What is stagflation? What is the cure for stagflation?
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Stagflation is a portmanteau word, a combination of the words "stagnation" and " inflation."
Stagnation usually is felt to be synonymous with recession. Inflation usually means prices rise (as measured by the Consumer Price Index) or the value of money falls, compared with the value of goods, by an amount considered excessive. Neither of these words has a rock-solid definition, and it is not unusual for the federal government to declare recessions, only to issue "corrections" months after the fact.
The Fed tries to keep what it defines as inflation in the 2% - 3% range. The fundamental belief is a "little" inflation is economically beneficial, while a lot of inflation, and any deflation, hurt the economy.
Clearly, determining when stagflation begins or ends is subjective and measured by arbitrary definitions. Nevertheless, stagflation is one of the most feared economic situations.
Why? Because the Federal Reserve Board's primary inflation fighting tool, raising interest rates, is believed to exacerbate stagnation. And what the Fed believes is it's primary stagnation-fighting tool, lowering interest rates, will exacerbate inflation.
Thus, the Fed believes it is caught in a dilemma. It's most important tool, cannot be used both ways. Imagine people caught on a burning ship, and their only life-saving tool is a fire hose. If they don't use it, they burn. If they do use it, they drown.
I said the Fed believes it is caught in a dilemma. In fact, there is no dilemma. The reason can be found in history.
Contrary to popular wisdom, history shows there is no correlation between interest rates and GDP growth. High rates have not slowed GDP growth; low rates have not stimulated GDP growth. In short, interest rates can be raised to cure inflation, without hurting GDP growth.
Contrary to popular wisdom, high interest rates have a positive effect on GDP growth. When rates are high, the federal government is forced to pay more interest, pumping more money into the economy
Not having learned from history, Chairman Bernanke now (2007) is following in the footsteps of Chairman Greenspan, cutting interest rates to cure a stagflation. It didn't work for Greenspan, who was saved by President Bush's tax cuts. It won't work for Bernanke, who may be saved by the next round of tax cuts.
Chairman Bernanke reminds me of the child, sitting in the back seat with his toy steering wheel. He thinks he's steering the car, but he's just going along for the ride.
There have been periods in which the Fed lowers interest rates many times, only to see the economy continue falling. Why the illusion persists is puzzling.
There are several reasons for this counterintuitive result:
1. For consumers, high interest rates are not a strong deterrent to buying. Millions of consumers willingly pay the high rates charged by credit card companies. Auto companies offer interest discounts to buyers, as do many other retail stores. An exception might be home sales, where interest rates do raise a temporary barrier. But even here, prospective buyers quickly become accustomed to the new rates, and seldom will someone never buy a home because of high interest rates.
2. Interest paid by a borrower is received by a lender, both of whom are part of the economy. The lender uses the money to pay salaries, buy equipment, pay rents, all of which benefit the economy. Thus, interest flows through the economy, changing hands, but neither helping nor hindering GDP.
Interest rate changes have only a minuscile effect on any corporation's bottom line. A company borrowing $100 million, and experiencing a 1/4% rate increase, will pay an additional $250K -- pocket change for large companies.
This leads to the conclusion there is one, and only one, solution to stagflation: Raise interest rates to cure the inflation and increase deficit spending to cure the stagnation.
Partial solutions have been attempted. Paul Volker, when faced with stagflation, "cured" it by raising interest rates. He cured the inflation. but the economy suffered, because it was starved for money. President Reagan's massive tax cuts then cured the stagnation, and paved the way for many years of strong economic growth.
There is one, and only one, solution to stagflation:
Raise interest rates to cure inflation and increase deficit spending to cure stagnation.
You will notice that the vast majority of economic solutions involve increasing the federal deficit. The reason: The vast majority of economic problems stem from a shortage of money in the economy (with inflation being a notable exception). A growing economy requires a growing supply of money. In the same vein, what do these data tell you?
1817-1821: U. S. Federal Debt reduced 29%. Depression began 1819.
1823-1836: U. S. Federal Debt reduced 99%. Depression began 1837.
1852-1857: U. S. Federal Debt reduced 59%. Depression began 1857.
1867-1873: U. S. Federal Debt reduced 27%. Depression began 1873.
1880-1893: U. S. Federal Debt reduced 57%. Depression began 1893.
1920-1930: U. S. Federal Debt reduced 36%. Depression began 1929.
1998-2001: U. S. Federal Debt reduced 9%. Recession began 2001
FREE MONEY :
THE ANTIDOTE TO POPULAR WISDOM ABOUT SOCIAL SECURITY, MEDICARE, THE
FEDERAL BUDGET DEFICIT AND FEDERAL DEBT, TAXES AND THE U.S.
Discovery begins when popular wisdom is questioned