Britain Succumbs to Virulent Strain of Stagflation

Stagflation is every politician's worst nightmare. If I refer you to the Oxford English Dictionary's definition of the word below, then I think you'll begin to understand why. It is defined here as: "persistent high inflation combined with high unemployment and stagnant demand in a country's economy." In other words, it's a particularly nasty economic disease which has no easy cure.

Judging by the latest economic figures, I'd say the UK is showing advanced symptoms of the disease since it qualifies on 2 out of the 3 criteria - and it won't be long before it qualifies on the 3rd.

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To back up my argument, let's start with the "high inflation" piece of the jigsaw. The latest official CPI figures have just come out far higher than expected (well, higher than clueless government ministers expected anyway) at 3.7%. The RPI figure, which paints a slightly more realistic picture of inflation - you know, the one the politicians would prefer you didn't notice, comes in at a scary 4.8%.

Straight away, the usual establishment economists have tried to explain away these figures as a temporary phenomenon (step forward Mr. Roger Bootle of Capital Economics), claiming that lack of demand in the economy will curb rising prices once various "one-off factors" fall out of the figures. The trouble is, people like Mr. Bootle have been saying things like this for quite a few years now. Well, I suppose if, like him, you've written a book called "The Death of Inflation" you've got rather a vested interest in talking the figures down, haven't you? That book was published way back in 1996 by the way, so I thought I'd run a little check to see if the inflation corpse is still twitching 15 years on.

According to the Bank of England's own inflation calculator, goods that you bought for £1 in 1996 when Mr. Bootle published his book would, in 2009, have cost you £1.39. With the recent spurt in price inflation, I think it's fair to put the current 2011 figure closer to £1.44. So I think we can safely say that, since "The Death of Inflation" was published 15 years ago, prices in the UK according to the official (and most likely watered down) statistics have actually risen by approximately 44% - some corpse!

Since part of the criteria for satisfying our definition of stagflation requires that inflation be "persistent", I think a term of 15 years more than qualifies on this count. I'd tell Mr. Bootle and other establishment economists of his ilk not to give up the day job, except for the fact that getting paid huge amounts of money to be consistently wrong about inflation over decades does seem to be their day job. Nice work if you can get it I suppose.

Now what about the 2nd piece of the stagflation jigsaw - stagnant demand? Well, just recently here in the UK we had our very own Chancellor of the Exchequer, George Osborne, blaming the weather for a shocking 0.5% drop in the country's GDP figures for the last quarter of 2010. Admittedly, these were preliminary figures subject to later adjustment and yes, the arctic conditions in the run-up to the key Christmas trading period were undoubtedly a factor in suppressing demand. But for Mr. Osborne to try and blame it all on the weather, as he did no less than 17 times during one particular TV interview, really is grasping at straws.

Quite simply, demand is down, not because of the wrong kind of snow, but because we live in a debt-based consumer economy and consumers are now maxed out on debt. Even at current low interest rates, debts are so high that consumers will still struggle to pay them off - and the banks won't lend any more money to them anyway. Why won't the banks lend any more? Because they're under assault on two fronts:

Firstly banks are now seriously hamstrung by the new Basel 3 Capital Adequacy Accord. That sounds like quite a mouthful, I know, but put simply all it means is that, over the next 8 years, banks are going to have to set aside more capital as a buffer against future bad debts. If banks have to set aside more capital, then logically they'll have less money to lend out. This new legislation was agreed in the wake of the 2008 financial crisis.

Secondly, banks are keeping a very close eye on the teetering UK housing market. In total, as of November 2010 they have 1.2 trillion pounds secured against UK residential property, so any sign of house prices falling further will put many of those loans under water. In other words, if UK property goes down, the banks go down - again! Which means that the UK taxpayer would have to bail out the banks - again!! Our politicians are, of course, well aware of this, but, that doesn't stop them demanding that the banks start lending more. Well, hey, why let the truth get in the way of a bit of self-serving political grandstanding?

So since we're so reliant on increasing the amount of debt in our economy to get any kind of "growth" and the banks are terrified of lending any more for the reasons stated above, then it's really no surprise that demand has been flat - and it's likely to stay that way for the foreseeable future no matter how much the politicians huff and puff. So that's the second piece of the stagflation jigsaw slotted into place.

What about the 3rd and final piece - unemployment? Well according to the official statistics at the ONS, the unemployment rate in the UK in the last quarter of 2010 was a shade under 8%. That doesn't sound a lot when compared with Spain's official rate, for example, which is hovering around the 20% mark. However, buried in the ONS figures is a rather more alarming figure: the number of people unemployed in the 16-24 year old bracket is now 20.3%! It gets worse: the number of people designated as "economically inactive" in the 16-64 age bracket is now 23.4%, up 0.2% on the quarter - so this is a rising trend. Put another way, 9.37 million people in the working-age population are "economically inactive". If we take into account that these figures were compiled before the public sector job cuts have begun in earnest, then it looks like we've just laid the final piece of the jigsaw and now have the complete picture. Unemployment is on a firm upward trajectory, demand is falling and, as I've been saying for some time in these articles, inflation is accelerating. The official diagnosis for Britain's economic disease is indeed stagflation.

This is all very depressing, I know, but if you're an active investor like me, there is at least something you can do to protect yourself and your family from the symptoms of this unpleasant ailment. As set out in the introductory pages of my website, you need to construct a portfolio with a bias in favour of shares and commodities which can protect you from the ravages of inflation on the one hand, yet still expose you to the areas of the world and investment sectors where, unlike the UK, demand is still growing and likely to continue growing for many years to come. That means investing in commodities like gold, silver, oil and agricultural products which offer inflation-protection, as well as large, high-yielding blue-chip companies in the FTSE which have broad exposure to fast-growing emerging markets.

Just because the nation's economy is looking a bit off colour, doesn't mean your investments have to succumb too.

Until next time,
Happy Investing,
John Mac, the Hands-On Investor.

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