There has been a lot of talk recently about the United States economy entering a period of Stagflation. Stagflation can be defined as a period of time in which economic growth remains below historical averages while significant inflation is present. A period like this is looked on as the worst of two worlds: the low economic growth results in a higher ‘natural’ rate of unemployment than in more normal times; and the economy still has to deal with an inflation rate that erodes earnings and causes an allocation of resources favoring wealth protection and not productivity. A period of Stagflation tends to be self-perpetuating because the lower productivity results in slower growth and the slower growth exacerbates inflation which further stymies productivity, and so on.
Stagflation also puts the Federal Reserve System “in a box”. If the Fed attempts to ease during such a period, the argument goes that its efforts will tend to go into further inflation. If the Fed attempts to restrain inflation, it will only worsen the unemployment situation. The monetary authorities are faced with a real dilemma.
One of the problems in understanding how Stagflation can occur is that people tend to focus on aggregate demand factors when studying economic fluctuations. If economic shocks come from the demand side, a slowdown in demand translates into slower economic growth which is accompanied by higher unemployment and lower inflation. But, this is not how we define Stagflation.
Instead, Stagflation comes about due to a supply side shock which produces both a slowdown in economic growth and higher rates of inflation (for a given amount of aggregate demand). But, how does this come about?
In terms of economic growth I would argue that two things contribute to the possibility of a slower expansion. First, there is the restructuring that most financial and non-financial firms are going through right now. When firms are going through the process of restructuring they lose focus as to what they really should be concentrating on. I know this sounds contradictory, but my business experience points to this very thing happening at a time like this. When you are restructuring you are concentrating on getting back to basics, eliminating those things that you shouldn’t be involved in and retrenching into those things that you should be involved in. (Should you sell businesses, something that takes time and attention?) Also, financials need to be cleaned up. (Perhaps new capital needs to be raised, something that takes time and attention.) Furthermore, expenses need to be trimmed, people let go, and superfluous efforts eliminated (all taking time and attention).
During such times, executives do not focus on creating or sustaining competitive advantages because their focus lies elsewhere. Achieving and sustaining competitive advantages are what produce exceptional returns over time. But, achieving and sustaining competitive advantages takes time and effort since the primary sources of competitive advantage result from things like barriers to entry and from customer captivity. Barriers to entry come from economies of scale and research programs that create a continuous competitive flow of innovation. Customer captivity comes from building customer relationships through product and service quality and support. A firm generally has to restructure first before it is able to concentrate on these paths to better than average performance. And, since building competitive advantage must be very intentional, it must be the primary focus of management.
The second factor that contributes to slower economic expansion is the impact that inflation has on economic performance. As we saw very clearly in the 1970s, an inflationary environment results in managements directing attention away from longer-lived more productive investments and into shorter-term assets that act like an inflation hedge. Such investment slows down improvements in productivity because productivity improvements tend to be more prevalent in longer-term assets than in short-lived ones. The threat of higher inflation results in lower productivity growth.
Both factors, loss of focus and reduced productivity growth (each of which tend to reduce innovation), contribute to slower economic growth and a less vibrant business environment. This re-focus also results in a change in business leadership. As the culture of businesses change due to different economic environments, management leadership tends to change as well. Promotions and hiring’s go to managers that are more risk averse and less dynamic and this contributes to a slower pace of economic expansion.
On the policy side, both monetary and fiscal policies are directed to stimulate aggregate demand. The general prescription for monetary policy is to lower interest rates (or at least not raise them) and speed up monetary growth. On the fiscal side , a general effort is made to cut taxes and/or increase government expenditures. If the above analysis is correct, both efforts will go to produce more inflation rather than stimulate production, and this, as we have seen, will just contribute to making the situation worse.
If we think we are entering a period of Stagflation, then we must be sure that we understand where the economic shock has come from…the demand side or the supply side. If Stagflation results from a supply side shock then pursuing demand side remedies will only make the situation worse. If Stagflation is coming from the supply side then the government must create more appropriate policy responses fit to meet the needs of the times.
If Stagflation is a supply side problem then we must look at the behavior described above in order to come up with appropriate actions. First of all, inflation is an enemy and its fire must not be fanned! (This even ignores the impact that inflation potentially has on the value of the dollar.) Any policy actions that encourage inflation only create a cumulative problem that just adds fuel to the fire and makes the inflationary spiral that much more difficult to stop. It is hard for policy makers to fight inflation at a time like this because voters and politicians are clamoring for more economic growth and less unemployment.
The second part of the problem is not only difficult but slow to unwind. Also, there are two components to this second part. The restructuring of businesses, both financial and non-financial, must take place and it must take place in as orderly a fashion as possible. This takes time. It has taken the American economy quite a few years to get into the situation it is now going through and getting out of it will be painful and time consuming. Adding to the normal adjustment process is the added problem that the United States, as well as the world, is also in need of moving away from fossil related energy sources and moving into an age of cleaner and more efficient energy sources that are not fossil related. So, we are going though an adjustment related to the financial excesses of the past decade or so as well as an adjustment related to the absence of a sound energy policy in the developed world.
The other thing that must be avoided at this time is the move to a more inner-directed management. For the economic growth rate to increase and unemployment to drop, managements must strive to create sustainable competitive advantage by focusing on what they do best and innovating in order to keep ahead of their competition. Costs must be contained, not through cutting back on expenses, but, through economies of scale achieved in the application of core competencies and increases in productivity. This too will take time and the intentional efforts of business leaders and entrepreneurs.
To combat Stagflation we must have monetary policy and fiscal policy working together. Monetary policy must work to keep inflation moderate. Fiscal policy must work to create an environment that encourages the improvement of productivity and risk-taking. Yes, there needs to be a safety-net for Americans that are hurt by unemployment and economic dislocation. But, if Stagflation is a supply side problem, the resolution to the problem must come from stimulus programs that impact the supply side of the economy.