TL;DR

Stagflation occurs when an economy experiences high unemployment rates combined with stagnation or negative growth (recession) and rising prices (inflation). There are strategies to combat recession and inflation individually, but as they have conflicting effects, the combination of both makes it difficult to control stagflation.

Introduction

On the one hand, economic stagnation or recession can be resolved by increasing the money supply, through cheaper loans to companies (lower interest rates). More available money generates economic growth and increased employment rates, which can effectively ward off or combat a recession.

On the other hand, economists and governments often try to control rising inflation by reducing the money supply to slow the economy. This can be done by increasing interest rates, i.e. making it more expensive to apply for loans. Businesses and consumers apply for fewer loans and spend less. Therefore, reduced demand causes prices to stop rising.

However, when an economy experiences stagflation, we have the worst of both sides: an economic recession combined with high rates of inflation. Let's see more details about stagflation, its most common causes and possible solutions.

What is stagflation?

Stagflation is a macroeconomic concept first mentioned in 1965 by Iain Macleod, a former British politician and Chancellor. The name is a combination of the terms stagnation and inflation and describes an economy with minimal or negative economic growth (recession) and high unemployment rates combined with rising consumer prices (inflation).

The measures usually adopted to combat each of these conditions individually can worsen the other. Therefore, dealing with stagflation is a challenge for the government or central bank. Typically, high employment rates and high growth correlate positively with inflation, but this is not the case with stagflation.

Economic growth is typically measured by a country's gross domestic product (GDP), which is directly related to employment rates. When GDP is not performing well and inflation is rising, severe stagflation can lead to an even greater financial crisis.

Stagflation x inflation

Stagflation, as we have seen, is the combination of inflation and economic stagnation or negative growth (recession). Although inflation can be defined in different ways, it often refers to an increase in the prices of goods and services. We can also describe inflation as a decrease in the purchasing power of a currency.

Why does stagflation occur?

In short, stagflation occurs when the purchasing power of currency decreases at the same time that the economy slows down and the supply of goods and services decreases. The causes of stagflation vary depending on the historical context and different economic perspectives. There are several theories and opinions that explain stagflation in different ways, including the monetarist, Keynesian and new classical models. Let's see some examples.

Divergences between fiscal and monetary policies

Central banks, such as the US Federal Reserve, manage the money supply to intervene in the economy. These control measures are known as monetary policy. Governments also influence the economy directly with expenditure and tax policies known as fiscal policy. However, the conflicting combination of fiscal and monetary policies can generate uncontrolled inflation and slow economic growth. Any combination of policies that reduce consumer spending while increasing money in circulation can generate stagflation.

For example, a government can increase taxes, reducing the disposable income of its population. At the same time, it is possible that the central bank will simultaneously adopt the strategy of quantitative easing (“money printing”) or reduce interest rates. Government policy will negatively affect economic growth, while the central bank will cause an increase in the money supply, which often leads to inflation.

The introduction of fiat currency

Previously, most major economies pegged their currencies (backing) to a certain amount of gold. This mechanism was known as the gold standard, but was abandoned after World War II. The removal of the gold standard and its replacement with fiat currency removed any limits when it came to the supply of money. Although this makes it easier for central banks to control the economy, it also increases the risk of harming inflation levels, causing a rise in prices.

Increases in supply costs

A sharp increase in the costs of producing goods and services can also cause stagflation. This relationship is especially true for the energy sector and is known as a supply shock. Consumers also suffer from rising energy costs, typically resulting from rising oil prices.

If the costs of producing goods are higher, prices rise. Therefore, consumers have less disposable income due to the cost of energy, transportation and other energy-related services. As a result, the likelihood of stagflation is greater.

How to combat stagflation?

The fight against stagflation is done through fiscal and monetary policies. However, the exact measures adopted by these policies depend on the school of economic thought.

Monetarismo

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

In this scenario, a monetarist would first reduce the money supply, causing a reduction in overall spending. This would decrease demand and cause prices for goods and services to fall. The downside, however, is that this policy does not encourage growth. Growth would have to be tackled later, through the combination of a more "loose" and flexible monetary policy with fiscal policy.

Supply-side economics

Supply-side economics is another school of thought. As the name suggests, the focus is on increasing supply in the economy, reducing costs and improving efficiency. Energy price controls (if possible), investments in efficiency and production subsidies will help reduce costs and increase the aggregate supply of goods and services. This reduces consumer prices, stimulates economic production and reduces unemployment.

Free market solution

Some economists believe that the best measure to remedy stagflation is to leave it to the free market. Rising prices will eventually be contained by supply and demand, as consumers cannot afford goods and services. As a result, there will be a reduction in demand and inflation.

The free market will also allocate labor efficiently and reduce unemployment. However, this plan can take years or even decades to work, often leaving the population in precarious and unfavorable conditions. As Keynes said: "In the long run, we are all dead."

How could stagflation affect the cryptocurrency market?

It is difficult to define the exact effects of stagflation on the cryptocurrency market. However, we can make some basic assumptions if we assume other market conditions remain the same.

Minimal or negative growth

In an economy that grows very little or is in recession, income levels stagnate or even decline over time. In this case, consumers have less and less money to invest. This will likely lead to a reduction in cryptocurrency purchases and an increase in sales, as individual investors need money to pay their daily expenses. Slow or negative economic growth also encourages large investors to reduce their exposure to riskier assets, including stocks and cryptocurrencies.

Government measures against stagflation

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

This reduces liquidity, as people keep their money in banks and loans become more expensive. As rates rise, high-risk, high-return investments are less attractive. Therefore, cryptocurrencies will likely experience a reduction in demand and prices during periods of rising interest rates and reduced credit/money supply.

After controlling inflation, the government will likely try to stimulate economic growth. This is generally done through quantitative easing and reducing interest rates. In this scenario, the effects on cryptocurrency markets will likely be positive due to the increase in money supply.

Rising inflation

Many investors argue that Bitcoin offers a good hedging strategy against rising inflation rates. With higher and rising inflation, keeping your wealth in fiat currencies, without generating interest, reduces its real value. To avoid this, many have turned to Bitcoin, aiming to preserve their long-term purchasing power and also make profits. This is because investors see BTC as a good store of value, thanks to its limited issuance and supply.

Historically, this hedging strategy may have worked for investors who have accumulated Bitcoin and other cryptocurrencies over the years. Especially during or after periods of inflation and economic growth. However, using cryptocurrencies as a hedge against inflation may not work as well in shorter time frames, particularly during periods of stagflation. It's also worth noting that there are other factors at play, such as the increased correlation between the stock and cryptocurrency markets.

Stagflation in the 1973 oil crisis

In 1973, the Organization of Arab Petroleum Exporting Countries (OPEC) declared an oil embargo on a certain group of countries. This decision was a reaction to these countries' support for Israel in the Yom Kippur war. With a drastic decrease in supply, oil prices rose, causing shortages in the supply chain and rising prices for consumers. This led to a large increase in the inflation rate.

In countries like the US and the UK, central banks reduce interest rates to stimulate growth in their economies. With lower interest rates, loans become cheaper, so consumers have more incentive to spend than save. But the mechanism normally used to reduce inflation is to increase interest rates, which encourages consumers to save.

Because oil and energy costs account for a large portion of consumer spending and rising interest rates do not sufficiently stimulate growth, many Western economies experience high inflation rates and a stagnant economy.

Conclusion

Stagflation is a peculiar situation for economists and governments, as inflation and recession generally do not occur simultaneously. Tools to combat stagnation often cause inflation, while strategies to control inflation can lead to slow or negative economic growth, that is, recession. Therefore, in periods of stagflation, it is worth considering the macroeconomic context and its multiple factors, such as currency supply, interest rates, supply and demand and unemployment rate.