Stagflation and the Economy

Once upon a time, Keynesian economists believed that there was a trade off between inflation and unemployment. "Too much" employment, they believed, caused high inflation. If the economy began to "overheat," the Fed could cause a recession by restricting the flow of credit to the economy, thereby slowing economic activity and putting a damper on inflation. William McChesney Martin, Jr, Fed Chairman from 1951 - 1970, believed that the Fed's job was "to take away the punch bowl just as the party gets going." At least that was the theory.

After Martin left his post, the Fed was confounded by an entirely new phenomenon in the 1970's: stagflation, a combination of economic stagnation, high inflation, and high unemployment. No one believed such a thing could happen until it did, because it wasn't in their economic models.

It looks like we're headed towards stagflation once again, in certain parts of the economy. Check out this article from the Telegraph UK: Airlines to cut 60m seats for Christmas.

Airlines are set to make the reduction, the equivalent of one in every 14 seats, in response to high oil prices and the global credit crisis, according to the Official Airline Guide (OAG). Reduced availability is almost certain to force up ticket prices.

In all there will be 59.7m fewer tickets available compared to October-December last year. Routes will be scrapped at 275 airports around the world and 3,500 fewer planes will be needed, according to the OAG.

While Europe will suffer the loss of 5.5m seats, America will be worst hit, with a reduction of about 20m.

The slow economy has hit the airline industry hard. They were already overbuilt due to artificially cheap credit supplied by the Fed, as I explained here. When the hammer of a slowing economy fell, they needed to take drastic measures to survive. Cutting seats and routes to force up prices is once such measure. (Charging for water, pillows and blankets is another)

even though we have a stagnant economy, the cost of flying will go up. This is the paradox of the economy that many people will be confounded by - prices won't behave like they believe they are supposed to based on the economic models in their heads. Airline prices are not going up only and directly because of high fuel prices. It is a little more complicated than that. It has to do with Fed policy that encouraged overinvestment in the first place, and the huge cutback in supply of seats. It is important to remember that things are not always as they appear at first blush.

In the coming, difficult economic environment, different industries will be affected differently. Prices in some industries will go up, in others they'll go down. Some industries will disappear altogether. For example, Netflix and video on demand are likely to eliminate the concept of a video rental shop.

Word to the wise: there is no such thing as "The Economy." There are multiple sectors that make up the economy, but each will be affected differently.