Stagflation: The Two-Headed Monster

...in a period of stagflation virtually every form of wealth is vulnerable.

By Citizen Correspondent Josh Sidman

Date Posted: 10/17/07

Reader Rating:

In previous articles, I discussed the possibility that the American economy may be headed for a rare and highly problematic situation in which we experience economic stagnation and erosion of the currency at the same time. In ordinary times, economic crises usually take one of two forms – i.e. either recession or inflation. Since these two phenomena normally spring from opposite causes, they rarely occur concurrently. However, if an extended period of bad economic decision-making is combined with unfavorable world conditions, it is possible to have both at the same time. This extremely destructive phenomenon is called stagflation. The unique challenge posed by this economic two-headed-monster is due to the fact that the cure for either of the two problems is likely to exacerbate the other, and vice versa.

Recent headlines seem to indicate that stagflation is increasingly likely. A Reuters news story today entitled "Housing Starts Skid, Inflation Flares" highlights the developing conundrum facing the financial authorities. Housing starts last month fell 10.2% to an annualized rate of 1.191 million. (A level of 1 million is consistent with past recessions.) Meanwhile, spiking prices in commodities and an accelerating increase in the Consumer Price Index indicate that inflation is a growing concern. The threat of inflation couldn't come at a worse time from the point of view of the Fed, since just when it would like to have a free hand to cut interest rates further in order to bail out the real estate market, rising prices and the eroding dollar may severely limit the extent to which monetary policy can be used to address the threat of recession.

So, what does all of this mean for the average Joe? How should one manage personal finances in such a tricky environment? Unfortunately, there are no easy answers, since in a period of stagflation virtually every form of wealth is vulnerable. Investing in the stock market (which is still near record-high levels) while the economy may be on the brink of recession is obviously not a good idea. On the other hand, conservative investments like bonds and other fixed-income instruments are problematic due to the falling value of the currency.

While I do not profess to be an expert on the subject of investing, I would like to offer three investment ideas that I think will outperform if stagflation becomes a reality. The first is one that I have discussed before – i.e. gold. Gold has historically been considered one of the safest stores of economic value.