The surprise is going to be the dollar strengthening. At this point the widely accepted “can’t fail” trade is to bet against the dollar. Buy gold and commodities and foreign currencies. It’s almost as popular a bet as buying real estate was a few years back. Real estate can’t go down. The dollar can’t go up. Until it does.
The refusal of banks to lend is telling us something. I suspect it’s that the destruction of their capital has been much more extensive than most imagine. Unless they start lending the money supply isn’t going to grow. The Fed can inject a trillion dollars into the banking system, but if there is no appreciable lending it’s not going to affect anything. The countervailing force of massive credit destruction is dwarfing the creation of high powered money by the Fed.
In the 70s we had a rapidly expanding money supply and all the lending you could want. There was no credit destruction to offset it. The smart move was to borrow all that you could, and everybody was trying to do exactly that. This went on until Paul Volcker choked off the creation of new credit in order to break the back of inflation.
Stagflation also has an industrial/manufacturing component: capacity utilization will be maxed out. That’s why expansion of the money supply went straight to inflation during the 70s. There was no excess capacity to come online as demand was stimulated. This is why Reagan’s program was designed to shift the supply curve to the right, to increase the production possibility frontier of the economy, so that new demand would let the economy grow rather than simply drive prices higher.
Today we have excess capacity up the wazoo. There are thousands of excess factories being closed down in China, there are thousands of excess retail stores being closed down in the US. This is a much different environment than what existed during the 1970s. I don’t see stagflation in our future. I think we will see prices fall, but so will incomes. In that fashion our standard of living on average will fall.
I understand the credit destruction argument. Assets disappearing and debt relatively constant on bank balance sheets means deteriorating equity. New reserve borrowing will be used by banks, if at all, to restore asset integrity as a balance sheet class. Purchase of Fed bonds and "safe" assets. No real passion to lend to consumers and struggling businesses and risk more asset decay. Asset decay works to constrict money supply, notwithstanding Fed attempts at stimulus by cutting reserve rates, etc. I'm on board so far.
How does this translate into a strengthening dollar? Scarcity of dollars to borrow? What causes the dollar to strengthen against foreign currencies and commodities? Also, I understand the Reagan era supply side stimulus to sop up excess consumer demand. More goods means stable prices. But, here, consumers are pulling back to clean up personal balance sheets. Aggregate demand is down and stimulating supply would be folly. The supply curve is sliding to the (pardon the pun) left at an accelerating pace as companies are slashing costs and going out of business. The Federal stimulus package seems like an irrelevancy as it only creates an artificial bubble in demand. Capital is too smart for that old trick. Who would invest capital and hire labor to meet an artificial demand signal? Not me.
I am haunted by the fear that the world will shun the dollar because of our current economic mismanagement. This will cause huge price increases in imports, and, as most consumer stuff in America is made elsewhere, consumers will pay a higher price for most goods. This could create an inflationary effect akin to the 1970's oil bump where prices kept rising while the economy slugged along. As always, your thoughts are appreciated.
They are sitting on mountains of reserve cash in an attempt to weather the coming storm.