Thursday, August 12, 2010

Stagflation and Obsolete Houses

Is it possible to have deflation and rising energy prices at the same time?

Some Wall Street economists say no. The prospect of deflation, they say, will prevent energy prices from rising. 

That, however, is a false confidence caused by forgetting the distinction between the national economy and the world economy. The possibility of deflation may deter price increases, but deflation in one country can have only a limited effect on prices that are set in a global market. 

There is a historical precedent for energy price increases during an otherwise deflationary period. This was the period of 1974–1981 in the United States. The prices of everything that was energy-related went up, while other prices held steady or declined. But energy is a significant component of all manufactured goods, so in general, it was a period of rising prices. At the same time, there was persistently high unemployment — similar to the current situation. In the press, this combination of effects was referred to as stagflation. 

With respect to buildings and fuel-burning vehicles, energy is a complementary good. Classically, then, when the price of energy increases, we can expect the value of buildings and cars to decrease. This could go on for an extended period of time, as it may take seven to ten years for world oil prices to edge up from their current low levels around $80 to a sustainable level around $250. 

Oil prices have already doubled from their recent lows. This is part of the reason for the continuing decline in home values. In the 1970s, millions of older houses were retrofitted with insulation to make them relevant again. Millions more were torn down. The same thing could happen again, only this time, virtually all houses built to date will need something changed. 

This general decline in the value of houses is one of the signs that has some observers seeing deflation, but it is not really deflation in the classical sense. It is just a reflection of the technological obsolescence of the houses.