What is Stagflation?

What is Stagflation?

The portmanteau stagflation combines the words stagnation and inflation. This economic phenomenon combines two or three negative economic trends that rarely occur together: poor economic growth, high inflation, and high unemployment levels. Although it has occurred fewer than three times over the last century, its effects are difficult to overcome because actions to curb one trend could create a chain reaction of wealth-destroying events.

Learn what stagflation is, its history, how it works, why it occurs, and its consequences.

What Is Stagflation?

The term stagflation is often used to define an economy with low economic growth, high consumer-price inflation, and rising unemployment. When the economic output is shrinking or expanding more slowly, job opportunities are fewer. The result is high unemployment levels, which leaves consumers with less money to spend.

Stagflation is quite a rare phenomenon because inflation shouldn’t occur in a weak economy. In normal economic conditions, slowing growth prevents inflation, which causes consumer demand to drop just enough to curtail rising prices.

History of Stagflation

Stagflation isn’t a theoretical concept. This term was first coined by British Conservative Party politician Iain Norman Macleod in 1965 at a time when the United Kingdom was experiencing simultaneous high inflation and high unemployment. Initially, stagflation was a pipedream to many economists because inflation and unemployment typically move in opposite directions. However, it was during the 1973-1975 recession in the U.S. when stagflation was proven to be real.

In the 1960s, the U.S. spent a lot of money on its war with Vietnam. Besides, the post-World War II economic boom was proving unsustainable. America’s manufacturing industry was also lagging, and foreign competitors started catching up. The rising competition reduced the number of factory jobs as workers were forced to seek lower-paying service jobs. A saturation in the labor market triggered rising unemployment.

To curb these economic challenges, President Richard Nixon enforced regulations to freeze prices and wages. He also made it easier for the Federal Reserve to control the value of the U.S. dollar. Unfortunately, the actions only provided short-term relief and didn’t get into the root cause of the problem.

The worst period of stagflation was catalyzed by the 1973 oil crisis resulting from an oil embargo by the Organization of the Petroleum Exporting Countries (OPEC). The embargo saw oil prices soar fourfold. Higher gas prices pushed consumers to smaller, fuel-efficient cars from German and Japanese manufacturers, which further damaged the American economy.

Some economies tried to stimulate the economy through more government spending, but this didn’t reduce unemployment, further spurring inflation. It was not until the early 1980s that the U.S. successfully managed stagflation after amending its monetary policy.

How Stagflation Works

Stagflation combines stagnation, a period when the economic output is shrinking or growing more slowly, and inflation (rising prices). Inflation reduces the value and purchasing power of money, while a lower economic output is the result of poor productivity.

This could be the epitome of misery. The money people earn continues to buy less and less, which results in a rising cost of living. Poor productivity and high unemployment in the economy keep consumer wages low, making it difficult to compensate for any shortfalls. Stagflation wipes out income and savings as businesses cut down wages, reduce hiring, and hold back on investments.

The most common culprit of stagflation is a government printing currency or monetary policies that create credit. Both create inflation through an increased money supply. Similarly, some monetary policies like increased taxes or rising interest rates derail economic growth by preventing extensive production by companies. Conflicting expansion and contraction policies may slow economic growth while spurring inflation. The result is stagflation.

What Causes Stagflation?

Economists have heavily debated the causes of stagflation because the phenomenon largely remained a theory until the stagflation of the 1970s. Some of the suggested causes of stagflation include:

Poor monetary policies

Stagflation is often the result of mistaken economic policies. In attempts to regulate the economy, governments and their central banks may make the wrong choices. In the 1970s, for instance, the U.S. administration tried to maximize employment in the economy, which inadvertently raised inflation and slowed down growth. Legislators and central banks often find it difficult to tackle stagflation because efforts to curb one trend may spur another.

Supply shock

According to the supply-shock theory, the sudden decrease in the supply of a commodity or service will usually lead to stagflation. This triggers an increase in prices, which cuts down profit margins for companies and eventually slows down economic growth. For instance, a sudden decrease in oil supply causes its price to rise sharply. Higher oil prices trickle down to businesses, which then pass down to consumers through higher prices, lower wages, and layoffs as well. As inflation and unemployment rise, reduced spending slows down economic growth. The combination of these scenarios fundamentally causes stagflation.

Consequences of Stagflation

The consequences of inflation can be particularly adverse because the phenomenon combines scenarios that are often contradictory — rising prices and declining economic output. This causes economic stagflation as consumers enjoy lower buying power while their salaries and savings decline. 

Stagflation has direct consequences on consumers. Affordability takes a hit as consumers find it harder to meet their basic needs, especially if they’re unemployed. Those employed are not spared either because they are at risk of lower wages and job loss, which will reduce their purchasing power.

Stagflation also impacts investors. Returns from the stock markets are generally lower during periods of stagnation compared to during normal economic conditions. Stagflation also reduces growth in companies, which could affect stock prices.

International trade is often a victim of stagflation. An increase in global commodity prices increases the cost of doing business while pushing inflation higher. Global unemployment may also impact global economic output, and the trickle-down effect will eventually impact consumer spending.  

Conclusion

Stagflation occurs at the intersection of rising prices and slowing economic growth. The effects of this phenomenon are extremely damaging, from the erosion of consumer income and savings to a reduction in business output. Stagflation can be difficult to combat if it’s so entrenched, but governments and central banks can take evasive action before it takes root. 

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