The Big "S" is back

There is a very peculiar view that is emerging amongst lay people who study monetary issues but are not necessarily degreed in economics.  These are folks who make it their primary hobby to study what money is, how it works what it does, why it does it and how it does it and this week there is a small but growing voice that keeps asking a question that appears to be nonsensical on its surface.  Here is the question. 

Is it possible to have a situation where currency becomes increasingly expensive (high interest rates) and at the same time incredibly tight signaling an economic downturn with loss of productivity and resources?

In other words, is it possible to have a tightening monetary situation where money is incredibly expensive to obtain, resulting in less consumption due to the lack of monetary availability and at the same time, empty shelves at stores, decreased productivity and less consumption?  Before I try to speak somewhat intelligently on this issue, I’d like to define some words not only for your benefit but mine as well to make sure we are on the same page.  So there are various forms of monetary stability and they are usually defined by the increasing or decreasing of currency availability in the economy which results in inflation or deflation or stagflation.  Here are the definitions online about the three stages I just mentioned.

Deflation:   is defined as a decrease in the general price level of goods and services, which leads to an increase in the purchasing power of money. This phenomenon occurs when consumer and asset prices decline over time, often associated with a contraction in the supply of money and credit. Essentially, during deflation, you can buy more goods or services with the same amount of money, making money scarcer and more valuable.  

Ok, makes sense – so less money in the system means you can buy more stuff with your money even though you might have less off it because it has the effect of making goods and services cheaper by default.  If you have 1 Ferrari in the entire city and everyone wants your Ferrari and you want to trade it in for Chevys or Fords, you will have the option to get a lot of Chevys or Fords because you have the 1 thing everyone wants. 

Inflation: is the rate at which the value of a currency is falling and consequently the general level of prices for goods and services is rising. Inflation affects a sector, an industry, or a country’s entire economy. Inflation can be caused by different factors, such as increased demand, increased costs, or increased money supply. Inflation is sometimes classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.

In other words, if there is more money chasing the same good and services, the value of money goes down because there is a lot more of it but the economic output is not increased significantly to account for it so there is more money chasing the same amount of goods, therefore everything costs more.  This of course means that those who have a lot more money will be better off and be able to purchase a lot more stuff than those for example on a fixed income, who will now have to severely cut back on the products they get because their money buys a lot less than before. 

Stagflation: saving the best for the last.  Stagflation is the simultaneous appearance in an economy of slow growth, high unemployment, and rising prices.  Once thought by economists to be impossible as anything but a short-term problem, stagflation's appearance in the 1970s has had monetary officials on guard ever since.  Policy solutions for slow growth tend to worsen inflation, and vice versa. That makes stagflation hard to fight.  The U.S. faces its first long-term threat of stagflation in two generations after the Trump administration imposed significant new tariffs in 2025.

So what is stagflation and why is it so unusual?  Well, basically when there is a high unemployment, which staggers the economic output, people lack the income to buy things, while at the same time things cost way more than they did before is referred to as stagflation.  I am told that this is a nightmare scenario because unlike with inflation, where Central banks can increase interest rates and reign in runaway inflation, or increase the monetary supply by buying treasury bonds thereby increasing the monetary supply to stimulate economic growth, there is virtually nothing the FED can do to shake off the scourge of stagflation.  If they increase the monetary supply, they risk pushing prices even higher, causing a further contraction of the economy and even more layoffs.  If they constrict the monetary supply, they run the risk of pricing everything out of control and it reduces economic output thereby resulting in more layoffs.  Either way, they exacerbate the problem. 

That was widely the case in the 1970s where the OPEC embargo created a dramatic increase in energy prices with a corresponding reduction in economic output.  So, things cost more, and they were less available. That brings us to today’s scenario.  There is less money available for everything due to economic contraction, that money buys less goods and services than before due to higher priced items (things cost more), there are less goods and services available than before AND the cost of money is higher than before so even people who can borrow money, will probably not do so because the interest rates will be so much higher.  Money will be one of the things that will be super expensive going forward.  While we wait for countries to come to agreements about who will ship what to whom and for how much, and wait for the tariffs to be finally put to rest by the US Administration, we have to prepare for our budgets to be more lean, more restrictive and do with less than before.  What this also means is now is the time to perhaps say goodbye to variable rate loans.  If you have a loan that has a variable rate and you have the option to lock in a rate, I might do that if I were in that position because money will become more expensive down the line I think. 

This also means that as baby boomers are starting to retire and are facing a protracted medical issue in some cases, where they will have reduced benefits coming to the from the federal government, they will have no choice but to borrow money against their assets – namely houses they have paid off – at a high interest rate and those loans will probably not be paid back before the owners pass away.  So not only is the current generation in the prime of their working careers not getting ahead financially as much as previous generations had the opportunity to do so due to layoffs and economic contractions, but when their parents pass away they will be deprived of the assets they might be counting on to sustain them in their retirement years because those assets will revert back to the lending institutions that will own the notes on them. 

The time to cut back on unnecessary spending is now while it is possible if it is possible and start putting aside cash – if money becomes more expensive in the future, cash will be king once again.