What Is Stagflation?

Stagflation is a challenging economic condition characterized by slow growth, high unemployment, and rising inflation. This combination presents a significant dilemma for economic policymakers because efforts to address one aspect of the problem can often worsen another. For example, measures to reduce inflation may lead to higher unemployment and vice versa.

Stagflation was once considered impossible by economists, but it has occurred multiple times since the 1970s, notably during the oil crisis. As of mid-2022, concerns about stagflation resurfaced in the United States, with some experts predicting a short-term stagflationary period due to policy decisions prioritizing unemployment over inflation control.

Key Takeaways:

• Stagflation combines slow economic growth, high unemployment, and rising inflation.
• Initially deemed impossible, it has occurred since the 1970s.
• Policy measures for growth can worsen inflation, making stagflation hard to combat.

Understanding Stagflation

The term “stagflation” was first used by British politician Iain Macleod in 1965 during a period of economic stress in the UK. He described the simultaneous occurrence of stagnation and inflation as a “stagflation situation.” The term gained prominence in the U.S. during the 1970s oil crisis when inflation doubled in 1973 and reached double digits in 1974, with unemployment peaking at 9% by May 1975.

Economists used the “misery index” to illustrate stagflation’s impact, which is the sum of the inflation rate and the unemployment rate, reflecting the real-world effects on the population.

History of Stagflation

For much of the 20th century, economists believed stagflation was impossible due to the prevailing economic theories, such as the Phillips Curve, which posited a trade-off between inflation and unemployment. This view, rooted in Keynesian economics, suggested that policies to lower inflation would increase unemployment and vice versa.

However, the occurrence of stagflation in the 1970s challenged these theories. It demonstrated that inflation could persist even during periods of slow or negative economic growth. Since then, every declared recession in the U.S. has seen a continuous year-over-year rise in consumer prices, except during the lowest point of the 2008 financial crisis, where the price decline was limited to energy and transportation.

Causes of Stagflation

There is no consensus among economists about the exact causes of stagflation. However, several theories attempt to explain its occurrence:

Oil Price Shocks

One theory suggests that stagflation results from sudden increases in oil prices, which reduce an economy’s productive capacity. The 1970s oil crisis is a prime example. In October 1973, OPEC issued an embargo against Western countries, causing global oil prices to surge. This increase in costs led to higher prices for goods and rising unemployment as production and transportation became more expensive.

However, critics argue that sudden oil price shocks do not explain all instances of stagflation, as similar conditions have occurred without such shocks since the embargo.

Poor Economic Policies

Another theory attributes stagflation to poor economic policies. For example, former President Richard Nixon’s tariffs on imports and wage and price freezes in the early 1970s aimed to curb inflation but led to economic turmoil once controls were lifted. This theory suggests that restrictive market regulations in an inflationary environment can contribute to stagflation.

While this explanation is appealing, it does not account for other periods of stagflation that lacked similar policy mistakes.

Loss of the Gold Standard

Some theories point to monetary factors, such as the end of the gold standard. In 1971, Nixon removed the last vestiges of the gold standard, transitioning to fiat currency. This change removed constraints on monetary expansion and currency devaluation, potentially contributing to stagflation.

Stagflation vs. Inflation

Inflation is the general rise in prices and the decline in purchasing power over time. Stagflation, however, combines inflation with economic stagnation and high unemployment, a combination that challenges traditional economic policies.

Before the 1970s, many economists believed in a stable trade-off between inflation and unemployment. However, stagflation showed that prices could rise even during economic downturns, complicating the relationship between these variables.

Special Considerations

The modern economic consensus acknowledges that inflation can persist during economic stagnation. Policymakers now focus more on managing inflation rates rather than eliminating inflation entirely. The dramatic episodes of stagflation in the 1970s may be historical footnotes, but the combination of slow growth, high unemployment, and rising prices is now seen as a potential feature of economic downturns.

Causes and Effects of Stagflation

Economists debate the root causes of stagflation, but generally, it is triggered by a supply shock, such as an oil crisis or a critical shortage of essential parts. For example, during the COVID-19 pandemic, disruptions in the semiconductor supply chain slowed the production of goods like laptops, cars, and appliances, affecting inflation, employment, and growth.

Why Is Stagflation Bad?

Stagflation is detrimental because it combines three negative economic conditions: slow growth, high unemployment, and rising prices. This combination defies the typical economic logic that prices should not rise when consumer spending power is low.

What Is the Cure for Stagflation?

There is no definitive cure for stagflation. Economists generally agree that increasing productivity to spur growth without additional inflation is essential. This would allow for the tightening of monetary policy to control inflation. However, this solution is easier said than done, emphasizing the need for proactive measures to prevent stagflation.

Conclusion

Stagflation remains a complex and challenging economic phenomenon. Its occurrence in the 1970s reshaped economic theories and policy approaches, highlighting the limitations of traditional models like the Phillips Curve. Understanding the causes and effects of stagflation is crucial for policymakers to develop strategies to mitigate its impact and prevent its recurrence in future economic cycles.

Economists and policymakers must remain vigilant in monitoring economic conditions and be prepared to implement measures that address the multifaceted challenges of stagflation. This includes fostering productivity, maintaining balanced trade policies, and ensuring that monetary policies are responsive to both inflationary pressures and economic growth needs. By doing so, they can better navigate the complexities of stagflation and safeguard the stability of their economies.