How Sucking in Just the Right Places Can Stimulate Even the Limpest Economy: Part 2

In light of the current economy, I’ve decided to repost some articles originally written back in early and mid 2008. Enjoy…

“INFLATION!”
This is the third scariest word in any economy… falling behind only depression and recession respectively. What exactly is inflation and what makes this word the bane of any economically inclined individual.

I guess the best way to approach this is to start with an example. I’m sure you’ve encountered at least one elderly person that has wistfully repeated the following, “I remember when one dollar would get you 5 gallons of gas“, or “You used to be able to buy a loaf of bread for a nickel“. If you are like me you probably just thought… Whatever, and went right back to ignoring the old bastard.

Well as a kid, the idea of purchasing a pack of Wrigley’s Gum for 3 pennys sounds both novel and exciting, but it’s not until you reach adulthood that the true power of inflation starts to open your eyes.

In short, inflation is a general rise in the price of goods and services. Inflation in its most general terms effects an overall economy; however, sometimes it can effect specific sectors of the economy, which in turn will generally lead to a disagreement between different factions as to whether or not it even qualifies as “true inflation”… more on this later…

The obvious reason why people hate inflation is that it makes the dollar in your pocket “weak”. If the price of a 10 oz. can of corn changes from $0.90 to $1.00 over the course of a year, with no change in quality, then this price change represents inflation (source wikipedia.org). Think gasoline, homes, clothes, and food… items that you can’t live without. Economists estimate that under normal economic conditions, inflation rises by an average of 5% annually. This means that if you place $10,000 under your mattress on January 1st 2007; by January 1st 2008 your $10k will only have the purchasing power of $9,500.

Now let me state that I am not going to use this forum to A) confuse you with any economist lingo or B) bore you with any algebraic formulas. If you want to find out more in-depth info regarding this topic I’m sure you know how to use the wonderful tool known as “Google”. It is; however, necessary to have a working understand of how inflation operates so that you can understand how our current economic environment could potentially become an incubator for a vicious period of high inflation.

If you were paying attention you noticed that I said under “normal” economic conditions we experience 5% annual inflation. There are certain times that an economy will experience abnormal conditions that can cause the rate of inflation to skyrocket, but what are these conditions? Well as of July 2008 there are two major factors that could potentially lead to large rise in inflation. First is gasoline prices, and the second is food prices. Now as I mentioned earlier, from time to time different factions will have differing opinions on whether, at any given time, we may be heading towards a period of excessive inflation. These different factions will also argue about the root causes of the inflation.

Ben Bernanke and Warren Buffett represent two of the most influential voices in the current argument regarding our present economical conditions. In the red corner we have Warren Buffett. His view is that if we do not do something soon to rein in gas and food prices and also interest rates (I’ll explain the relationship between interest rates and inflation shortly) we will be saddled by extremely high levels of inflation.

In the blue corner we have Ben Bernanke. This gentleman happens to be at the head of the most powerful financial institution of the United States of America, and if you want to be realistic the most powerful financial institution in the world, The Federal Reserve (Fed) also known as the central banking system. Ben Bernanke’s view is that both high gasoline and commodity (food) prices are isolated from the rest of the economy at large, and therefore by themselves will not be sufficient drivers in a sharp rise in inflation.

As I’ve said many times, I view Warren Buffett as the single most credible source when it involves anything financial; I guess being the wealthiest man in the galaxy just earns you a certain respect when it comes to money… I do however tend to agree with Ben Bernanke’s inflation argument. Basically Big Ben is saying that we do not need to “press the panic button” yet, because although we are experiencing record high prices in gas and food, another area that has traditionally lead to a rise in prices is experiencing a fire sale of sorts… HOUSING!

I’m sure you remember way back in 2006 when people were willing to buy a house for 20%, 30%, even 50% more than it was worth. Shortly thereafter we experienced a crash in the housing market that took several areas of the economy down the sh*tter with it. This event has had a cooling effect on the economy at large, and for the latter part of 2007 and early part of 2008 was the only thing on people’s minds. Then along came super high gas and food prices and all of a sudden investors, economists, and members of our government had a new monster to keep an eye on, and this is exactly what Ben Bernanke is currently doing.

You see, the Fed does have a powerful weapon in the war against inflation, and as gas prices and the price of commodities (corn, rice, and soy) stay at record levels it may have to unsheathe this “weapon”. The weapon I’m referring to is interest rates.

When an economy grows too fast, the price of good and services start rise. If you think about it, it makes sense. People are making more money; therefore, they have more to spend. People have more to spend, so businesses increase production and raise the cost of their goods. Because businesses are increasing their production they need to hire more workers and so they pay them more money to attract them faster. Those new employees have money to spend and the cycle goes on and on. Eventually; however, this cycle will lead to increases in inflation (the rising price of good and services).

Since businesses fuel their growth with lines of credit (money borrowed from the bank), the lower the interest rates are, the cheaper it is for businesses to fund their expansion, and so the business growth, and consequently the inflationary cycle, continues unchecked. When the fed starts to see this cycle getting out of control they raise interest rates, which is the rate at which “normal” banks borrow money from the fed. When the Feds raise their rates normal banks won’t want to lose their margins and so they also raise their rates, and all of a sudden businesses borrowing slows because they don’t want to pay high interest rates on their borrowed money; this causes the economy to slow down. So if you think about it, the main purpose of a central bank is to artificially spur or tide the growth of an economy, and inject liquidity (cash) whenever necessary.

If the American economy was not currently experiencing a recession brought on by the housing and credit market, I’m sure the Fed would have already moved quickly to raise interest rates to levels high enough to stave off potential inflation caused by food and gas prices. However, since the overall economy is doing so poorly, Ben Bernanke and co are afraid that if they increase interest rates from their current low levels they will force a slowdown in an already sh*tty market, and it is here that Ben’s argument starts to make a lot of sense.

Recession + high commodity and gas prices

Guess what, there is another animal lurking in the wings that could potentially combine our existing recession (despite what the beer drinker in Washington claim) with the potential for high inflation (there is still no concrete proof that we will even experience high inflation) to really make for a rough economic environment, and I think that this, more than just inflation, is what Mr. Bernanke is focused on.

The former head of the Federal Reserve, Alan Greenspan, has been speaking out loudly about the phenomenon called Stagflation (a stagnant economy coupled with rising inflation) for over a year now. You see, if you go back to disagreement between Ben Bernanke and Warren Buffett you will find that they both may be correct.

Ben is saying that the housing and credit market wrecked our economy and we can’t have run-away or even high inflation because businesses can’t afford to raise the price of their goods, and he’s correct. At the moment people are having enough trouble affording even basic necessities at their current prices. On the other hand Warren is saying rising gasoline and commodity prices are effecting other areas of our economy and causing an artificial increase in the cost of goods, and he’s also correct. Examples of this artificial increase in the cost of goods can be seen in – plastics because they are petroleum based (you may notice that soda bottles are thinner and have smaller caps now), and corn, soy, and rice which all cost a lot more in the grocery store now.

So to put it in a nutshell, our economy is stuck between the proverbial rock and a hard place. At the moment the fed actually has its hands tied. Any attempt to jump-start our economy will have long term effects in other seen and unforeseen areas. Raising interest rates will slow an already slow economy. Lowering interest rates will potentially fuel inflation, and at the moment would do little to grow the economy. Pouring a bunch of cash into the banking system will also fuel inflation and banks are hardly eager to lend money at the moment, especially since many are fighting to stay liquid (see IndyMac). So, although it sounds a little silly to say it, at the moment the Fed’s best solution may be to adopt a wait-and-see mentality. Eventually the slow market will correct itself and at that point the Fed will be able to focus on controlling inflation. Unfortunately for the time being average Americans are going to continue to feel a financial pinch due to gasoline and food prices.

The other day, while I was standing in line at the gas station, some guy was telling me how it just cost him $75 to fill up his mid-sized car. I just stood their nodding my head listening to him. Then with a wistful smile across his face, and his eyes half glazed-over he said, almost to himself, “I remember when it used to cost me only $35 to fill up my car”. The irony is, I couldn’t ignore what this old bastard was saying because I was thinking the same thing…

max

Originally written by Max in 2008

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