What's worse than a recession?

Yes, depression is worse, but not an immediate concern. We still have plenty to worry about, though.

Back in the seventies, we ran into an economic situation that broke the rules. It was so unprecedented that economists had to make up a new name for it: stagflation. Briefly, stagflation is what you get when the economy isn't growing and unemployment is up (recession), but prices continue to rise (inflation). It's the worst of both sides of the business cycle, rolled into one.

Economists still debate the specific mechanics of what happened, but all agree that rapidly increasing fuel prices played a major role. Higher energy costs are reflected not only in the prices of gasoline and heating oil, but in the price of food and virtually every other consumer good. It takes energy to produce and transport a product, and at least part of the costs of production must be passed along to the consumer.

If income had kept pace with price increases back then, inflation would have been the only problem, but that's not what happened. Faced with increased fuel costs while trying to remain competitive, many producers responded by cutting labor costs. As workers were laid off, demand dropped, putting more pressure on business.

According to classic economic theory, when demand drops, prices should drop as well -- but thanks to unprecedented cooperation among the OPEC states, fuel prices continued to rise. Producers in the United States responded in the only way they could: they pushed up product prices while continuing to lay off workers. Demand for goods and services continued to fall, but prices kept rising. High unemployment put downward pressure on wages, decreasing demand even more. Times were hard.

What saved us was the collapse of oil prices in 1982. Our slowing economy decreased demand for oil, and the OPEC oil cartel couldn't keep its act together. Various member states began selling more than their quotas to maintain their incomes; competition returned to the oil business, and the price of crude fell to less than half of what it was at its peak. The Reagan Administration claimed credit, of course.

There are clear similarities between 1973 and 2008. Adjusted for inflation, today's oil prices are higher than they were at their peak in 1982, and the dollar is weaker than it has been at any time since the 1970s. The sub-prime mortgage crisis and the immense increase in federal borrowing to finance high-end tax cuts and the war in Iraq have sharply reduced the availability of credit. Less credit means less demand for goods and services, which leads to less demand for labor, and higher unemployment. There is no indication that oil prices will drop sharply any time soon.

Fed Chairman Ben Bernanke, under considerable pressure from Wall Street, tells us to expect further cuts in the discount rate, but the threat of stagflation puts the Fed into a double-bind -- cutting interest rates can make the coming recession less onerous, but create inflationary pressures. Cutting interest rates also will put further downward pressure on the dollar, making all imports -- including oil -- more expensive.

It's also unlikely that rate cuts will be increase demand as much as they may have done before the credit crunch. Burned in the sub-prime meltdown, financial institutions are hesitant to offer consumer credit as readily as in the past, and consumers who can qualify are beginning to pay down their debt rather than make new purchases.

In other words, cutting rates might do more harm than good -- except, of course, for hedge fund managers and other financial services executives, who earn annual bonuses based on how well the market does. Rate cuts do tend to send stock prices higher, and we can't expect the richest individuals in the country to get by on just their seven-figure salaries, can we?