Dec. 15, 2022

Are We Headed Toward "Stagflation?"

Several readers have asked whether I feel our economy is headed into Stagflation? At the risk of sounding like the guy you ask for the time, and he tells you how the watch is made. Here is my, I hope not too lengthy, answer.



Stagflation, that combination of inflation and recession, is a term that gained widespread use in the late 1970s. Stagflation described just what was plaguing our economy. We had a combination of high inflation with slow economic growth.

Until then, most economists did not think such a situation could exist. Their thinking went like this. If the economy was experiencing inflation, that meant excessive demand. People were buying everything they could, thereby driving up prices. Implied in this is the central concept that people were working so they could afford to buy everything in sight. And if they were working, then the economy must be humming along. Inflation must go hand in hand with economic expansion.

So the concept of inflation implied economic expansion. A recession at the same time as inflation didn't compute. You could have one, say inflation, or the other, say recession, but you could not have both at the same time.

At least, that was the thinking of the old-school economists.

That is until the 1970s. Suddenly, no matter what the economists thought, here we were with both inflation and recession simultaneously, and no one could deny it. And just like that, everyone's favorite economic term became: Stagflation.

The old economists were partially correct. It is just that they failed to recognize an essential player in the economy, one that would have greater and greater influence over our fortunes from the 1960s on.

That player, as you've probably guessed, is the US Government. It began with Lyndon Johnson and his "guns and butter" strategy of increasing social spending (the Great Society) while fighting the Viet Nam War. That's when Government spending began to take off.

Johnson was followed by Richard Nixon, who was no piker regarding spending. And the Nixon/Ford Administration was followed by Jimmy Carter, who was himself a big spender. Carter had the misfortune of enduring the OPEC Oil embargo, which both ignited inflation and caused the economy to drop into

recession. Our first real sign of Stagflation.

So aside from World War II, Carter saw government spending as a percent of the total economy reach its highest level, just under 20%.

And that's been the benchmark for government spending in the years since. Two recessions, 1982 and 2008, saw government spending exceed that 20% benchmark. But each time, the economy improved, and government spending fell back to that 20% benchmark or less.

Your friends may tell you, "there's nothing wrong with Government Spending." They'll say the Government should spend more and more as that will provide stimulus. The more, the merrier. That is how the Biden Administration feels about government spending.

If anyone tells you that, respond with one word: Stagflation. You see, it is not the government spending in itself that's the problem. It is paying the bills after all that spending. When Lyndon Johnson left office, the economy was performing OK.

The cost of capital in the 70s climbed as we continued to pay for the "guns and butter" of the 60s. The economy sputtered and stammered for the decade that followed, the 70s. The burden of Johnson's Government Debt overhung the entire financial system. Excessive government bonds and other debt drove interest rates higher than they should have been. Creating monetary inflation while crowding-out private financing.

To an outsider, it might have appeared that inflation and recession had come together somehow. But for those who knew the history of the 60s and 70s, it became evident that this "Stagflation" was the lingering hangover of excessive government spending.

So, knowing that Stagflation originates in Washington, it is caused by the Government's overspending, which crowds out private enterprise, thereby slowing the economy—and knowing that the benchmark Spending Rate for the Government is approximately 20% of total GDP.

We can now answer our readers' question: Is this economy headed into a period of Stagflation?

As you know, everything changed in 2020. That was the first full year of Covid and the time when the Federal Government and other state and local governments took a much more active role in the economy.

The government budget expanded dramatically. At the Federal Level, the deficit, as a percentage of the economy, grew by 50%. Government spending went from that traditional 20% to nearly 30%.

To give you an idea in real dollars. Only in the last year of the Trump Presidency had the government budget reached a trillion dollars. Currently, Congress is debating whether to approve a $1.5 trillion budget. That's 50% greater than two years ago. And yet many in Congress feel that even that is not enough.

And therein lies the answer to the Stagflation question. Are we headed into Stagflation? Absolutely. And it grows more likely each day that Washington pays for guns, butter, and anything else they can think of.



Econ Briefs


It's a trifecta this morning. The Bank of England and the European Central Bank joined the Federal Reserve in raising interest rates by 50 basis points this morning. All three banks have now hinted that this will not be the last interest rate hike and that we should expect more tightening next year.

You don't think that the three banks are coordinating their efforts, do you?

Last night China reported on three significant measures of their economy. Industrial Production, Retail Sales and the Unemployment Rate. All three indicators were down substantially and below Wall Street Estimates. It is becoming increasingly likely that the Chinese economy is entering a significant economic slowdown.

Here in the US, better than expected Initial Claims for Unemployment. Initial claims are reported at 211K for the past week.

And then a couple of simply awful reports. First retail sales reported a negative 6/10th%, and this is not the time of the year when that should be happening. The holiday sales season is usually the best time of the year for retailers. And yet, here we are with retail sales going negative.

The other terrible report this morning is from the State of New York. You may remember that the Empire State Manufacturing Index started some bad times on Wall Street when it reported a contraction of over 30% in July. Well, they're at it again. This morning the Empire State Manufacturing Index reports a negative 11%. The worst month since that July debacle and a clear indication that my neighbors to the North are having some real issues in production.

In earnings today, steel company Nucor Steel and marijuana company Hexo Corp are trading lower on their results.