Stagflation


Last week the Angry Bear mentioned an article on Salon that he thought merited sitting through their ad to get a day pass for. Well, I did and got to wandering around through it and decided to go ahead and pay for a subscription so I wouldn't have to go through the ads to get to James Galbraith's columns. This one from May 20, 2004 is wonderful, and matches my own views about Alan Greenspan: The man who stayed too long. Greenspan has made quite a few mistakes in his career as Fed Chairman, and he's fixing to make another one, one that may bring back the stagflation of the 1970's.

Salon: The man who stayed too long

Greenspan is already telling us, as clearly as he ever does, that the Fed will shortly repeat the mistakes of the last oil price shock, back in the 1970s. Faced with inflation -- even just a small amount -- it will raise interest rates. This is called "fighting inflation." The headline writers will say so endlessly, until you almost think it is true. But the effect is just the reverse. As higher rates drain funds from many companies, they will respond by raising their prices even more. Only much later, when the effect of high interest rates is to clobber demand, growth, employment and commodity prices, will inflation finally decrease.

Stock prices rose in 2003 in part because the dollar was falling. Hence U.S. transnational corporations could convert their euro earnings into more dollars, making their earnings look terrific. (No doubt, the administration's cutting the tax rate on dividends also helped.) A rise in rates and the dollar will unravel this effect. And higher rates may also hit the banking sector, depreciating banks' assets (including mortgage-backed securities) while increasing their costs. Will banks respond, as they did in 1994, by increasing their lending? It's doubtful: Pent-up demand for new loans does not appear to be there, as it was 10 years ago.

The outlook, therefore, isn't for another noninflationary boom. It's for stagflation -- the combination of low performance and rising prices some of us dimly remember from the Vietnam War. Thanks to Iraq and his own longevity, Greenspan is now likely to go out on a sour note: the man who stayed too long.

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