Stagflation
What Is Stagflation?
Stagflation is characterized by slow economic growth and relatively high
unemployment—or economic stagnation—which is at the same time
accompanied by rising prices (i.e. inflation). Stagflation can also be alternatively
defined as a period of inflation combined with a decline in gross domestic product
(GDP).
KEY TAKEAWAYS
Stagflation refers to an economy that is experiencing a simultaneous
increase in inflation and stagnation of economic output.
Stagflation was first recognized during the 1970's, where many developed
economies experienced rapid inflation and high unemployment as a result
of an oil shock.
Prevailing economic theory at the time could not easily explain how
stagflation could occur.
Since the 1970's, rising price levels during periods of slow or negative
economic growth have become somewhat of the norm rather than an
exceptional situation.
Stagflation
Understanding Stagflation
The term "stagflation" was first used during a time of economic stress in the
United Kingdom by politician Iain Macleod in the 1960s while he was speaking in
the House of Commons. At the time, he was speaking about inflation on one side
and stagnation on the other, calling it a "stagnation situation." It was later used
again to describe the recessionary period in the 1970s following the oil crisis,
when the U.S. underwent a recession that saw five quarters of negative GDP
growth.1 Inflation doubled in 1973 and hit double digits in 1974; unemployment hit
9% by May 1975.2 3
Stagflation led to the emergence of the Misery index. This index, which is the
simple sum of the inflation rate and unemployment rate, served as a tool to show
just how badly people were feeling when stagflation hit the economy.
Stagflation was long believed to be impossible because the economic theories
that dominated academic and policy circles ruled it out of their models by
construction. In particular, the economic theory of the Phillips Curve, which
developed in the context of Keynesian economics,
portrayed macroeconomic policy as a trade-off between unemployment and
inflation. As a result of the Great Depression and the ascendance of Keynesian
economics in the 20th-century economists became preoccupied with the dangers
of deflation and argued that most policies designed to lower inflation tend to
make it tougher for the unemployed, and policies designed to ease
unemployment raise inflation.
The advent of stagflation across the developed world in the mid-20th century
showed that this was actually not the case. As it result, stagflation is a great
example of how real-world economic data can sometimes run roughshod over
widely accepted economic theories and policy prescriptions.
Since that time, as a rule, inflation persists as a general condition even during
periods of slow or negative economic growth. In the past 50 years, every
declared recession in the U.S. has seen a continuous, year-over-year rise in the
consumer price level.4 The sole, partial exception to this is the lowest point of the
2008 financial crisis—and even then price decline was confined to energy prices
while overall consumer prices other than energy continued to rise.
Special Considerations
Theories on the Causes of Stagflation
Because the historical onset of stagflation represents the great failure of the
dominant economic theories of the time, economists since then have put forth
several arguments as to how stagflation occurs or how to redefine the terms of
existing theories in order explain around it.
One theory states that this economic phenomenon is caused when a sudden
increase in the cost of oil reduces an economy's productive capacity. In October
1973, the Organization of Petroleum Exporting Countries (OPEC) issued an
embargo against Western countries. 1 This caused the global price of oil to rise
dramatically, therefore increasing the costs of goods and contributing to a rise in
unemployment. Because transportation costs rise, producing products and
getting them to shelves got more expensive and prices rose even as people got
laid off. Critics of this theory point out that sudden oil price shocks like those of
the 1970s did not occur in connection with any of the simultaneous periods of
inflation and recession that have occurred since then.
Another theory is that the confluence of stagnation and inflation are results of
poorly made economic policy. Harsh regulation of markets, goods, and labor in
an otherwise inflationary environment are cited as the possible cause of
stagflation. Some point fingers to the policies set in place by former President
Richard Nixon, which may have led to the recession of 1970—a possible
precursor to the period of stagflation. Nixon put tariffs on imports and froze
wages and prices for 90 days, in an effort to prevent prices from rising. The
sudden economic shock of oil shortages and rapid acceleration of prices once
the controls where relaxed led to economic chaos. While appealing, like the
previous theory this is basically an ad-hoc explanation of the stagflation of the
1970s, which does not explain the simultaneous rise in prices and unemployment
that has accompanied subsequent recessions up to the present.
Stagflation and the Gold Standard
Other theories point to monetary factors that may also play a role in stagflation.
Nixon removed the last indirect vestiges of the gold standard and brought down
the Bretton Woods system of international finance. 5 This removed commodity
backing for the currency and put the U.S. dollar and most other world currencies
on a fiat basis ever since then, ending most practical constraint on the monetary
expansion and currency devaluation. As support for their theories, proponents of
monetary explanations of stagflation point to this event, as well as the historical
record of simultaneous inflation and unemployment in fiat money-based
economies, and the countervailing historical record of extended periods of
simultaneously decreasing prices and low unemployment under strong
commodity back currency systems. This would suggest that under an unbacked
fiat monetary system in place since the 1970s, we should actually expect to see
inflation persist during periods of economic stagnation as has indeed been the
case.
Other economists, even prior to the 1970s, criticized the idea of a stable
relationship between inflation and unemployment on the grounds of consumer
and producer expectations about the rate of inflation. In these theories, people
simply adjust their economic behavior to rising price levels either in reaction to or
in expectation of monetary policy changes. As a result, prices rise throughout the
economy in response to expansionary monetary policy, without any
corresponding decrease in unemployment, and unemployment rates can rise or
fall based on real economic shocks to the economy. This implies that attempts to
stimulate the economy during recessions could simply inflate prices while having
little effect on promoting real economic growth.
Urbanist and author Jane Jacobs saw the disagreements between economists
on why the stagflation of the ‘70s occurred in the first place as a symptom of
misplacing their scholarly focus on the nation as the primary economic engine as
opposed to the city. It was her belief that in order to avoid the phenomenon of
stagflation, a country needed to provide an incentive to develop "import-replacing
cities" — that is, cities that balance import with production. This idea,
essentially diversifying the economies of cities, was critiqued for its lack of
scholarship by some, but held weight with others.
The de facto consensus on stagflation among most economists, financiers, and
policymakers has been to essentially redefine what they mean by the term
“inflation” in the modern era of modern currency and financial systems.
Persistently rising price levels and falling purchasing power of money—i.e.
inflation—are just assumed as a basic, background, normal condition in the
economy, which occurs both during periods of economic expansion as well as
during recessions. Economists and policymakers generally assume that prices
will rise, and largely focus accelerating and decelerating inflation rather than
inflation itself. The dramatic episodes of stagflation in the 1970s may be a
historical footnote today, but since then simultaneous economic stagnation and
rising price levels in a sense make up the new normal during economic
downturns.
Frequently Asked Questions
What Causes Stagflation?
Stagflation is characterized by slow economic growth and relatively high
unemployment—or economic stagnation—which is at the same time
accompanied by rising prices (i.e. inflation). While many theories abound, the
consensus is that stagflation occurs when money supply is expanding while
supply is being constrained. For example, if a government prints currency, which
would increase the money supply and create inflation, while raising taxes, which
would slow economic growth, then the end result would be stagflation.
Why Is Stagflation Bad?
Conceptually, stagflation is a contradiction as slow economic growth would likely
lead to an increase in unemployment but should not result in rising prices. This is
why this phenomenon is so dangerous. An increase in the unemployment level
results in a decrease of consumers spending power and, if you tack on runaway
inflation, that means that what money they have is losing value as time goes by.
So, less money being worth less and less.
What Is the Cure for Stagflation?
There is no definitive cure for stagflation but the consensus amongst economists
is that productivity has to be increased to the point where it would lead to higher
growth without additional inflation. This would then allow authorities to tighten
monetary policy to reign in the rampant inflation component of stagflation. That is
easier said than done so the key to preventing stagflation is to be extremely
proactive in avoiding it.
