Recently, a dear friend of mine, an economist in Mexico, made an unpleasant prediction. “It’s back to the 1970s, baby. Stagflation and all that.” Oh goody. I am unfortunately old enough to remember just what that means.
“Highest inflation in forty years,” another friend, and not a partisan of President Biden, announced gleefully to me. Since this person, off to a fine start as a bankruptcy lawyer in New York, is just thirty four years old, I wonder if he realizes what he’s saying. Very likely good news for people in his business. But very bad news for the rest of us.
Why? The just concluded meeting of Central Bankers in Sintra, Portugal, has announced the era of low inflation is over. “The process is highly likely to involve some pain, but the worst pain would be from failing to address this high inflation and allowing it to become persistent,” said Jay Powell, chair of the Federal Reserve. And what “process” would that be. It’s called raising interest rates, which is one of the things central banks can do to fight inflation. Earlier this month, the Federal Reserve raised interest rates, specifically the Federal Funds rate, by 75 basis points. Is that a lot? Well, the Fed’s new “target range” is 1.5 to 1.75 percent. Basically, the Fed Funds rates is what banks charge each other to lend excess loanable funds. Forty years ago—41, to be exact, the rate was over 20 percent. 22.36 percent, to be exact. So if the Fed’s inflation fighting medicine is geared, Holy Smoke, to what was going on 40 years ago, 1.5 percent or so is peanuts, as in Jimmy Carter’s peanuts. You’ll remember President Carter farmed peanuts in Georgia before inflation and Ronald Reagan took him out. We got a long way to go if that’s where things are headed.
There are some uncomfortable similarities to those now-forgotten times. The Russians were in Afghanistan, Ukraine already being part of the Soviet Union. Commodity prices were headed up. The international economy had been disrupted by what economists call “supply shocks,” but these were a consequence of oil prices rising and not a virus like COVID-19. Still, things did get out of control. By 1979, inflation here had hit 13 percent and Jimmy Carter had brought in Paul Volcker to whip inflation now (WIN) (something Carter’s predecessor Gerald Ford had conspicuously failed to do). Mr Volcker put us and much of the world through a wringer, and the 1980s are remembered as a “lost decade” in some parts of the world, where rising interest rates combined with foreign loans delivered an economic knockout punch. It wasn’t pretty. Ask someone from Mexico or Peru, just for starters. Be prepared to hold their hand.
The short story is that rising interest rates kill demand by making the cost of borrowed money higher. So people stop buying things, people get tossed out of work, wage increases stop, production falls. You can overdo this medicine. Like you can cure high blood pressure by strangling the patient, but then there is no game at all. Right? You flatline, you’re dead, and high blood pressure is the least of your worries.
Now, why am I going on about this? Well, turns out that in the 1980s, household debt in America was around 50 percent of GDP. In other words, in total, as much as half of national income, more or less. In 2020, house debt was about 80 percent of GDP, or 60 percent higher. Ok, so what?
Well, two things. Back in those more innocent times, a lot of interest rates were fixed—not sovereign debt, like Mexico’s, they will tell you—so arguably, the full brunt of rising interest payments was somewhat mitigated. It’s complicated, so you’ll have to trust me. I had a student loan at 7 percent, so I was effectively paying minus 6 percent in 1980. The lender was, in effect, paying me.
But bankers learned, alas, and very few consumer rates today are fixed, including credit cards and a lot of mortgages. Which means no more free money if inflation rises. You’re going to feel the increase immediately.
The implication, it seems to me, is that if you thought the 1980s were tough, you ain’t seen nothing yet. Interest payments relative to income are going to be higher this time around, which means that belt-tightening is going to be a lot, well, tighter. You know all those property mavens who took seminars about how to get rich in real estate. They borrowed a lot of money. Ouch.
Like Yogi Berra said, supposedly, forecasting is hard when it involves the future. So I don’t make forecasts. But if I did, I’d say given all our other problems in the United States, what’s on the horizon may be worse than what we’ve seen in the past few years. I’m not an alarmist. But I can count. And I’m worried.