Stagflation

What happens when the good times stop rolling? When the fat lady starts singing? When you shoot for double or nothing and come up short? What happens when, in brief, the shit hits the fan?

Want a sneak-preview? Dust off those old 1970s-era dictionaries. Look up “stagflation.” What does it mean? Well, here’s what it doesn’t mean. It has nothing to do with stags—of the male deer variety or the inebriated men-on-the-town-before-a-wedding type—and precious little to do with “flats,” “flatulence,” or any other word beginning with f-l-a-t. What it has an awful lot to do with is stagnation and inflation.

If you’re an economist, you’ll already know that when these two demons tango together, things get pretty bad pretty quick. If you’re not an economist, you might soon be getting an invitation to the dance.

A year or two back, when the housing market started to go all soft and squidgy, most real-estate agents pooh-poohed the notion of a bubble bursting. Couldn’t happen, they said. Wouldn’t happen. Too much was at stake. Too many people needed the bubble to keep floating along for it not to do so. Then it happened. And in Sacramento, it wasn’t just a matter of the bubble deflating slightly. Instead, it popped, leaving one hell of a mess in its wake. In many parts of the city, housing prices are down about 30 percent from their recent highs. The region has a higher percentage of homeowners in foreclosure than just about any other metro area in the country. We’re in the same club of shame, for Pete’s sake, as Detroit.

“Construction is a cyclical business, by its nature,” says 63-year-old David Lucchetti, CEO of the Sacramento-based company Pacific Coast Building Products, and Sacramento Metro Chamber’s recently named Sacramentan of the Year. “Every 10 years or so, we see a turndown in business. And we’re going through one now. I’d have to say, though, this cycle has been more severe, quicker, than in the past. We’re far beyond a recession right now in the residential construction business. It’s a severe recession, let’s say. It dropped off the table very quickly. I anticipate we’re here for at least a couple more years.”That was just the housing market. Sure, people who took out loans on stupid terms got burned. Sure, people who needed to sell quickly suddenly found their houses were worth less than they paid for them and had to rapidly familiarize themselves with nasty-sounding phrases like “negative equity.” Sure, an awful lot of greedy sub-prime mortgage sharks ended up taking a hit. Sure, a ton of construction employees have been laid off.

“It’s a general trend, but Sacramento was hit even harder, because of the [scale of the] construction industry,” says Ta-Chen Wang, an economic historian at Sacramento State University.

Sure, as more people foreclosed, the number of renters swelled, creating the possibility of long-term upward price pressures within a local rental market not regulated by rent controls. But, again, that was just housing. The rest of us, the ones lucky enough not to need to sell or refinance, those of us whose livelihoods were not tied to the construction industry, would be just fine. In fact, for would-be homebuyers, the lower costs represented a boon, an opportunity to get into a market no longer overheated.

For a level-headed businessman like Lucchetti, it was just a matter of riding out the bad times. “I happen to believe that in the long-term, everybody needs a house to live in, or an apartment, and as long as we continue to see growth in the population, our business will continue to grow. This is a desirable area to live.”

Then the banks started worrying about their money walking out the back door, and credit markets all over the world started to seize up—not just banks becoming cautious about lending money to would-be homebuyers, but getting all squirrelly when it came to lending to other financial institutions. The mechanisms that keep the system going began to gum up. … Lending institutions became impossible to put a value on. Insurance systems stopped working. Municipal and county bond payments suddenly skyrocketed. And so, the Federal Reserve began stepping in with one set of emergency measures after another: lowering the interest rate it charged banks for borrowing from the government, guaranteeing more and more bad debts, bailing out failing investment banks. Congress and the president stepped in with huge tax rebates designed to inject a shot of adrenaline into a faltering consumption economy. Entire new regulatory structures were dreamed up and brought to the fore of public discourse in a matter of months, even weeks.

And, since the wheels began coming off the financial system last August, each intervention has shored the markets up for a week or two … and then the slide has continued anew. Recession. That ugly word that serves to scare citizens of the mass-consumption society in much the same way stories of witches and goblins used to strike fear into the hearts of little children in bygone days. Recession. Nobody’s taking out those large home-equity loans anymore, the ones that mainly fueled the consumption binge of the past decade. People aren’t spending like they used to. And as a result, the economy’s not generating the job growth it needs to keep unemployment in check.

Over the past year, unemployment in the Sacramento region has increased from 5.9 percent to 6.4 percent, with industries such as furniture sales and other businesses dependent on a dynamic housing market skidding to a standstill. And, at least in theory, the economy hasn’t even formally entered a recession yet. When it does—as most economists now believe it will in the coming months—that unemployment number will likely go up quite a bit further.

“I don’t have any jobs going,” says 62-year-old Roseville contractor Van Berg. “It’s part of the business. It slows down, picks up; then it’ll slow down, pick up. It was worse back in the ’70s. There was another spell in the ’90s. It’s the same as back then. People aren’t willing to give up their money to do things. That’s a problem. People are unwilling to spend because they don’t know what the economy might do, and so they keep their money. They’re scared.”

Some Sacramento boosters believe the region will weather the storm relatively easily. Indeed, as recently as February, the Sacramento Metro Chamber’s Regional Economic Forum released an upbeat study predicting strong regional growth over the coming years, fueled largely by job growth in high-tech industries, including new green technologies. The six-county region, the report concluded, would outgrow all other areas of the state through at least 2014.

“[Sacramento is] well-positioned to take advantage of new opportunities, new products,” explains Doug Svensson, president of the Walnut Creek-based economic-forecasting company Applied Development Economics. “The innovation sector’s really strong in Sacramento: clean energy and green technology.”

“We have 90 companies, about 1,500 jobs in clean-green,” estimates John DiStasio, SMUD’s assistant general manager of energy delivery and co-captain of the Metro Chamber’s clean-green technology team. “Everything from renewable technologies to fuel cells. The reason Sacramento is uniquely positioned in this is that California is a leader nationally and internationally with energy policy.”

Already, DiStasio estimates, upwards of half-a-billion dollars is wrapped up in local clean-green companies, and that figure will likely grow considerably, owing to recently passed legislation to limit greenhouse-gas emissions and invest more in the development of solar-energy systems. “There’s going to be a lot of emphasis on cleaner transportation, cleaner energy technology,” DiStasio says. “A lot of companies want to locate here to be near the Capitol, the energy commission, UC Davis, the California lighting center, the California Fuel Cell Partnership.”

More generally, DiStasio believes people will continue to flock to the region for what he terms “a lot of livability factors.” Translation: It’s a nice place to live and, when it’s snowing in the rest of the country, it’s generally sunny here.

True … but then there’s the flipside.

In the more pessimistic scenario, the U.S. economy as a whole is heading for rocky times, the sort of once-in-a-generation events that throw all local economic calculations and predictions to the wind.

Here’s the rub. Normally, in a recession, one saving grace is that inflation stays low. After all, if there’s less money floating around, if there are less jobs available, wages and prices are unlikely to go up. But, for two reasons, that’s not happening this time around. The first reason is largely global in nature: As demand for food and oil grows globally, so commodities prices on the global markets head north. At the same time, as we buy more and more produce from China, we’re left vulnerable to inflationary pressures within the Chinese economy—which has been growing at breakneck speed for two decades now, and has a huge labor force that is finally starting to demand more reasonable wages in return for making the world’s low-end consumer goods.

The second reason is homegrown: In throwing everything into avoiding a domestic recession, using lower interest rates as a primary tool, the Fed is making the dollar—which has been struggling for several years now to maintain its value—increasingly unattractive to investors (since money invested in other currencies now generates a higher rate of interest). And as the dollar’s value slides, so imports, from Japanese cars through to Italian pasta, cost more, as do all dollar-priced commodities, prime among them oil.

And so, even as the economy teeters on the edge of recession, the cost of living is soaring. Wholesale inflation is now higher than at any time since the early 1980s. In January alone, wholesale prices rose 1 percent over the previous month. “We’ve got rising [materials] costs and falling sales prices,” explains Lucchetti. “If this is protracted, you’ll see substantial changes in the industry. Consolidation. Bankruptcies.”

And inflation isn’t just affecting the construction industry. The price of a gallon of gas is at an all-time record high. In many local gas stations, consumers are paying close to $3.80 for a gallon of regular unleaded—meaning businesses have to pay more to transport their produce, commutes from the suburbs are becoming evermore unaffordable and real estate in those suburbs ever-less desirable. Witness the collapse of property values in the once-ballyhooed Elk Grove. Food prices are galloping ahead. And, while retail prices in the rest of the economy are not rising so rapidly, it’s only a matter of time before producers start having to pass along their higher production costs to consumers.

The Fed’s making a bet that it can keep the economy functioning via an emergency low-interest rate policy without losing control over inflation. But if speculation or crisis—the shutdown of major oil pipelines, another Gulf Coast hurricane—drives energy prices even higher on the international markets, it’s a gamble that could go dramatically, suddenly, wrong.

“We’ve already seen rising prices, primarily in energy. A lot of the price pressure has been concentrated within limited areas,” argues Suzanne O’Keefe, associate professor of economics at Sac State and a member of the Sacramento Regional Research Institute. “But energy costs are parts of expenses for every production process. So you’d expect it will lead to higher prices—and it’s starting to. We’re seeing it in food and other areas.”

While producers will hold off as long as possible in raising prices, at some point, to avoid bankruptcy, they’ll have no choice—and when prices do go up, they might well jag sharply up. Think of a spring storing up energy and then releasing it all at once. There’s at least a possibility the American economy is doing the same with inflation, holding it back, holding it back … until finally, it bursts out in a rush of price hikes. Recent economic data suggests this might already be happening. When food and energy prices are factored into the inflation calculations, the rate of inflation in the first quarter of 2008 approached 7 percent.

Sure, banks are still offering relatively low mortgage rates—though the Fed’s rate cuts haven’t really fed through into the mortgage market that much; but nobody wants to lose money on a mortgage deal. If long-term inflation jags up above the rate of interest, banks—from the Federal Reserve on down—are going to jack up their interest rates to stay one step ahead of the game.

If inflation starts getting out of hand, says Bill Fike, president of the local bank Umpqua California and a man who has spent close to three decades working as a banker in Sacramento, “The first thing the Fed will do is raise rates. To stifle demand. So you won’t see interest rates go sky high. But could they [mortgage rates] go up to 8 percent? Sure. Right now, rates are 5 3/4, 6 percent, today. They could go up to 8 percent. Inflation isn’t going to help anybody, certainly.”

Enter boogeyman No. 2.

Peaking out from behind the nasty recession imagery is an even uglier spectacle. Stagflation. A brutal combination of a stagnant economy and an inflationary spiral. It happened once before in living memory, in the 1970s, and like now, the inflation was largely driven by escalating oil and food prices. Between March 1972 and March 1973, the cost of food staples soared, with eggs and wheat seeing increases of more than 100 percent in a single year. Today, 35 years on, food staples are once again seeing extraordinary price hikes. Corn prices, in particular, have soared, partly because more corn is being diverted into ethanol production, partly because investors have bought up crop futures as a hedge against the weakening dollar. Similarly, with oil, when OPEC flexed its muscles and cut supplies, prices went through the roof. Today, more because of excess demand than cutbacks in supply, prices are doing much the same.

Back in the 1970s, real income was eroded, and then eroded again, by several years of in-your-face inflation and escalating interest rates. The government distributed lapel pins reading “Whip Inflation Now: WIN,” and for several years, that empty sartorial gesture seemed about the best the politicians in D.C. could do to wage war against the rising prices. Wage and price controls, initiated by President Nixon, failed to rein in inflation. And, for the first time since World War II, consumers faced limits on how much gas they could buy and when they could buy it.Federal Reserve “beige book” summaries from those years paint a grim picture. Phrases like “sluggish,” “marked slowing in residential construction” and “weakening economic outlook” are peppered throughout the summaries for the decade. In the summer of 1975, the Federal Reserve Bank of San Francisco published a study titled “Western Energy and Growth,” in which it explained why California was so vulnerable to downturn. “The growth which brought California to its present eminence has created a treadmill effect,” the authors wrote, “which results in serious adjustment problems whenever the treadmill slows down. In even the mildest business recession, unemployment soars and other signs of stress appear.”

When John Griffing, one-time staff director of the California Senate Budget Committee, and currently director of the University of California Center Sacramento’s Public Service Programs, bought his first house in the city in 1980, the interest rate on his mortgage was 13.5 percent—and he considered himself lucky to get that. In December 1980, the prime rate reached 20.35 percent, about 8 percent higher than it had been only six months earlier, and the Federal Reserve reported that mortgage rates in some parts of the country had gone as high as 16 percent. In Boston, Chicago, Atlanta and San Francisco, mortgage lending had ground to a near standstill, the Fed reported, while in St. Louis, three out of every four mortgage applications were being rejected.

In a period of stagflation, explains Fike, “the higher inflation brings higher unemployment. Higher unemployment brings less productivity. Less productivity brings less income, less revenue. Less revenue is less investment. Profit margins get squeezed. The biggest thing people don’t like is uncertainty. If stagflation hit and people start to raise rates to try to halt it, it increases the period of uncertainty.”

Few are predicting that inflation will be allowed to get as out of control as it did in the 1970s, but even a moderate dose of higher-than-average inflation combined with economic slowdown—stagflation-lite, if you like—could have a brutal effect on the economy.

In normal times, a wealthy, powerful country can absorb inflation by generating new income sources to cover rising costs—not least through housing prices going up. But these aren’t normal times, and America’s housing market has largely collapsed—meaning that, for now anyway, ordinary people are going to have to simply watch as inflation eats away at their disposable income, which means they’ll be even more reluctant to spend, making it that much harder to jumpstart the economy again. Call it a psychology of inflation.

Until recently, the official line was that America wasn’t about to enter a recession. Now Federal Reserve chairman Ben Bernanke is acknowledging the numbers suggest the country’s heading into one.

A couple months back, Bernanke assured the country that America wasn’t on the edge of stagflation. That he felt the need to do so is, perhaps, the surest indication that this is, indeed, a very real risk. After all, we’re not at risk of suddenly all going bald or growing third legs, but Bernanke doesn’t waste any energy reassuring us of these obvious truths. You only devote time to strenuously denying something when, deep down, you’re more than a little worried about it. Perhaps, if out-of-control inflation numbers keep emerging over the coming months, he’ll end up backpedaling on this issue too. Recession? No way … oops, maybe way. Stagflation? Impossible … oops, watch out for that $4 gallon of gas.

Sacramento is a government town. Should we head into a stagflation era, that long-standing reliance on government as a pillar of the local economy could be either good or bad news. On the one hand, even though Gov. Schwarzenegger has called for 10 percent across-the-board cuts in state programs, generally government fires fewer people during a downturn than does the private sector, and those who are laid off tend to get better severance deals. After all, private companies come and go, but there’ll always be a need for government.

When stagflation hit in the 1970s, recall old-timers like international trade consultant Jock O’Connell, who has been around the halls of power for three decades, the city was semi-immunized from the unemployment impact. “There were a lot of layoffs going on in the private sector,” he remembers, spectacles dangling on a band down his chest, as he sips a large glass of malbec red wine and munches on olives at one of the new bars recently opened up in the downtown area. “But Sacramento was largely inoculated from that because of the state government. The region also had ample employment in the defense sector. McClellan Air Force Base and Mather Air Force Base were still in operation. The army depot was still flourishing, down south of Rancho Cordova. That was a major employer. So, between state government and federal government defense-related employment, the area was pretty much cushioned from a lot of the economic shocks going on.”

But, on the other hand, most state employees work under long-term union contracts, in which wage increases are mapped out for several years in advance. While their jobs are more protected than are professional jobs in the private sector, their wages are less flexible. If inflation spikes at a level far higher than that envisaged during the wage negotiations, government workers have little choice but to bite the bullet until the next contract negotiation. “State salaries tend to be more inflexible than the private sector,” argues Kristin van Gaasback, a monetary policy specialist at Sac State. “It’s possible you’ll see the disproportionate impact of inflation fall on the city.”

“The city will certainly feel an impact,” John Griffing calculates. “All the new restaurants and condos being built downtown, I presume a lot of their clients are tied into the state. And I think building more condos and apartments downtown, which has been going at a pretty good clip these past few years, will really stagnate. On the one side, it’s harder to borrow money; and on the other side, people are losing jobs.”

Today, though, the regional economy is far larger and more diverse than it was a generation ago. We’re still a government town, but there’s also an awful lot of private sector jobs in the region—and those jobs, particularly the lower-end ones, might well be buffeted during a slide into stagflation.

“The least of the worst scenarios is we end up neutral,” says O’Connell somewhat cryptically. And then he explains that he means the best of a bad bunch of outcomes is that the global inflationary pressures America faces will be canceled out by the collapse in consumer confidence that has followed in the wake of the housing crash, leading to us ultimately muddling along much as we did before. And the other options? Well, there’s stagflation. … Or, he says, angrily, “There’s a fairly good likelihood we’ll see economic stagnation that’s not accompanied by high rates of core inflation. Whether it gets as bad as the depression [of the 1970s] hinges upon the ability to use monetary or fiscal policy to counteract the effects of stagnation. And to a large extent, that rests on political will. The current administration doesn’t give a fuck. They’re just biding time till they leave office. For the middle class, we’re talking about a mild recession. For the working class and underclass, it’s a depression.”