Between the Devil and the Deep Blue Sea

As we move into the era of energy scarcity, the laws of economics will change. A pointer towards what is in store for us was last week's announcement of an unexpected rise in Eurozone inflation, leading to the threat of increased interest rates from the European Central Bank (ECB).

Eurozone inflation in April hit 2.8%. This against a backdrop of sluggish economic growth across the continent - growth in the Euro area is forecast to reach 1.6% at most in 2011 - and falling consumer confidence.

In other words, consumers worried about their jobs and future incomes are keeping a tight grip on their wallets - yet prices are still rising.

The reason? Soaring commodity prices on world markets - especially for energy and food.

Just as the laws of physics work differently when you move at the speed of light, so strange things start to happen in the economy as we reach peak oil.

World production of crude oil has barely increased since 2005. Soaring demand from India and China is hitting against the buffers of limited supply - and that is driving up the price not just of oil, but of other energy sources and of food.

This is the equivalent of imposing an extra tax on the economy, with the proceeds going to commodity producers. One consequence is to slow down growth.

In normal times an increase in interest rates, by taking money out of the economy, would reduce demand for goods and services and therefore inflation. But what is "normal" is starting to change. If the ECB raises interest rates, it will hit consumers in the pocket and further dampen growth in the Eurozone - but it will do little to stop inflation driven by commodity prices.

The only circumstance in which these will temporarily fall back are those we witnessed in late 2008 - a sharp global recession.

The fact is there will be no return to "normal" growth of the kind we got used to in the 1990s and early 2000s. Instead we find ourselves trapped between the devil and the deep blue sea.

The devil is the soaring cost of energy, which drives up inflation at the same time as it slows down growth.

The only way to escape is by diving into the deep blue sea - the choppy waters of recession.

The last time developed economies suffered from "stagflation" - a combination of economic stagnation and rising prices - was after the oil shocks of the 1970s. On that occasion the causes of high energy prices were political.

This time there is simply not enough oil in the ground.

Stagflation once appeared as dated as bell-bottoms and mullet haircuts. But not only is it back in fashion -we can expect it to become a near a permanent feature of the economic landscape.