Unless you’ve been living under a rock (or unless you’re Ron Paul) for the past decade or so, it’s not news to you that Iran has become a threat to the stability of the Middle East. Their nuclear program – which they themselves claim is for peaceful purposes – could, if they manage to develop a nuclear bomb, render them untouchable. A nightmare scenario involves Iran attacking Israel with said nuclear bomb, turning Tel Aviv into a heap of rubble and creating an electromagnetic pulse that would cause a blackout in Israel and make it very hard to retaliate.
We don’t know what will happen. I’m not a foreign policy expert, so I will leave that analysis to someone else. That’s not the subject of this post. Instead, what I’d like to talk to you about is this: Could Iran cause stagflation?
First, let me just briefly explain what stagflation is – some of you (those born in the 40’s or earlier) will know, some of you might have heard the word before but never really understood what it meant, and to some of you, this might be the first time you hear about it. Anyway: Inflation and growth are typicaly tightly linked. During times of a booming economy, inflation is high because of increasing demand and salaries (people can afford more, so retailers can charge more). During times of recession, the opposite is true: People don’t spend as much, salaries go down, retailers are forced to cut prices.
Stagflation, as some of you may have suspected by now, is a combination: The economy is in a recession (or has stagnated), but yet inflation goes up. Before the 1970’s, no-one thought this could even happen.
What happened then in the 1970’s? The simple answer is the oil crisis happened. You see, oil doesn’t really work like most other goods. We’re absolutely dependent on it, yet most of the western world isn’t producing any significant amounts of oil (the US produces some, Canada quite a bit – but with those two exceptions, most western countries have to rely on imports). So an increase in the oil price is really only good for countries outside the western hemisphere.
When the oil price suddenly quadrupled from 1973-1974, this had two effects:
1) Inflation. Because oil is used in the production and transportation of really most goods sold, an increase in the price of oil meant an increase in the general price level.
2) Stagnation. While inflation is normally associated with growth, because this price increase wasn’t rational (it wasn’t caused by an increase in demand but rather an embargo by OPEC), and because like I said oil was so essential for the economy, the price increase lead to stagnation.
The tricky part here from the central bank perspective is: Should you raise interest rates and fight the inflation, or lower them and fight the stagnation? Should the government stimulate the economy, or cut spending to cool off inflation? I know no-one here – including me – are big fans of government stimulus, but you get the dilemma.
What does Iran have to do with this?
Iran, for those who haven’t been following the news, is threatening to block the strait of hormuz, a strait 20 % (some give higher figures) of the oil consumed every year is transported through.
What would the consequence be? Essentially, it would be stagflation. That was the case when oil prices quadrupled in the 1970’s, and that will be the case if they quadruple today – the US has the same dependency on oil then as it does now.
But couldn’t such a blockade be removed, militarily? Of course it could. Back in the days of Ronald Reagan Iran blocked the strait of Hormuz, but he simply had the Air Force kick them out of there. Sure, Iran is a tad stronger today than it was then, but it still shouldn’t really be a problem.
Except for one thing: Obama.
We’re talking about the guy who begged, not ordered, Iran to give back a secret drone. Do you see the problem? It’s not that the US couldn’t crush a blockade, it’s that under Obama, it probably won’t happen.
However, there is hope. First of all, Iran might not go through with this – you never really know when you’re dealing with such irrational states. They may wait until they have a nuclear weapon.
Second of all, there are plenty of arab countries who would be annoyed, to say the least, if Iran were to cut off their only source of revenue. Yes, this is what it has come down to: We’re now relying on Saudi Arabia to defend ourselves from our enemies. This would be the worst scenario as this would alter the power balance in the middle east.
Third, Israel happens to be depending on oil too. They’re slightly more aggressive than the US, and they’re already ticked off with Iran for, well, planning to exterminate them.
If stagflation does happen, what will this mean? First, some Republicans may think it would mean the end of the Obama presidency. After all, Obama depends on the health of the economy to win re-election – right? Not so fast.
While it is most likely bad news for Obama, this would first of all give him a chance to blame the state of the economy on, well, another state. It’s hard(er) to attack Obama for being dovish on foreign policy given that he as we all know gave the OK to an operation that killed Bin Laden. He is, of course, dovish – not to say squerrilish – on foreign policy, but it’s a much tougher sell to make to voters now than it was in 2008.
Just like Obama has already tried to blame the state of the economy on Europe, he’ll blame it on Iran. Plus, if Iran blocks the strait of hormuz and Obama does take military action, that will blow away the argument that Obama is weak on foreign policy. It will still be true, but it will go from a hard to an impossible sell with voters.
Also, this is the kind of situation which is easy to screw up, in particular if we choose a nominee with a bigger mouth than brain (I’m looking at you, Newt Gingrich). This kind of situation will give the Republican nominee a chance to show leadership and act presidential – and also an opportunity to use bomb-throwing rhetoric, make incredible threats and burn bridges. Let’s make sure we have a nominee who opts for the first option.
What is the Federal reserve likely to do? They can either act against the stagnation or the inflation, and, knowing the Fed, I’m pretty sure it will be the first option. The federal reserve is not nearly as afraid of inflation as it is of stagnation. The Fed, by its printing of unprecedented amounts of money, has shown that it really doesn’t care about inflation. Sure, the inflation hasn’t shown up yet – but it will. You can’t print trillions of dollars and expect it to have no consequences. Because, while you can create money out of thin air, the same isn’t true for real wealth.
This, in turn, will lead to increased yields on American bonds. Normally inflation is associated with growth and so, even if bond yields are pushed up, that doesn’t really matter as tax revenue goes up as well (you pay more on your bonds, but you also get more money). Not this time however, as stagflation means the economy isn’t growing and so the amount of tax revenue stays flat at best. This could make investors question American’s payback ability, which drives bond yields up further. This is known as a “bad equilibrium” in the bond markets: The ability of a country to pay back its debt is questioned, driving bond yields up, which leads to the country actually getting more trouble making the payments, which drives bond yields up further and so on, in a vicious cycle.
Where does this all end? We don’t know. If stagflation persists, the Eurozone is almost certain to break down. It’s fragile enough as it is. If a massive euro collapse does happen, with contagion to the American financial system, the plug will really have been pulled on the economy.
There isn’t much we can do about this, but pray for a happy outcome – and vote with our brains, not our primitive instincts. If enough of us do this, this can turn out to be nothing but a drama with a happy ending. If not, this may well turn into an economic horror story.
- Iran More than Doubles 2012 Defense Budget (bigpeace.com)
- Hormuz Hysteria (americanthinker.com)
- Is War in the Middle East Cheaper Than Peace? (theblaze.com)
- Ahmadinejad wants to double Iran defense budget (jpost.com)
- White House: No rush on Iran (thehill.com)
- Strait of Hormuz in Greater Context (americanthinker.com)