Thursday, October 13, 2005


Last Year it was the D Word.
Could it be the S or the I Word Next Year?

2004 was the year of the D, word. Deflation. The Fed Funds rate was 1%, inflation was bopping in at around 2%, and interest rate monitoring dudes and dudettes were raising the ugly prospect of deflation, or negative inflation.

Deflation is not a good word. Profits fall, growth stalls, and monetary authorities have no real tools left. It would be left to the spending authority, the US government, to induce stimulus through more deficit spending.

Then there is another other word. The S word.[i] Stagflation, that confounding condition of the 1970s. Stagflation was the somewhat conumdrous condition of both high inflation AND slow economic growth. Many economists, prior to stagflation, believed high inflation and slow economic growth were incompatible. The then-current Keynesian economic belief was that inflation was a condition of a well-managed stimulated economy and that only a well-managed stimulated economy could produce inflation. If the economy was growing too slowly, just stimulate it. If the economy was overheated, withdraw the stimulus. Stimulus, or lack of it, was the switch that ran the economy. Growth was the product. Inflation the byproduct. Simple. Or so it seemed until the 1970s.


Then came the 1980s and the monetarists. Paul Vohlker, Milton Friedman, and the other intellectual descendants of Friedrich Hayek. They correctly saw inflation as a generally monetary event, or, in the language of economists, an endogenous event. (“Endogenous” means from inside the system), as opposed to an exogenous event. (“Exogenous” means from outside the system.) The monetarists determined that there was too much liquidity in the economy. This inflation-causing liquidity could only be checked by constricting the monetary supply. Monetarist constrictions worked and inflation has generally been contained since the early 1980s.


The Author is an inveterate internationalist. He will not collude with the Nativist[iv] chorus that China (and WalMart?) are draining the American economy. But he does recognize the immense economic power that China exercises. The Author recently read an article entitled “Are we at the start of a trend rise in global interest rates?” by Rodney Dickens, Head of Research for ASB Bank, New Zealand. Dickens states in the article that the Chinese economy had important effects upon both deflationary pressures in the first few years of this century and the current commodity price increases. [v]

Dickens states that from mid-2001 to mid-2004, low levels of global capacity utilization brought fears of global deflation. At that time, booming Chinese production and associated cheap Chinese costs of production played a part in this spare capacity and deflation story”[vi]


Global commodity prices are currently at high levels. Dickens notes that global utilization is behind this increase in commodity prices. Greater demand for commodities produces higher prices. And growth in Chinese output and increases in consumer spending in China help fuel the increase in commodity prices. So in effect, notes Dickens, the Chinese economy has “been playing a part in keeping down global inflation by increasing supply, especially increasing the stock of productive capacity around the world, [and] it is now starting to play an important part in fueling world demand.”[vii]

Dickens concludes with this troubling assertion. “The extent of the rise in commodity prices in recent years rings warning bells about the more general inflationary implications of the stronger demand.”[viii]

In an upcoming post the Author will address some ways to profit from rising commodity prices.


[i] No, not the S**t word, although Stagflation sure felt like S**t. The Author does not use vulgar words in this blog and his Newsletter. Of course he will make sly references to them, but vulgarity is a line of decorum the Author does not wish to cross in his non-fiction writing. The Desert of the Real is a discursive space and a PG rated space. And the Author’s dad has a PC and reads the Desert of the Real Post.
[ii] The first monetarist leader in a western democracy was not a man, but Margaret Thatcher, the Tory Prime Minister of Great Britain. Thatcher, also called “The Iron Lady” and “Mag the Hag”, was the Prime Minister from 1979 to 1990. In 1990 she was dumped by her own party for John Major. In 1979 Thatcher embarked upon a policy of privatization of public industries, tax cuts, deregulation, and a monetarist central banking policy. She turns 80 on today, on October 13th. Happy Birthday.
[iii] As the Author states in the Header, 1970s cinema is always fair game in the Desert of the Real.
[iv] American Nativism is a crude and perpetual feature of the political landscape. In the excellent but violent film “The Gangs of New York”, the Nativists were led by Daniel Day Lewis’ character, Bill ”The Butcher” Cutting. Cutting was based on a real historical figure, William “Bill the Butcher” Poole. These Nativists resented Irish Immigrants and opposed the Civil War Draft on racist grounds.

And yesterday the Author saw an interesting factoid in the “On this Day in History” section of the newspaper. On October 11, 1890, the Daughters of the American Revolution was founded (DAR). The Author, in a more naïve time in his life, believed that the DAR was formed to honor the sacrifices of their ancestors in the American Revolution. Instead, the DAR was probably formed in 1890 to differentiate Nativists from the waves of immigrants from Italy and Eastern Europe, those “huddled masses” that only a decade earlier had been welcomed with a message on the Statue of Liberty. We must never forget that it is the diversity and energy of immigrants that makes this country vibrant. See the Author’s post of September 24, 2005, “Americans on Dopamine”.
[v] Mr. Dickens article is reprinted in the “Out of the Box” newsletter from John Mauldin of Investors Insights. The link to Mr. Mauldin’s site is
[vi] Dickens, “Are we at the start of a trend rise in global interest rates?”
[vii] Dickens.
[viii] Dickens. This statement conflicts with the Author’s position that inflation is mainly a monetary event. There is no doubt that higher commodity prices will raise the cost of value-added goods that contain those commodities. The real inflationary question is whether the government will fuel liquidity or contain it. If the profligate US Congress and the President throw more deficit spending at hurricane recovery (and everything else) and continue their tax-cutting policy, then inflation WILL result. But if Washington can employ fiscal discipline (the Author is really trying to say this with a straight face), then the means-reverting mechanism of the commodity markets will take effect, lowering demand and in turn, commodity prices.

Case closer to home. New Mexico politicians are lining up in front of the news cameras pitching gasoline tax rebates or suspensions in gas taxes to “ease the pain” of high fuel prices. The Author recognizes that the pain is real for some people, just a hangnail for others. But this pain is the market in operation. It must hurt. It is the pain of learning a good lesson. Americans must respond to these prices by changing their behavior and entrepreneurs must be incentivized to find alternatives to high fuel consumption. (And the environment must be protected!) If there were another way, the Author would like to hear it. Really. The Author welcomes well-reasoned and constructive criticism. But no ranting. The Desert of the Real is hot enough. No flames needed.