Stagflation vs. Deflation

Spain faces stagflation risk, says Solbes

Spain has run up the world's second highest current account deficit during a decade of debt-fuelled growth and consumer spending is plunging now that households and firms face credit restrictions.

This somewhat proves the old adage. When in Spain, do as the Americans do. No wait. That's not it. When in America, do as the Romans do? No. When in Rome, do as the Romans do? Nevermind. Heck, just hand me a fiddle so I can play while our prosperity is burned.

Is the economy going back to the 70s?

Tim Bond at Barclays Capital put it bluntly. “We have no reason to expect that the inflation outcome over the next few years will be much different to the outcome in the 1970s.”

Surely there must be some good news.

“The good news is that it does not appear to be affecting wages yet. People tell me they are settling for no more than last year.”

That's the good news? Does that sound like good news for our many malls, restaurants, and auto dealerships? Higher wages are blamed for the stagflation of the 1970s. I'd just like a believer in this theory to explain why wages did not keep up with inflation in the 1970s then. Real wages peaked in January of 1973. The nastiest part of the stagflation didn't hit until the late 1970s though. Similarly, real inflation adjusted wages appear to be peaking yet again. If history is any guide and wages have anything to do with it at all, then the rising wages during the late 1990s have already done the damage. Right?

“Central banks and investors are fearful that inflation expectations will push up core prices and entrench the inflation problem,” he said. “This is a genuine fear, but our cyclical models of inflation suggest deflation [falling prices] is a bigger risk on a three to five-year view than seriously high inflation.”

I play both sides of this fence as you know. I wouldn't argue. Inflation is a genuine fear and so is deflation (we are seeing home price deflation). To me, that simply says we're VERY highly leveraged. What I'd really like to know is what inflation will be doing over the next 20+ years. I'm not optimistic. In any event, a deflationary outcome would be even more devastating to the global stock markets. It would also inspire Ben Bernanke to increase helicopter production as a way to ensure our future prosperity. Maybe that's why I am not optimistic.

It somewhat stinks being a bear. We have to choose a proper defense. What works during deflation kills us during stagflation (and vice versa). The bulls have it much easier. Just buy stocks. Use both hands. Load up. You simply can't lose.

I therefore have opted to play the relatively wimpy middleground with I-Bonds and TIPS. I won't take much damage if any during a deflationary crash and I will have at least some protection against inflation (although serious hyperinflation would wipe me out). In the words of Greenspan, there is no safe store of value.

This is not investment advice. If I had good investment advice, do you think I'd be sitting in I-Bonds and TIPS?