The Faltering War Economy
On Friday, the Labor Department reported inflation numbers for March. Inflation, driven by the Iran war, broke out of its recent well-behaved pattern, as consumer prices rose by an annual rate of 3.3 percent, almost a full point above its February rate. The April report will surely be worse.
But that was only the headline. Retail gas prices were up 21.2 percent and have continued to rise in April; and other goods dependent on oil are up as well. And the problem isn’t just prices but shortages, as detailed in our new series Aftermath about the economic consequences of the war.
With higher prices, consumers have less disposable income. Real hourly earnings were down 0.6 percent in March. Consumer pessimism leads to further reluctance to spend. The University of Michigan’s consumer sentiment index fell to its lowest level on record. The initial April reading, of 47.6, was down almost 11 percent and well below last April.
The employment picture has been weak as well. The monthly unemployment rate has bounced around, but job creation is well below trend. The average rate of job growth over the past six months is under 20,000 a month, down from over 100,000 a month before President Trump took office. And artificial intelligence will also eat into employment, whether because of legitimate productivity gains or because hiring managers use it as an excuse to cut jobs.
The one area of job growth is the health care sector. But that’s mostly a sign of sickness, reflecting the gross inefficiency of our for-profit health care system. With Trump’s war on immigrants, employers are having a hard time filling many service-sector jobs, raising costs.
There is a name for this overall picture: stagflation, which refers to the improbable simultaneous combination of rising inflation and rising unemployment. This in turn leaves the Federal Reserve with no good options. If the Fed runs true to form, it will give priority to trying to damp down inflation by raising interest rates, which will slow the economy further and put people out of work.
At the Fed’s last meeting, on March 17-18, despite Trump’s pressure to cut rates, only one member of the Federal Open Market Committee voted for a rate cut. At the next meeting, on April 28-29, there could be rate increases.
Price increases driven by an external shock, in this case the price of oil, violate the usual connection between inflation and unemployment. Inflation is high and rising not because the economy is running too hot, but because of a sudden spike in the cost of one major input that cycles into other price increases. That same price increase weakens the economy and adds to unemployment. If the Fed raises interest rates, that will only further crater the economy.
Even if oil were to resume moving through the Strait of Hormuz soon, it would take months for prices and supplies to return to anything like normal. Since the best we can expect is some kind of fragile truce that could be broken at any time, while Iran maintains some level of operational control of the strait, the cost of oil will price in that risk, and prices will not return to their prewar level for a long time. Even Trump himself conceded that gas prices may not go back to where they were before the war by the time of the midterm elections.
Just offstage is one other peril. In recent years, the financial economy has become highly overleveraged, the result of low interest rates combined with vanishing financial regulation. Our colleague David Dayen wrote this prescient explainer price last November, and the risks have only increased since then.
One such area is so-called private credit. This is basically banking without any regulatory safeguards, engaged in by private equity and other investment firms.
Supposedly, private credit transactions are insulated from the banking system, so if borrowers fail to pay back lenders there is no systemic crisis. But dig a little deeper and you find that purveyors of private credit themselves borrow from banks. And though there are no official statistics on the size of this unregulated and unmonitored sector, Paul Krugman, citing industry sources, puts it at about $1.5 trillion. As Krugman reminds us, this was roughly the size of the subprime mortgage sector on the eve of the 2008 collapse.
There are also alarming signs of bubbles in crypto and AI. Many speculative investments in crypto are heavily leveraged. Crypto has no inherent value. It is simply a bet on other people’s bets. Bitcoin has fallen from a peak of $124,000 to about $71,000 today.
The stock market is absurdly concentrated in AI, which faces a variety of threats including insufficient computing power, since semiconductor production is partially dependent on, you guessed it, the Strait of Hormuz. AI itself is heavily leveraged. There is also a tech-vs.-tech paradox, in which AI renders a great deal of software obsolete, undermining one major part of the tech sector which has received significant funding support from … private credit firms.
As the real economy weakens and interest rates rise, so do the risks of a financial crash. All of these risks are exacerbated by the serial shocks of the Iran war. It is Trump’s war and Trump’s economy.
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