Guest Speaker: Joseph E. Stiglitz, Stagflation Redux
Americans are being bombarded with bad economic news. Gasoline prices have hit $4 a gallon in some places, food prices are soaring, and there are increasing worries about inflation. Meanwhile, given the slowdown in job growth, the credit squeeze, the bailout of Bear Stearns, and tales of more than two million foreclosures expected in the next year, there are also increasing worries about recession.
Those of you who studied economics in the past quarter of a century may be puzzled: When the economy sputters and the unemployment rate goes up, isn't inflation supposed to go down? The Federal Reserve Bank is supposed to carefully balance the two. But if we get a big dose of both inflation and unemployment at the same time, then what?
This is not the first time the country has faced this unpleasant situation. Back in the 1970s, the U.S. and the world first faced inflation combined with stagnation, an unexpected economic condition that was dubbed stagflation. Economists back then talked of the misery index, the sum of the unemployment rate and the inflation rate. By 1975, the index hit 17.68. Under President Bill Clinton, the index fell to 6.05, the lowest it had been since 1956.
Some time ago, I predicted that 2008 would be marked by the return of stagflation, and unfortunately, my prognosis seems to have been correct. Unemployment in February 2008 stood at 4.8 percent and inflation at 4.03 percent, meaning the index was a moderate 8.83. First-quarter jobs reports pointed to rising unemployment, however, and though inflation may not return to the double-digit levels of 30 years ago, it is likely to hit a level not seen in years.
This bout of stagflation, like the previous, is largely related to imported inflation. The price of oil contributed to our economic woes in the 1970s, just as it does today. This year, even when one adjusts for inflation, oil prices have reached an all-time high. And unlike the 1970s' inflation, today's version is also being driven by soaring prices worldwide for a range of commodities, including, importantly, food. The prices of rice and other grains have reached roughly the highest levels in a quarter of a century.
If it is true that misery loves company, then we can take comfort in the fact that everyone around the world is in the same situation. In fact, inflation rates are soaring in developing countries, where food and fuel prices loom much larger in the lives of ordinary people. Inflation in China, for example, is above 8 percent.
When inflation is primarily imported, policymakers are stuck between a rock and a hard place. Here in the U.S., prices are not rising naturally -- that is, not because labor markets are too tight or because the demand for certain goods exceeds supply. As a result, inflation targeting, so fashionable among the world's central bankers, gets policymakers into trouble. If the Fed lowers interest rates, it risks making inflation worse. But if it raises rates, it risks making the recession worse. In a period of stagflation, the Fed and other central banks should adopt the economic version of the ancient Latin dictum: First, do no harm.
The burden for righting the economy thus shifts to fiscal policy, but I believe that the stimulus package Congress passed in February was too little, too late -- and badly designed. Plus, the huge deficits we ran up even before the downturn -- partly attributable to the war in Iraq -- have reduced the room to maneuver. Money spent on contractors in Iraq just doesn't help the American economy very much.
These are the economic realities entrepreneurs will have to deal with in the months ahead. For most businesses, the dominant concern will be the stagnation component of stagflation -- that is, the slowing of sales. Unless you have anticipated this, you will probably face excess capacity and the buildup of inventory. Financing this slackness in your organization in this downturn may prove particularly difficult and expensive, as the unfolding credit crunch reflects a weakening of the nation's banking system that will probably get worse before it gets better.
Data on the extent of cutbacks in credit are hard to come by, so the outlines of the current crunch are not yet clear. But because they often have fewer financing options, small businesses are likely to feel the pinch the most. If you are among the many American business owners fortunate enough to be sitting on high levels of liquidity, you will want to husband these resources, as your banker may be unwilling or unable to assist you if conditions deteriorate more rapidly than expected.
At best, credit availability appears to be erratic. Banks are reassessing their balance sheets and exposure to risk. At worst, even those businesses that thought they were on a sound footing may find themselves facing difficulties, as many lenders look for clauses in the fine print of agreements that will allow them to retract a commitment they would rather not honor. This makes it all the more important for businesses to monitor inventories and reshape product lines. Consumers will, for instance, be more careful about what they buy -- purchasing fewer luxuries, for example -- and smart businesses will anticipate this change in spending habits.
One of the hardest decisions in any downturn involves personnel. It has become fashionable for executives to immediately get tough, laying off workers as soon as they are not needed and writing down losses as soon as they occur. These strategies may placate your investors and bolster your financial position in the short term, but I believe they are pennywise and pound foolish. Though it sounds cliché, a company's most important resource is its people. Investments in people pay off. Treating workers as if they were simply disposable commodities undermines morale and in the long run leads to a loss of productivity.
Similarly, in the face of an economic downturn, many businesses cut back on research and development. This also is shortsighted, for it undermines the foundations of growth. Don't let general fears set off by stagflation force you into unnecessary cutbacks. Keep an eye on long-term profitability.
Managing the inflation part of stagflation requires a separate strategy. It has been a long time since the country has faced even moderate levels of inflation, and some of the problems it poses -- and opportunities it presents -- may have been forgotten.
As inflation increases, so does the uncertainty about prices. Seriously consider buying insurance against future price changes. You may be tempted to speculate on price swings, but I would advise against this. Speculation is fine for those who specialize in following price movements and who can invest heavily in acquiring information. They typically do far better than amateurs. For the rest of us, speculation is an easy way to get burned. Hedge instead of speculating -- and focus on your core business activities.
Inflation also presents special problems in terms of accounting, and those who understand those problems can reduce their tax liabilities significantly. Today, most businesses use last-in-first-out, or LIFO, accounting, which subtracts the cost of the latest widget you put in inventory from the cost of the last widget you sold in order to calculate gross profit. Some companies, however, still use first-in-first-out, or FIFO, accounting, which subtracts the cost of the oldest widget in your inventory from the cost of the last widget you sold. In a period of rapid inflation, when the price of widgets is probably on the rise, FIFO companies will appear to be selling their widgets at much higher profit margins than LIFO companies, and their tax liability will be higher as a result. So if you haven't yet made the switch to LIFO accounting, now is the time to do so.
Finally, for those companies that can gain access to money, inflationary periods are often good times to take on short-term debt, if the companies can afford the interest payments, and invest in bonds and Treasury bills. Thanks to inflation, returns and interest rates will rise in value at roughly the same amount. But the increased interest rates are tax deductible, while capital gains will be taxed at a lower tax rate. Thus, an investment that yields even modest gains will produce an outsize real return.
I realize that some of this may be hard to follow. But stagflationary times are complicated; they present business owners with scenarios they won't encounter in more predictable economic moments. The important lesson in managing inflation is not to be deceived. Take into account that the yardstick by which you measure the value of assets -- of people, of R&D, and of inventories -- is constantly changing. By focusing on the real value of assets, you can survive the elements and, indeed, position your company to flourish when the economy finally turns around.
Joseph E. Stiglitz is the co-author, with Linda J. Bilmes, of The Three Trillion Dollar War: The True Cost of the Iraq Conflict (W.W. Norton, 2008). The winner of the 2001 Nobel Memorial Prize in Economics, he chairs the Committee on Global Thought at Columbia University, where he is a professor.