owners alike found themselves increasingly uncertain as to what it actually was they should be doing if they were to make a profit; Naturally, then-either voluntarily, or by force of circumstances-they did less of everything. Production was cut back. Joblessness rose and stock prices plunged.

For a while, as all this went on, the politicians and the central banks fell back on their two most readily utilized means of Depression-busting and resorted to a Command Economy of price fixing, mandatory wage caps, excess profit taxes and restrictions on the mobility of capital and, of course, more Inflation to combat the spreading stagnation of output and work.

Ultimately, it was recognized as being inherently self-defeating and, clad in the political camouflage of an adherence to the 'new' doctrines of monetarism, the central bankers began to do what was long overdue: They cut back sharply on the pace of credit creation, raised interest rates and let the inevitable bust (recession) work itself out. That in a nut shell was what Stagflation was all about-

Today, there are all to many uncomfortable parallels; a) Money; the world is awash in it B) Fiat money or credit created out of thin air is confused with Real Capital (backed by Savings). So that to day our national savings rate is Zero. C) Prices of resources are rising rapidly and setting new all time highs D) Governments have their noses in everyone's affairs and their fingers are in everybody's pockets. E) Oil is getting more and more expensive as it too approaches all time highs. Natural Gas is setting new all time highs almost daily and we are not even into the heating season yet F) Accounting is a mess ( Sarbanes Oxley is a disaster waiting to happen).

G) The dollar is being held aloft by foreign central bankers who are getting more and more worried as the size of their holdings of US dollars reaches the stratosphere. H) We also have a war, giving us a modern day Gunsand Butter economy. J) We even have Twin deficits, Budget and Trade averaging about $700 billion a year) and K) the politicians are proposing nonsensical policies that not only won't work but like Schumer's 27 ½% Tariff on chine imports could bring about a world wide Depression. Hopefully, at the rate things are going, Nothing will be passed. Then If all that wasn't enough along comes the biggest natural Disaster in American History, Katrina & Rita.

In reality, when it comes to the economy there are truly very few fundamental differences between the socialists Democrats and the Conservative Republicans, they are both Keynesians. However there is one huge difference today and that is Globalization. The dismantling of many man-made barriers to trade, such as existed during the Cold War era of the 60s and 70s, has eliminated a good deal of the power of organized labor. Globalization has also given business a lot more leverage in their negotiations with its workers and a lot more clout with politicians who are anxious that they not simply up stakes and leave, if conditions become too onerous at home.

Therefore, today, we may well see spurts and stalls in "growth" as the intensity and the unexpectedness of the global policy of Inflation varies from Central Banker to central banker But, what we will not see, this time around, is "cost Push" inflation where wages are rising faster than prices and thus, generalized unemployment will not increase alongside the cost of things at large. Stagflation, then-once we bother to educate ourselves as to what it is and what causes it-seems highly unlikely.

INFLATION: If there is one thing that any economist, analyst or media talking heads should know is that; its impossible to have the Money Supply increase at a rate of 10% (a year compounded) above the Growth rate of GDP and not end up in Inflation. So far most of this massive money and credit creation has been sucked into first a Stock Market Boom, then a bond Market Bubble and finally into a Real Estate Bubble. The one thing all Bubbles have in common is that they require ever increasing amounts of money accompanied by ever decreasing interest rates. With Long Term interest rates already near 45 year lows, how much lower can long term interest rates go As any would-be Alan Greenspan (his reign is rapidly coming to an end) knows, you can detract attention from their multitude of sins if only Real Estate prices the S&P are rising steadily into the ionosphere. Wishful thinking? Most probably! Goldilocks economies can't last forever and this one is already very long in the tooth.

Being a natural contrarian, I believe that based on P/E multiples and Price to dividend ratios, among other more esoteric valuation calculations, I'm convinced that the market and Real-Estate are now 25% - 40% over valued. More importantly, if the market is to continue it's up trend, it will continue to require ever increasing amounts of new money. (Which privatization of Social Security could supply). From 1982 through 2000 both the public and private pension funds had a massive change in their investments as the stock market portion shifted from being 25% of there assets to where they are now upwards of between 50% for individuals to 75% for pension funds and with the US already absorbing 80% of the worlds savings, where could a massive injection of new money into the stock market possibly come from.

NO NEW MONEY NO SUSTAINED BULL MARKET; ball game over! What will be the first signs? Why sharply falling volume of stock trading of course.

In the ever increasing unlikely event of a Bush victory in privatizing social security, that could extend this rally into a Bull Market. So if for whatever reason it begins to look like he may succeed then back up the truck and fill it with common stock. But as far as I am concerned, I have been going Short and buying puts on any breakouts to NEW HIGHS but most of all I'm holding on to my Gold and buying more on any dips back to $410-$420 support or on any breakout above $475/oz. I could be wrong of course but in my opinion we are in the early stages of the next 16-20 year down to sideways stock market similar to 1962 to 1982.

The BIG question is? what will be the trigger that starts the next leg of the Bear Market. Your guess is probably as good as mine but for me an inversion of the yield curve or another ½ to 1% further increase in interest rates could trigger the biggest bear sell off in history.


Aubie Baltin CFA, CTA, CFP, Phd. (retired)
Palm Beach Gardens, FL
[email protected]


18 October 2005

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