Some observers fear return of rising prices, stagnant growth

Veteran Indianapolis banker Andy Paine vividly remembers the crisis management meeting called by his late mentor, Tom Binford,
in 1975. Stagflation—the unprecedented combination of stagnant economic growth and inflation—threatened to ruin
Indiana National Bank, one of the state’s three biggest financial institutions.

Business borrowing was on
the skids. Worse, the bank’s portfolio of fixed-rate home mortgages, once a cornerstone of stability, was rapidly becoming
a sinkhole, because the bank had lent at rates far below what it now had to pay depositors.

Binford’s first
order of business was to pull his personal checkbook from a coat pocket and write a $10,000 check to the United Way, and then
pass it around the table and name an officer as the bank’s gift campaign manager for the year.

It was clear
Binford not only knew the bank was fighting for its life, but also that he expected his managers to help not-for-profits in
the same boat.

Then Binford asked what they planned to do about stagflation.

“There was not a
word spoken for at least two minutes. We all looked at our fingernails or at our shoes,” remembers Paine, 72. “And
he said, ‘Great. We’ve now established our No. 1 priority. Because a year, year and a half from now, when I ask
that question, you will all answer with one voice.’”

Today, some observers fear stagflation could make
a comeback. Those who lived through it hope it doesn’t.

Stagflation lurking?

The
period started with OPEC’s 1973 oil embargo and then defined the decade as a time of high unemployment, national malaise
and long lines at gas stations. Inflation spiraled upward as consumers, fearing goods would cost more in the future, bid prices
ever higher.

In one particularly brutal stretch, from ’73 to ’75, inflation soared from 3.4 percent
to 12 percent, but the gross domestic product shrank in five out of 12 quarters.

Stagflation wasn’t officially
defeated until 1983. But it took Federal Reserve Chairman Paul Volcker’s wrenching campaign of raising interest rates
to record levels above 20 percent, as well as another deep national recession, to bring it under control.

Indianapolis
investment manager Gary Baxter, 68, frets that another round of stagflation is possible.

The sheer amount of borrowed
money the government has pumped into the economy to underwrite bank bailouts and the federal stimulus could be the unintended
spark, said Baxter, president of locally based Baxter Capital Management. He retired last year after three decades of leading
the group of economists who crafted Indiana’s annual state budget forecast.

Baxter suspects the United States
actually may encourage inflation in order to repay its debts to foreign governments with cheap dollars. He’s not sure
whether or when to expect a robust national economic recovery. And he’s skeptical about any prospects of the Obama administration
and a Democratic Congress scaling back spending while unemployment remains high.

“Our concern is the risk
that not next year, but probably beginning sometime in 2011 or 2012, we could have serious inflation,” Baxter said.
“The crazy thing is, here we are in one of the few deflationary periods [in U.S. history] talking about the huge risk
of inflation. It’s hard to get people to focus on it, but the risk is out there.”

He’s not the
only one who’s concerned. Joe Barnette, the retired chairman and CEO of Bank One Indiana, is also watching for inflation
to become a problem again.

“There are those who think, if history is any guide at all, that following a period
of time where the government expands as we have, throwing in this case trillions of dollars into the economy at large …
that will lead to inflation, and that the Federal Reserve will be tested to try to control that by raising interest rates,
which people are hesitant to do,” said Barnette, 70.

Imprecise parallels

The
parallels aren’t exact. Some believe stagflation was a unique phenomenon bred by circumstances that aren’t likely
to be repeated.

Indiana University history professor Michael McGerr points out that, in the 1970s, the United States
was much more dependent on manufacturing jobs—jobs that were hard to replace following layoffs or factory closings.

Also, single-income households were still the norm before women joined the work force en masse, earning more resources
to fuel the consumer demand that eventually grew the economy. Significantly, policymakers have learned enough about stagflation
to develop tools to avoid it, such as careful control of interest rates and the money supply.

McGerr points out
that spending on the wars in Iraq and Afghanistan haven’t overheated the economy like Vietnam once did. There’s
also no pressing energy crisis like Organization of the Petroleum Exporteing Countries’ oil embargo. And politically,
Obama’s watchword is “hope,” the opposite attitude of the nation’s impotent, defeatist attitude 30
years ago.

“A key point in this is stagflation in the ’70s produced a sense of futility. There were
not good answers,” McGerr said. “Take [President] Gerald Ford distributing ‘Whip Inflation Now’ buttons,
one of the lamest attempts [at addressing stagflation] available. We’re not in the same situation.”

Modern
economic problems are clearly different. Paine, who eventually became Indiana National’s CEO, noted interest rates are
at all-time lows.

Even so, banks are unwilling to lend and businesses are afraid to borrow—just like in the
1970s.

“Today, it’s probably the lack of liquidity in the system which is holding back growth,”
Paine said. “And that is not because of high interest rates. It’s because of credit risk believed to still be
within the system. But the practical result is similar.”

In the ’70s, America faced serious economic
competition from Europe and Japan for the first time since World War II. Likewise, Barnette noted, America today faces tough,
rising rivals in India and China. Increased global competition for resources will likely spur inflation.

Lessons
for today

That means the stagflation era holds lessons for modern business and investors. Now, as then,
highly leveraged companies struggled, while their debtless competitors enjoyed a huge market advantage. In both eras, successful
companies kept their inventories low and stretched accounts payable and receivable as far apart as possible.

Paine
remembers Indiana National concentrating on two concepts to “right the ship.” The bank dedicated itself to constant
measurement of progress, moving to formal strategic plans for the first time. It also emphasized innovation by developing
such new products as specialized loans collateralized on a company’s cash flow.

Some of the products weren’t
especially profitable, but they helped keep customers afloat during troubled times—and cemented relationships that paid
huge dividends in later years.

Bottom line, Paine said, is that stagflation taught Indiana National to recognize
the signs of the times and how to restructure its business around them.

“You had to do business in a different
way. You had to change,” Paine said. “The saddest thing is, we [always] really have a hard time learning, a hard
time changing, even though we need to change.”•