Few assets benefit in stagflation

A combination of inflation and slow growth rarely helps any asset class. We had almost a decade of this in the 1970s, and stock and bonds suffered miserably. Even commodities struggled to rise in real terms.

1970s - a miserable decade

OPEC hit the world with two oil price increases. In 1973, the price per barrel went from a few dollars to over ten dollars, and in 1979 from the low teens to over 30 dollars. The west was far more dependent on oil than today.

The oil price fed into just about all prices, and inflation went out of control. By 1980, it was around 10%. People were accustomed to cycles in the economy. Normally, inflation would only rise when the economy was doing nicely and it was the excess demand that pushed up prices. However, in the 70s, jobs were scarce as unemployment also headed towards 10% and so there was plenty of unused capacity in the economy. This was inflation plus stagnation, and they had a nice word for it: stagflation.

No one knew what to do about stagflation. Australia tried wage freezes. Unions were more powerful then, and tried to ensure their members' wages were maintained. In the UK, they had 'the winter of discontent' and things became so bad that they were ready for the dose of medicine called Thatcherism.

No easy answer to stagflation

However, what could the authorities have done? A rise in the price of oil is like a tax on the entire country. Just about everyone is going to be worse off.

Unfortunately, there is no easy policy the authorities can adopt to fight stagflation. The economic theory has done a lot for economic management in normal conditions. The greatest economist ever, John Maynard Keynes, told us what to do: increase and decrease the government budget to smooth out the economic cycles. When people are not spending, governments should do the spending for them, and borrow the money. How insane were governments to reduce, rather than increase, government spending in the Great Depression! On the other hand, if people are spending too much and the economy is overheating, governments should cut back.

Keynes did not really trust interest rates as an economic tool. One reason was that in a recession, an interest rate cut may not be enough to encourage overly pessimistic consumers and businesses to borrow and spend. You can only lead a horse to water. But again, in normal conditions, interest rates can be used very effectively. When inflation rises, a little tightening up of interest rates slows things down a little, and the inflation eases off. This method of controlling the economy has become even more important as politicians have hijacked the fiscal budget for politics, rather than economics.

The trouble with stagflation is that the authorities don't know whether to boost the economy or to slow it down. Trying to create jobs risks even higher inflation, and trying to solve the inflation problem makes the job situation even worse. So it is not clear what to do with the budget balance or with interest rates.

These problems for the economy and the policy makers are reflected in the markets, and there is nothing attractive to investors. All you can do is to stay in cash, and to sell the other markets.

The stagflation of the 1970s only really ended when the US Federal Reserve gave the economy a sharp dose of very high interest rates in the early 1980s, and allowed a recession. Hopefully, we will not get another decade like the 70s for a long time.