Stagnation vs. Sagflation

Goldman Sachs recently argued that the world economy may be entering a period of Stagnation. “During these episodes, GDP per capita growth hovers below 1 percent and is less volatile than usual. They are also characterized by low inflation, rising and sticky unemployment, stagnant home prices, and lower stock returns,” wrote Jose Ursua, an economist at Goldman Sachs.

Goldman Sachs appears to have described the current environment and applied a name to it, although they have not adequately explained the volatile commodity, debt, and equity prices. My problem with the argument is that the remedy appears very similar to what we've been trying for the past few decades. “Whether these countries manage to avoid a ‘Great Stagnation’ by a pick-up in the recovery is likely to depend on policy being able to restore confidence and putting in place reforms that can decisively jolt growth,” Goldman Sachs argues. I am assuming a "jolt" means stimulus in the form of lower taxes or more spending.

In my opinion, Goldman Sachs misses the underlying problem, which is structural in nature. Decades of activist fiscal and monetary policy to avoid economic slowdowns have produced a perverted economic environment. Inefficiencies have built up into bubbles and then burst, resulting is massive losses of investment and political structures set up to avoid further losses. An economy cannot allocate resources to capital destroying endeavors indefinitely, either due to the siren call of bubbles or politically protected segments. Eventually, the economic activity slows as investors and businesses earn diminishing returns on their investments. 

The US economy needs to go through a period of healing, in my opinion, which could prove painful for many. I believe confidence is restored by allowing poor investment decisions to fail, enabling the failure to be understood, and clearing the environment for healthy investments to take their place. The problem is that people are increasingly looking to the government to "fix it." I find it highly ironic that the capital markets, which tend to advocate less government intervention, are breathlessly anticipating a bailout in Europe and further Fed actions. For over 30 years we have been lowering taxes, legislating Keynesian stimulus spending, and providing ever more accommodating monetary policy. Asking for more government intervention is like a drug addict asking for another hit, it feels good initially but only leads to more pain.

Under my Sagflation theme I argue that fundamental deflationary pressures in the economy likely cause slow to negative growth. These deflationary pressures largely stem from the excessive debt to be serviced by governments and consumers. As a result of the debt burden there are deflationary pressures through government austerity measures, falling house prices, weak wages due to high unemployment, falling commodity prices, stronger dollar as other regions weaken, and eventually lower prices for goods and services as costs subside, competition intensifies, and technology advancements improve quality.

Offsetting the deflationary pressures, under my Sagflation theme, are overly active monetary and fiscal policies attempting to avoid deflation. These aggressive policies are more arbitrary, mostly temporary, and reactionary. By aggressively trying to stimulate the economy through tax decreases, spending increases, and monetary jolts, these policies result in more volatile prices (not less) as the economy swings from inflationary pressures back to deflationary pressures. Until the government addresses structural inefficiencies and markets clear the poor investment decisions over the past few decades, I believe we are stuck in an environment of low-to-negative growth and volatile prices.

What the US government should do, in my opinion, is focus on structural changes that enable efficient markets to operate. Reform the tax code, streamline regulations, and as much as possible remove the money from politics. The money flowing around DC creates conflicts of interest and encourages inefficient legal structures that favor one entity over another, to the detriment of society as a whole. The current argument between "no new taxes" and spending to stimulate the economy misses the real problem, in my opinion. I am not opposed to higher tax rates on the wealthy to fund longer-term stimulus spending. This is because tax rates on the wealthy are low by historical standards and the wealthy have generally benefited from the economic inefficiencies to a greater degree. Additionally, performing a thorough "reorganization" of the government that improves efficiency is likely overdue.

Goldman Sach's "Great Stagnation" is closer to identifying the problem, in my opinion, than "Stagflation," but is still off the mark. In my view, "Sagflation" explains the issues better and offers greater insight to make proper investment decisions.

In a deflationary period, which I believe we have been turning towards for much of 2011, I believe long-term treasuries tend to outperform, which the strong performance in my position in 30-year treasuries has supported. As inflation expectations decline the real interest rate improves on longer-term treasuries. In addition, in a deflationary world the economic landscape can look scary, in my view. Under these circumstances investors are looking for safe havens, of which treasuries rank near the top, in my view. For these reasons I have maintained my 30-year treasury position.