Stagflation Explained
The combination of recession, inflation, and high unemployment rates characterizes stagflation in an economy. Although different strategies exist to combat inflation and recession individually, it is difficult to control stagflation because the two effects are conflicting.
Basics
Stagflation is a situation in which an economy suffers from a combination of high unemployment rates, negative growth, and rising prices. The conflicting effects of inflation and recession make it difficult to control stagflation, even though there are strategies to combat recession and inflation individually.
To address economic stagnation or negative growth, increasing the money supply can be an effective measure by lowering interest rates, which leads to expansion and higher employment rates, ultimately preventing or combating a recession.
On the other hand, to control rising inflation, the money supply must be reduced to slow down the economy, often by raising interest rates, making it more expensive to borrow money. Reduced demand causes businesses and consumers to borrow and spend less, which can bring prices to a halt.
In cases of stagflation, however, the worst of both sides combines to create a severe economic challenge. To understand stagflation better, it is essential to explore its causes and potential solutions.
What Is Stagflation?
Iain Macleod, a British politician and Chancellor of the Exchequer, introduced stagflation in 1965 as a macroeconomic concept. Stagflation is a combination of stagnation and inflation, which occurs when an economy experiences low or negative growth and high unemployment along with increasing consumer prices. Typically, the economic measures employed to combat either of these conditions could exacerbate the other, making stagflation a difficult challenge for governments or central banks to address.
Unlike typical economic conditions, stagflation does not follow the general rule that higher levels of employment and growth correlate positively with inflation. The level of economic growth is often determined by a country's gross domestic product (GDP), which is connected to employment rates. The emergence of severe stagflation can lead to a more extensive financial crisis when GDP is not performing well, and inflation is increasing.
Stagflation vs. Inflation
Stagflation is a combination of high inflation and economic stagnation, characterized by low economic growth and high unemployment rates. Inflation, on the other hand, is a sustained increase in the general price level of goods and services in an economy over a period of time. It is also a decrease in the purchasing power of a currency.
What Causes Stagflation?
To put it briefly, stagflation is when the economy experiences a combination of reduced supply and growth along with a decrease in the purchasing power of money. The specific causes of stagflation can vary depending on the time and economic perspectives. Multiple theories explain stagflation, such as the monetarist, Keynesian, and new classical models. Several examples illustrate these different theories.
The Conflict between Monetary and Fiscal Policies
Monetary and fiscal policies are tools used by central banks and governments to influence the economy. Monetary policy is used to manage the money supply, while fiscal policy is concerned with government spending and taxation. However, when these policies conflict, they can lead to stagflation - a situation where the economy experiences low growth, high unemployment, and inflation.
This can happen when policies that decrease consumer spending are combined with an increase in the money supply. For example, if the government raises taxes, people have less money to spend, and this can negatively impact economic growth. At the same time, the central bank may use quantitative easing or reduce interest rates, which increases the money supply and can lead to inflation. When both of these conditions exist, it creates stagflation.
Fiat Currency
The gold standard used to be the common practice for most major economies to peg their currencies to a certain amount of gold. However, this practice was abandoned after World War II. Nowadays, fiat currency has replaced the gold standard, which has resulted in no limits on the supply of money. This may benefit central banks in controlling the economy, but it also puts inflation levels at risk, which could lead to higher prices.
Growth of Supply Costs
Stagflation can be triggered by a sudden surge in production costs of goods and services, specifically energy, which is referred to as a supply shock. The rise in energy prices, particularly oil prices, harms consumers and can lead to stagflation. When production costs rise and prices increase, while consumers experience a decrease in disposable income due to rising energy costs, the likelihood of stagflation increases.
How to Fight Stagflation?
Stagflation, the combination of slow economic growth and rising prices, can be addressed using different economic policies, depending on the school of thought. Governments typically use fiscal and monetary policies to tackle stagflation, but their implementation can vary depending on the economic perspective.
Monetarism
Monetarists believe that controlling the money supply is crucial to controlling inflation. They advocate for a reduction in the money supply to decrease overall spending, leading to lower demand and lower prices for goods and services. However, this policy doesn't encourage growth, and growth must be tackled later using a combination of loose monetary policy and fiscal policy.
Supply-Side Economy
To address stagflation, supply-side economists suggest increasing the economy's supply by reducing costs and enhancing efficiency. Measures such as price controls on energy, investing in efficiency, and providing production subsidies can lead to lower costs, higher aggregate supply, lower consumer prices, and increased economic growth, which in turn will reduce unemployment.
Free-Market Solution
Some economists argue that the best approach to stagflation is to leave it to the free market, where supply and demand will eventually reduce rising prices as consumers are no longer able to afford goods. In addition, the free market can allocate labor effectively, leading to lower unemployment. However, this approach may take a long time to be effective and could leave the population in unfavorable conditions, as Keynes famously said, "In the long run, we're all dead."
Stagflation's Effect on Crypto Market
Assuming other market conditions remain unchanged, it is difficult to fully determine the impact of stagflation on crypto. Nonetheless, some general assumptions can be made.
The effects of stagflation on the crypto market are difficult to define, but some basic assumptions can be made assuming other market conditions remain constant. Meanwhile, investors view Bitcoin as a potential hedge against rising inflation rates because keeping wealth in fiat currency without earning interest may reduce its value in times of inflation. BTC is seen as a good store of value due to its limited issuance and supply.
When an economy experiences little or negative growth, income levels tend to stagnate or decrease. This can lead to a decrease in crypto purchases and an increase in sales as retail investors require funds for daily expenses. Additionally, slow or negative economic growth can incentivize large investors to reduce their exposure to high-risk assets, such as cryptocurrencies and stocks.
Governments usually prioritize controlling inflation before addressing growth and unemployment. To curb inflation, one method is to decrease the money supply by raising interest rates. This can make borrowing more expensive and cause people to keep their money in banks, reducing liquidity. As a result, high-risk investments like cryptocurrency may become less appealing, and demand and prices could decrease.
Once inflation is under control, governments usually try to stimulate growth through quantitative easing and reducing interest rates. In this situation, the crypto market is likely to experience positive effects due to the increased money supply.
It is important to note that using crypto as a hedge against inflation may not work as effectively in shorter time frames, particularly during periods of stagflation. Furthermore, other factors such as the increasing correlation between crypto and stock markets are also at play.
Stagflation in the 1973 Oil Crisis
In 1973, OPEC declared an oil embargo on select countries as a response to the Yom Kippur War. The decrease in oil supply caused a surge in oil prices, which led to supply chain shortages and an increase in consumer prices. Consequently, inflation rates skyrocketed.
Central banks in the US and UK attempted to encourage economic growth by lowering interest rates. Low-interest rates make borrowing cheaper, which incentivizes spending over saving. However, the traditional method to reduce inflation is to raise interest rates and encourage saving.
Since energy expenses account for a significant portion of consumer expenditure and lowering interest rates did not lead to sufficient economic growth, many Western economies experienced high inflation and an unprogressive economy.
Conclusion
When an economy experiences both inflation and negative growth, it creates a unique challenge for economists and policymakers, as these two phenomena don't usually happen together. The typical tools used to address stagnation often result in inflation, while measures to curb inflation can lead to slow or negative economic growth. Therefore, in times of stagflation, it's important to take into account the broader macroeconomic context and various factors such as the money supply, interest rates, supply and demand, and employment rate.