TL;DR

Stagflation occurs when the economy experiences high levels of unemployment accompanied by stagnation or negative growth (recession) and rising prices (inflation). There are strategies for both dealing with recession and inflation, but because they have opposite impacts, the combination of the two makes stagflation difficult to control.

Introduction

On the one hand, economic stagnation or negative growth can be overcome by increasing the money supply so that companies can borrow money more cheaply (lower interest rates). More money leads to expansion and higher employment levels. This can prevent or overcome a recession effectively.

Instead, economists and policymakers often attempt to control rising inflation by reducing the money supply to slow the economy. This can be done by increasing interest rates, making borrowing money more expensive. Businesses and consumers are borrowing and spending less. Decreased demand causes prices to stop rising.

However, when the economy experiences stagflation, two equally bad things happen: a recession combined with high inflation. Let's dive in to understand the definition of stagflation, its common causes, and possible solutions.

What is stagflation?

Stagflation is a macroeconomic concept that was first mentioned in 1965 by Iain Macleod, a British politician and Minister of Finance. This name is a combination of stagnation and inflation which describes a condition where the economy experiences minimal or negative growth and high unemployment accompanied by rising consumer prices (inflation).

General economic controls used to address each condition can worsen the other conditions, making stagflation difficult for the government or central bank to handle. Typically, high employment levels and positive growth are associated with inflation. However, stagflation is a different matter.

Economic growth is often measured by a country's gross domestic product (GDP) which is directly related to employment levels. When GDP is not doing well and inflation is rising, severe stagflation can lead to a wider financial crisis.

Stagflation vs. inflation

As mentioned, stagflation is a combination of inflation and economic stagnation or negative growth. Although there are various definitions, inflation is often defined as an increase in the prices of goods and services. We can also explain inflation as a decrease in the purchasing power of a currency.

Why does stagflation occur?

In short, stagflation occurs when the purchasing power of money decreases along with an economic slowdown and a decrease in the supply of goods and services. The exact causes of stagflation vary depending on historical context and various economic views. There are various theories and opinions that explain stagflation in different ways, including monetarist, Keynesian, and new classical models. Let's look at some examples.

Conflicting monetary and fiscal policies

Central banks such as the US Federal Reserve manage the money supply to influence the economy. This control is called monetary policy. The government also directly influences the economy with spending and tax policies called fiscal policy. However, a conflicting combination of fiscal and monetary policies can lead to uncontrolled inflation and slow economic growth. A combination of policies that reduce consumer spending while increasing the money supply can ultimately lead to stagflation.

For example, the government can raise taxes so that residents have less disposable income. At the same time, the central bank can implement quantitative easing ("printing money") or reduce interest rates. Government policy will have a negative impact on growth, while the central bank increases the money supply. This often leads to stagflation.

Introduction to fiat currency

Previously, most major economies pegged their currencies to a certain amount of gold. This mechanism is known as the gold standard, but was largely abandoned after World War II. The gold standard was abolished and replaced with fiat currency which removed restrictions on the money supply. Although this can facilitate the central bank's work in controlling the economy, there is also a risk that the inflation rate will be disrupted which could lead to price increases.

Increase in supply costs

A significant increase in the costs of producing goods and services can also cause stagflation. This relationship is very real for energy and is referred to as a supply shock. Consumers are also affected by rising energy prices which usually come from oil prices.

If goods cost more to produce and their prices rise, while consumers have less disposable income due to heating, transportation, and other energy-related costs, stagflation is likely to occur.

How to overcome stagflation?

Stagflation can be overcome with fiscal and monetary policies. However, the exact policies implemented depend on each economic stream.

monetary

Monetarists (economists who believe that controlling the money supply is the main key) will argue that inflation is the most important factor to control.

In this scenario, monetarists would reduce the money supply first which would reduce overall spending. This leads to less demand and a decrease in the prices of goods and services. However, the weakness is that this policy does not encourage growth. The growth problem must be addressed later through easing monetary policy accompanied by fiscal policy.

Supply side economist

Another school of thought is to increase supply in the economy by reducing costs and increasing efficiency. Price controls on energy (where possible), investments in efficiency, and production subsidies will help reduce costs and increase the economy's aggregate supply. This lowers prices for consumers, stimulates economic output, and reduces unemployment.

Free market solutions

Some economists believe that the best solution to stagflation is to leave it to the free market. Supply and demand will ultimately solve the problem of rising prices because consumers are unable to purchase goods. This fact will cause a decrease in demand and a decrease in inflation.

A free market will also allocate labor efficiently and reduce unemployment. However, these plans may take several years or decades to succeed. People will live in uncomfortable conditions during the process. As Keynes said, “in the long run, we will all die.”

How does stagflation affect the crypto market?

The exact impact of stagflation on crypto is difficult to fully define. However, we can make some basic assumptions if we assume that other market conditions remain the same.

Minimal or negative growth

An economy that is barely growing or shrinking will lead to stagnant or even reduced income levels. In this case, consumers have less money to invest. This could lead to reduced crypto purchases and increased sales as retail investors need to access money for daily expenses. Slow or negative economic growth also encourages large investors to reduce their exposure to high-risk assets, including stocks and cryptocurrencies.

Government action against stagflation

Usually, the government will try to control inflation first, then deal with growth and unemployment problems later. Inflation can be controlled by reducing the money supply. One method is to increase interest rates.

This action reduces liquidity, because people will keep their money in banks. Loans will also become more expensive. As interest rates rise, high-risk, high-return investments become less attractive. Therefore, cryptocurrencies may experience reduced demand and prices during times of rising interest rates and lower money supplies.

After controlling inflation, the government tends to want to stimulate growth. This is usually done through quantitative easing and interest rate reductions. In such a scenario, the impact on the crypto market will tend to be positive as the money supply increases.

Rising inflation

Most investors think that Bitcoin can be a good hedge against rising inflation rates. If inflation is high, your wealth in non-interest-bearing fiat will reduce its true value. To avoid this, most people have turned to Bitcoin to maintain their long-term purchasing power and even earn profits. This is because investors consider BTC to be a good store of value due to its limited issuance and supply.

Historically, hedging strategies may work for investors who accumulate Bitcoin and other cryptocurrencies over many years. Specifically, during or after periods of inflation and economic growth. However, using crypto as a hedge against inflation may not be effective in the short term, especially during times of stagflation. It's also worth noting that there are other factors to consider, such as the increasing correlation between crypto and the stock market.

Stagflation in the 1973 oil crisis

In 1973, the Organization of the Petroleum Exporting Countries (OPEC) declared an oil embargo on a select group of countries. This decision was a response to support for Israel in the Yom Kippur war. With a significant reduction in oil supply, oil prices have increased resulting in supply chain shortages and rising consumer prices. This causes a significant increase in the inflation rate.

In countries like the US and UK, central banks cut interest rates to encourage economic growth. Lower interest rates make borrowing cheaper and encourage people to spend rather than save. However, a common mechanism for reducing inflation is to raise interest rates and encourage consumers to save.

As oil and energy costs became a major part of consumer spending, while cutting interest rates did not stimulate enough growth, many western economies experienced high inflation and economic stagnation.

Conclusion

Stagflation presents a unique situation for economists and policymakers, because inflation and negative growth do not usually occur together. Tools to overcome stagnation often lead to inflation, while strategies to control inflation can lead to slow or negative economic growth. So, during stagflation, the macroeconomic context and several factors need to be considered, such as money supply, interest rates, supply and demand, and the unemployment rate.