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Stagflation – the once and future King?

February 24, 2011

With Oil spiking, and Libia blowing up pipelines, is stagflation for the U.S. the inevetible next step?  No, but it is very, very possible.  In the world of theories about what might happen over the next year, Stagflation is a decent one.

One of the causes of Stagflation is the relationship between Lebig’s Law and oil. When we have a supply shock in that limiting resource, there is a potential for Stagflation.  There usually isn’t any good way to substitute out of oil – that is why it is limiting.  So a shock in supply for this oil causes a spike in the price of oil relative to other prices.  This single good must by definition get much more expensive relative to other goods.

Many people think of this as a tax.  I do too – I published the math in another forum in July of last year, and have a detailed model on how much oil prices impact the economy.  I agree with DB on the magnitude of the impact of price changes in oil.

Oil is special in that it causes price increases in a host of related products.  Nearly everything has transportation costs.  Because most of the basic stuff that we buy has significant transportation costs, thats where the ‘flation’ part of stagflation comes in.

But the Stag part comes in from the parts of the economy that are facing price cuts, but the goods cannot be made for that cost.  I wrote about a very similar idea in a post a while back:

But in the $100 total world, if the car gets more valuable, then everything else gets less valuable. Should my food be worth less because my car is worth more? But what if that other good cannot be produced at for profit at $30? Then, the world stays the same and no innovation happens.  We do not get a better car.

The case of stagflation is very similar to this example.  When oil goes up in value, there is simply less money to be paid for other goods and services.  However, some of these goods cannot be made in a profitable manner at the new, lower price level.

So what happens? Some people get laid off and dont’ get their jobs back.  Other products can be made from cheaper stuff and sold at the same price. Many goods go up in price to cover the embedded cost of oil.  There is lots of uncertainty about future economic prospects, so few businesses expand.

Welcome to Stagflation!  All of this because of a supply shock in limiting good, oil.

Oops!  Just realized I didn’t give my reasons for not liking the Stagflation scenario.  Guess what – they don’t matter!  Stagflation in the U.S. and Europe is a reasonable possibility, and you should prepare a trading scenario for Stagflation.  I am!

If you’ve ever played the game StarCraft, you’ll be very aware of the practical implementation of Lebig’s Law.  The game is resource and economic management.  You need to mine 2 different types of minerals to be able to build your forces.  To construct these forces takes time, and they can only be built at specific buildings that can be constraints. Your forces are then up against other forces that have different strengths and weaknesses.   It’s managing a mini economy in real time!  Fun stuff.



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