Stagflation and the Limits of Growth

by: Ray Hendon posted on: July 10, 2008 | about stocks: DIA / IEV / QQQQ / SPY    
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Is there anyone left who doesn’t expect (and fear) a world-wide economic downturn? Maybe I’m too close to my old profession as a dismal scientist. Perhaps I’m obsessive about economic concerns, but I can’t find any optimism among those who tend to matters of international growth. Regardless of where you look, there are clouds either overhead, as in the U.S., or on the horizon and blowing towards shore, as in Europe, Asia, Africa, and Latin America. The old giants are staggering, and the new ones will be soon!

The table below (click to enlarge), taken from Bloomberg, is a little outdated in what to expect in terms of real growth, but it is the latest available. In my view, and increasingly that of many others, real GDP growth in the U.S. and probably Europe will decline for 2008, and not be much better in 2009. Stagflation will not be a purely local affair for us.

Of course, there is no agreement about the severity or longevity of the downturn. There never is. But slower times are upon us, and the greater fear is that it could turn into a 1930s scenario of economic activity spiraling downward. This scenario unfolds like this: to protect themselves, the developed nations (the U.S. and Euroland, e.g.) will blame everyone else and begin pulling back from their bilateral and multilateral trade agreements. This they will do, trying to protect their domestic workforce from falling real wages and businesses from the effects of higher commodity prices. This, in turn, would be met by retaliation of our former partners in the developing world, in the form of trade embargoes, higher tariffs and inflated currencies. World trade plummets, and the heady times of ever expanding world economies comes to an end. It’s a horror of a scenario, and it did happen in the early stages of the 1930s depression.

Personally, I don’t think this will happen now, at least not to the worst extent. But, I do believe that this scenario will unfold in a modified form. We are already seeing embargoes of food commodities. Many of the rice producing nations in Asia are already prohibiting exports. Argentine farmers are trying to mobilize an embargo of their grain crops in order to lower domestic prices.

From our side, there is already talk of modifying NAFTA, hoping to scotch the flow of jobs to south of the border. It won’t work, of course. Muscle jobs are not coming back to America. But, our southern neighbors make tempting targets for demigods looking for a way to exploit our troubles for their benefit.

Fortunately, it doesn’t have to unfold in this way. The rapid expansion of the emerging nations has undoubtedly fueled the increases in prices for world commodities. And, in the short run world production of most of the commodities cannot be dramatically expanded. Prices did and will go up. But, over a longer time, additional production will brought on line. Already, in the U.S., farmers in the Midwest are planting new crops on land that has been fallow for decades. More oil will be found, and energy substitutes will be developed. All over the world there will be increases in production of foods and commodities.

On the demand side of the equation, adjustments will also be made that help lessen the blow. Americans and Europeans will learn to be more efficient with their petroleum products. We will develop more efficient cars; we will use cars less and public transportation more; we will move closer to work and take fewer driving vacations and unnecessary trips. Given some time, we will lower our use of the petroleum and help moderate the escalation of prices that has driven our real income down.

In the developing world, the same adjustments will be made. They will lower their production of manufactured goods (and the demand for the commodities used to make them), as the effects of the slowdown reach their factories. They will suffer from higher prices, just as we have, and their real incomes will fall some in the adjustment, just as ours has. China and other nations that are now subsidizing low petroleum prices will change, and bring market forces to their side, thus helping reduce demand for petroleum products.

In the end, the growth rate of the world’s economies will resume, but they will resume at levels more sustainable in both the developed and emerging markets. It was too much to expect that every nation could become rich overnight. The resources of the world are too constrained to allow for that—and that’s what we are bumping up against now. But, incomes around the world can rise as we accommodate the new demand and higher prices. It’s the old economic story: resources are limited, and the price system allocates them to the most efficient use. There are limits to growth in every economy, and the usual suspect in limiting it is the availability of raw materials to produce the higher income and the capacity to process it. But, that doesn’t mean that growth isn’t possible. It just means there are constraints. Growth will come back, only at a more moderate and sustainable level.

It will happen again, as it always has. We simply have to allow some time for it to come about, and we can allow for this adjustment not by panicking and setting off a retaliatory round of trade-repression measures.
 

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Ray Hendon

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This article has 14 comments:

  •  
    flatman
    Jul 10 09:01 AM
    Ok - I accept the theory. Its the timeframe that is important. How much time are we talking about ? I'm thinking 5 years. Thats a lot of stagnation and pain. During that time the standard of living in the US for the middle and lower classes will be declining. Our populist politicians are already blocking new free trade and will have even more power after the next election. Sounds like a recipe for the next depression.
  •  
    Fabien Hug
    Jul 10 09:18 AM
    One of the definition of economics is the allocation of LIMITED resources to UNLIMITED needs. Now that some big developing nations got a taste of consumer products, they are not going to stop. The pie may grow a little bit but not fast enough and we will have to share more of it.
  •  
    Mr T
    Jul 10 11:03 AM
    It isn't merely demand. Supply too will rise to accomodate, but that takes time. It is not the "below ground" resources that are bottlenecking, it's the above-ground.
  •  
    rayhendon
    Jul 10 11:44 AM
    I don't have a handle on the timeframe, at least in terms of competion. In economic proceses, things are rarely completed, anyway. Before one adjustmen is fully made, others begin. But, I don't think the U.S. will suffer as long as you think. With prices so high, the incentives to produce are high, so I think there will be some heroic efforts made to cash in on them--perhaps this will shorten the process.

    But I agree with the implications of flatman and fabian-the pie will grow, but our share will not be as big as it once was. This doesn't have to be such bad news, however. I think the pie wll grow a lot, given the incentives. In that case, a smaller share of a bigger pie may leave us in good shape--depending on how much it grows and how big our share turns out to be.

    Best wishes,

    Ray
  •  
    theinvesting
    speculator
    Jul 10 12:19 PM
    My Website
    The US is going to have problems for at least a couple of years, it has bad fundementals. That is why I'm short. China on the other hand has had a big decline but has great long-term fundementals. High saving. Over $1 trillion in reserves. Short the US-go long China.
  •  
    bbzz24
    Jul 10 12:58 PM
    ray,
    if you can afford it, please visit dubai or abu dhabi. you will get a handle what incentives there are to produce more of what they are already producing. as i see it: 0. they spend money on anything but productive assets.
    same applies to the u.s. as it hardly produces anything else but money.
    on the other hand china produces so much consumer goods that if they lose their external market they simply have to cut production and lay off 1/2 their workforce. japan does the same with industrial goods.
    there is no balance with regards to those countries and if they dont want to exchange depreciating paper for growth and employment there will be no trade. as of now it is mutually beneficial. if there is no trade between them they have to develop somewhat sustainable policies.
    do you see americans working real jobs that require skills and knowledge than just filling out paper documents or real estate agents? do you see japanese using their own machinery becuase there they have competitive advantage? do you see the chinese that barely make enough to feed themselves to just play with ipods and plastic toys?
    there is accute need for some balance of domestic investment: develop the sectors you are best at, but dont ditch everything else as it is necessary and use the tax system to redistribute wealth so you are not dependent on the mercy of others.
  •  
    RLoftus52876
    @yahoo.com
    Jul 10 01:02 PM
    I disagree on the long on China perspective. The Chinese economy is largely dependent on the US as a marketplace. Any downturn in retail consumption in the United States will eventually affect the Chinese.

    I agree with you that the US has bad fundamentals, I can't possibly go into all the explanations of why. I see a real shift coming in US consumerism that's going to tank a lot of business models based on the "Immediately isn't soon enough," or the "The best isn't good enough," consumer mentalities. The ultra wealthy will always have their toys, but right now is a very bad time to be a mid-range retailer like Kohl's or JC Penney.

    I think the real growth will be in alternative energy technologies, but before that can happen there's going to have to be more public pressure on municipalities that caved in to utility companies and enacted policies to limit or ban outright the installation of solar panels and residential windpower.

    There's a lot of change on the horizon, and I also think that we're going to see a lot of octopus-like dinosaurs collapse under the weight of their own management infrastructure in the next ten years. I think we're definitely heading for a new "Age of the Entrepreneur." If your rich and lazy today, chances are tomorrow you'll just be lazy.
  •  
    iThinkBig
    Jul 10 01:16 PM
    My Website
    I ran numbers in June 2007, the economy will shed 20% in the short and mid-term as it readjusts back to a Save and Invest economy.

    As many have figured out recently, there is no job creation to cushion the downward spiral. This is deflation we are in, not stagflation although the excess liquidity, market crash and oil shocks do feel a lot like the 1970's (right now, this will get far worse).

    Devaluing our dollar as monetary policy is a well documented remedy over hundreds of years (if not thousands going back to Romans who added other metals to there silver and gold coins) to avert public debt defaults. -20 GDP in June of 2007 was calculated, downward over a four year span. Market crash already happened in March, historically real fiscal pain felt 3 years afterward (similar: 1929 crash, 1987 black Tuesday, pain felt in 1933 and 1990). This deflation equations calculated then in June of 2007 was obviously before the massive oil shock which we have just started reeling from.

    Depression by 2011 but agree with other posters, we will recover quickly. The gridlock in Washington and bad governments on ruinous fiscal policy paths take time to slow down the momentum and reverse course. Let's hope the fiscal house of cards doesn't collapse completely, but that now depends to me on energy and job creation policy. In-between, much money can be purchasing deflated assets and holding them over a five year span but I suggest waiting until at least December of this year to deploy such a strategy. Have cash on hand, bullion and 30 days food and water supply.

    Me and business partner buying a place 50 miles from any major metro in October, first time in my life I was concerned to insulate my families risk in such a physical way. But America will go on. I am staying, much rebuilding will need to be done financially and politically. Very tempting to not leave the country, but this nation is home and some must defend it or we will see an emerging world order dominated by the Middle East and Russia. Not something I want to see...
  •  
    iThinkBig
    Jul 10 01:23 PM
    My Website
    To BBZZ24: There is a book named Investing in Dubai at your local book store. I have found it tremendously helpful in understanding the differences in culture and strategy to work with the GCC. They want to invest but besides the bigs, very little VC's have attempted to go there and create/secure monies for investing in our infrastucture here. Since Washington in there foolishness won't allow direct major investments, pooling start-ups and entrepenuars for them is the way to go. See ya over there!
  •  
    Zigg
    Jul 10 01:36 PM
    + governments (local,state,and federal) will likely be facing (worse) deficits... i'm not expecting capital gains/estate tax cuts to be renewed.
    + local governments will be in the unique position of increasing home valuations for tax purposes despite drops in real market pricing. certain local governments can only borrow to the extent of a % of real property valuations, so less valuation means less ability to borrow. if local government valuations drop, then the tax rate must proportionally increase to create the same stream of revenues, let alone increase to meet increased program/services costs.
  •  
    PastTense
    Jul 10 01:56 PM
    The situation is going to be a lot worse than you are suggesting: the reason is Peak Oil.

    Spend some time reading The Oil Drum:
    theoildrum.com
  •  
    huangjin
    Jul 10 02:30 PM
    I agree the thesis but not entirely with the conclusion. The economy always maximizes the old model and push it until it breaks. Since we have a (mostly) free economy, there is no model per se, just millions of people making individual decisions. The transition to a new model is painful, but also full of opportunity. Too many people are like an 1890s New Yorker looking at the city's growth and main method of transportation, and thinking, where are we going to put all the shit?

    Also, if everyone tries to get rich at the same time, it is the best situation of all because the greater the competition the greater (and faster) the improvement and the greater the prize. Necessity is the mother of invention.
  •  
    bender
    Jul 10 04:22 PM
    Well put, Ray. And to RLoftus: I agree that the real growth will be in the alternative energy sector. That’s where a decent slice of my income is going. Too bad there’s not an inverse fund for human population growth. That’s where all of my money would go.
  •  
    rayhendon
    Jul 10 10:03 PM
    I apprecate all the coments. I can see that there has already been much thought on this subject. A couple of specifics: bbzz24: don't assign the propensities of the gulf countries to the rest of the world. This part of the Middleast is, essentially, a one trick poney. They have oil, more oil, and, oil. Plus the distribution of inome from their oil deposints is not even. The reigning families control most of it, and the rest get little. This doesn't give the majority of the population much room to become entreprneurs. The can be expectd to continue producing oil because that is all they have.

    But in China, India and other developing nations, it's an entirely different story. They have resources beyond a single commodity, and they have a histoy of exploiting these advantages. So, I think that the response of the rest of the developing world will be substantially different than that of Arabia.

    There is not doubt in my mind that the future will be more competitive that it has been in the past. We must work harder to stay in the same place. But, America has such a great advantge in resources and experience, and in the willingness of its people to put their shoulders to the wheel, that I think we will do well in the competition. While we have been guilty of being lazy and fat, we are much more than that. Just watch and wait. You'll see.

    Best wishes,

    Ray

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