Why stagflation is coming

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By David R. Burton and Cesar Conda

Both the money supply and federal spending have increased at breathtaking rates over the past year, unprecedented in peacetime. The policy decisions made by the Federal Reserve Board and Congress virtually assure we will enter a period of 1970s-like stagflation.

The recovery, when it comes, will combine slow economic growth, unusually long un- and underemployment, stagnating real incomes, rising interest rates and inflation. There is little that policymakers, having made colossal mistakes, can do to prevent such an outcome. However, there are steps that can be taken to shorten the period of stagflation and return to an era of robust economic growth, good jobs and stable asset and consumer prices.

The money supply is measured several different ways. They all show alarming increases. The monetary base (coins, currency and bank reserves) has doubled over the past year. It is increasing at a rate 12 times the average since 1981. M1 (the monetary base plus checking deposits) increased last year by roughly 16 percent, a near record and three times faster than average since 1981. M2 (M1 plus most savings deposits and money market funds) increased 9 percent in the past 12 months (a rate more than 50 percent higher than the average since 1981).

The demand for money is relatively stable and generally increases in proportion with economic activity (although precautionary motives play a role). Given the huge increases in the money supply and credit, future inflation is virtually ensured. Money supply will outstrip money demand, and the excess money will cause prices to be bid up.

The prices of gold and other commodities provide real-time indicators of future inflation. They have been rising substantially for the past three to six months, depending on the commodity.

It is not certain, however, whether this price inflation will manifest in consumer prices or the asset markets (the stock and real estate markets) or both.

Equally alarming, fiscal 2009 federal outlays were $3,938 billion compared to $2,983 billion in fiscal 2008 - a 34 percent increase in one year. Federal spending has grown from 21 percent to 28.1 percent of gross domestic product in only one year. Only during the last three years of World War II has federal spending been a larger share of the economy.

These figures understate the degree to which federal spending and credit creation have increased because various federal entities have guaranteed something on the order of $10 trillion to $12 trillion in private debt.

Inflating asset prices in support of Wall Street, the banks and consumers who are upside-down on their mortgages is, presumably, a major, if unstated, goal of Fed policy. The Japanese proved in their "lost decade," however, that artificially propping up asset prices with cheap credit and government spending while failing to recognize losses and moving on is a recipe for stagnation.

Interest rates are low because of the massive credit and money creation. But as it dawns on investors that significant future inflation is virtually certain, long-term rates are starting to creep up. Long-term Treasury bond rates already have risen from 3.5 percent to 4.5 percent over the past eight weeks. They will continue to rise as investors demand larger premiums to compensate for inflation and the tax on purely inflationary gains.

The real measure of the federal economic footprint is not the tax burden, but the spending level. Right now, federal taxes barely pay for half of federal spending. It is frightening when one considers that the taxes paid by the taxpaying public would have to double to pay for the current level of spending.

The rest of the federal government's spending is paid for by borrowing (which is money not available to the private sector to spend or invest) or by creating money to buy federal bonds (which devalues everyone's assets and salaries with inflation). The dead-weight loss to the economy of a 34 percent increase in federal spending is quite large and will serve as a continuing drag on economic performance, as can be seen in the decades of poor performance in most European economies. Substantial George W. Bush-era spending increases, while not as dramatic as recent spending increases, are also part of the reason for lackluster economic performance over the past several years.

An economic train wreck is coming. Its cause is simple and straightforward: the breathtakingly bad monetary and fiscal policy during the past six to nine months - in other words, too much money and too much federal spending.

The first thing policymakers need to do is to stop doing harm. The Fed needs to immediately raise the federal funds target interest rate and slow money growth to normal levels. Congress needs to return federal spending to a more normal 19 percent to 23 percent of gross domestic product. It should reduce the U.S. corporate tax rate, currently the second-highest rate among industrialized nations, and, if possible, reform the tax system to promote work, savings and investment. Finally, it needs to control rather than exacerbate federal entitlement spending.

Instead, the Obama administration seems bent on doubling down and making a bad situation even worse with massive increases in business and individual taxes, nationalizing or taking control of major industries (including automakers, banks, insurance and health care), hidden but huge energy-cost increases in pursuit of the chimera of global warming and ever greater entitlement spending. The Congressional Budget Office recently estimated the Democrats' health reform plan would increase federal spending a further $1.3 trillion over 10 years.

Stagflation is baked in the cake. The question remains whether policymakers take the necessary steps to shorten the period of stagflation.

David R. Burton is a partner in the Argus Group, a Northern Virginia-based law and economics firm. Cesar Conda is a former economic and domestic policy adviser to Vice President Dick Cheney and to former Gov. Mitt Romney's 2008 presidential campaign.