Stagflation Revisited

Asia is going to have to face up to the possibility that very soon the world’s biggest economy, and one on which China depends for 34 percent of its exports, is going to slip into a depressing condition known as stagflation – a period when economic contraction occurs simultaneously with high inflation. Asia is in for a rough ride, just like everybody else.

Currently, Wall Street is divided into two camps: those who feel the Fed should fight recession and those who feel it should fight inflation. The former feel that a recession can only be avoided if the Fed rescues the economy from the imploding housing market. To these analysts, inflation is not a problem as it will be contained by slower growth. The other camp maintains that the housing slowdown is not significant enough to derail the otherwise healthy US economy, and should therefore not distract the Fed from its primary mission of fighting inflation.

As usual on Wall Street, both camps have it wrong. By concentrating solely on the demand side of the price equation, Wall Street ignores the impact of supply. In reality, strong growth increases the supply of goods and helps keep a lid on consumer prices. Weak growth reduces the supply of goods and has the opposite effect.

Now that Fed Chairman Ben Bernanke has pulled the rug out from under the dollar, the US currency has become a monetary black hole into which foreign lenders will be increasingly reluctant to trust their savings. That already appears to be happening, with China cautiously beginning to diversify its reserves away from treasuries, buying only US$17 billion worth so far in 2007. The threat of substantial exchange rate losses will compel foreigners to demand greater compensation for loans to Americans. Thus what the Fed bestows in lower short-term rates, foreign creditors will take away in higher long-term rates. Higher long-term interest rates, tighter lending standards, and a reduction in credit availability will suppress asset values and consumer spending, pushing the economy deeper into recession. After a brief disruption, Asia will benefit from no longer having to bear the cost of subsidizing the US economy, as it reclaims savings and consumer goods for itself.

However, as the dollar falls, far fewer foreign products will be imported into the United States, and more domestic products will be exported from the United States, which is going to teach China just how much its economy depends on exports. Wal-Mart alone was responsible for $27 billion in U.S. imports from China in 2006 and 11% of the growth of the total U.S. trade deficit with China between 2001 and 2006. A reduction in the domestic supply of goods will offset the diminished demand brought about by the recession, causing consumer prices to rise. So while Americans will indeed buy fewer products, they will pay much higher prices for those that they do. The bottom line is that consumer prices are headed much higher, not just despite the recession, but as a direct result of it.

Many economists acknowledge that a falling dollar will put upward pressure on import prices, but few consider its effects on domestically produced goods. For one thing, a weak dollar by definition raises the prices of globally traded, dollar-denominated commodities, such as oil, causing raw material costs for domestic manufacturers to rise. Also, as a weaker dollar causes foreigners to demand higher interest rates on the money they lend us, domestic capital cost will rise as well.

Further, a global market allows domestic producers to sell their products to the highest bidders, wherever they may reside. For example if a lobster fisherman in Maine can get a better price for his catch in Europe, he will sell to Europeans. A weaker dollar simultaneously makes domestically caught lobster more affordable in Europe as it makes them more expensive here. As domestic demand falls, foreign demand picks up. The result is that fewer Americans will eat lobsters, and those who do will be forced to pay more for the privilege.

In addition, many of the products the US exports will not be manufactured, adding little to GDP and creating few jobs in the process. These products will include used consumer goods, such as cars, appliances, consumer electronics, furniture, etc. Poorer Americans will be forced to sell such possessions so they can afford to buy other goods they will need more, such as food and heating oil. Of course, armed with more valuable currencies, foreigners will have lots of extra purchasing power with which to buy those used consumer goods Americans can no longer afford to keep, as items such as food and heating oil will be a lot cheaper for them. In other words, they will be repossessing all the stuff they sold us on credit.

Unfortunately, the choice that the US faces is much more difficult than deciding to fight recession or inflation. Focusing on one foe at a time is a luxury the country long ago squandered. In reality, it is facing an assault from all sides. The best course would be to hunker down, settle in for a nasty recession, defend the currency, and try to save enough so that when the dust settles the US can try to build anew. But with Bernanke at the controls, that doesn’t seem likely.

Peter D. Schiff (schiff@europac.net) is president of Euro Pacific Capital, Inc of Darien, Connecticut