Inflationary Recessions, Deflationary Recessions (and ‘Flationary Recessions)
January 10, 2007
First of all, let’s remember that the terms Inflation and Deflation refer to monetary conditions, in particular changes in the value of currencies, which is most directly represented in changes in the amount of currency necessary to buy an ounce of gold. A recession is of course a period of poor economic performance, typified by unemployment. As we will see, there are a variety of economic problems — even disasters — that don’t seem to qualify as recessions because everyone is working.
This note was inspired by a series of talks with a friend of mine. He was asking — did falling commodity prices indicate a coming recession? These days, falling commodity prices seem to primarily represent changes in Goldman Sachs’ proprietary commodity indices, which are followed by a large number of institutional “index” investors. GS recently cut its crude oil weighting in half, prompting a wave of automatic liquidation by index followers. (They pulled the same stunt this summer with natural gas.) First of all, what are “commodity prices”? This usually means some commodity index, which is usually heavily weighted in energy and precious metals. Besides oil and gold, and now copper, “commodities” have pretty much been on a tear to the upside, with enormous gains for nickel, zinc, lead, tin, wheat, corn, and so forth. They have been a bit weaker of late but the downturn is hardly noticeable within the context of their skyward launch.
But back to my point: all of the recessions since 1980 have taken place in an environment of monetary deflation/disinflation. The recessions didn’t cause the deflation — more likely the other way around, aggressively tight monetary policies, by Volcker in 1980-81 (leading up to 1982) and Greenspan in 1988 (leading up to 1990) created deflationary/disinflationary monetary conditions. The dollar rise of 1997-98 was, I believe, caused largely by the capital gains tax cut of 1997. Anyway, the graph below pretty much sums up the picture:
You don’t really need to be Sherlock Holmes to notice a bit of a connection there, between monetary conditions (represented by the gold price) and commodity prices. If you squint, you might notice that monetary conditions (gold) lead commodity prices, by about a year, which is about what one would expect. You will notice that the three major recession since 1980 — in 1982, 1990 and 2001 — are during periods of a below-average gold price (i.e., stronger than average dollar value), or disinflation/deflation. There was also a period in 1985 when commodity prices collapsed but the economy was booming. The same was true in 1999-2000. Funny how nobody was going on about “Dr. Copper” when it was below $1.00 in 1999.
Thus, everyone’s experience of recessions has been formed during these mildly deflationary periods. The deflation wasn’t caused by the recession, but it probably added to it in some way, increasing debt default rates for example. (We will have more on default rates in the future.) Correspondingly, the recovery periods following recessions have tended to be mildly inflationary/reflationary.
However, there were also two (I would claim) inflationary recessions as well — in 1973-74 and the late 1970s. Actually, the late 1970s doesn’t count as a recession. Actually, the “official” GDP growth rate was quite good. However, anyone living at the time understood that the inflation was getting quite disastrous, as the dollar’s value fell by a factor of 8x from $100/oz. in 1976 to $800/oz. in early 1980.
During the other inflationary recession, in 1973-74, of course commodity prices soared as the dollar’s value collapsed. The dollar fell from $35/oz. in 1970 to $200/oz. in 1974, a sixfold decline in value. Indeed, the recession was blamed on this explosion in commodity prices, especially the price of crude oil! And where was Dr. Copper? Soaring somewhere in the stratosphere. Then, in 1975-1976, the dollar made a recovery, commodity prices fell, and the economy recovered.
My conclusion: if the dollar’s value falls (as shown by the number of dollars required to buy an ounce of gold), then commodity prices tend to follow. If the dollar’s value rises, commodity prices tend to fall. There is a very close relationship there. However, there doesn’t seem to be much relationship with recession, per se. (Actually there is, but you have to look closer. We will at some point.)
While it is largely true that the 1973-74 recession was caused by monetary inflation, the 1977-79 period is very interesting because, although there was terrible inflation and commodity prices soared, there wasn’t a recession until Paul Volcker got busy in the early 1980s. The reason that Paul Volcker was installed at the Fed was the growing concern, bordering on panic, that the dollar was going to spiral into oblivion and take pretty much all the world’s currencies with it in a global hyperinflation. Pretty heady stuff. But, there wasn’t a recession! People didn’t lose their jobs, they didn’t stop shopping, and in fact there was quite a debt and housing boom going on (since people learned you could buy real assets with phony money). The point is, in an inflation you might not get the kind of bankruptcy/default/unemployment recession that we have become accustomed to in the 1980-present period. Indeed, in the German hyperinflation of the early 1920s, to take the most absurd situation imaginable, unemployment was very low– under 2% — and you can be sure nobody was defaulting on their loans. When you can sell a loaf of bread for a wheelbarrow full of money, you can certainly make the payments on your pre-inflation mortgage. Buying bread — now that was the problem, and since your savings had been obliterated along with your debts, you had to work!
What about when the dollar is stable, i.e. pegged to gold? That was the case in the 1950s and 1960s under the Bretton Woods gold standard arrangement. Take a look:
It appears that Dr. Copper has left the building. That index is about as pancake-flat as any economic series you’ll ever find. Now, the NBER dates several recessions during the period, at 1949, 1954, 1958, 1961, and 1970. Also, the US was a greater portion of the world economy at the time, so presumably the US economy would have a greater effect than today on world commodity prices. (Later we will look at copper specifically — very interesting!) You could say these were ‘flationary recessions, which took place when monetary conditions were neither inflationary nor deflationary.
There is considerable inflation today but not enough yet, in my opinion, to completely negate the stupendous buildup of debt, particularly mortgage debt, that would otherwise head into default in a recession. Indeed, the subprime problems now appearing — they appear ready to cascade — bear this out. At the same time, however, the inflation is helping keep the game going longer than anyone accustomed to the deflationary 1980s-1990s recessions could have believed. I think the eventual — and by that I mean within two years — result will be rather serious inflation, but until then it appears there will be many twists and turns.