What is stagflation

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Stagflation describes high unemployment combined with stagnation or recession and rising prices (inflation). Containing these phenomena can be extremely challenging.

Introduction

On the one hand, economic stagnation and negative growth can be curbed by increasing the money supply. As a result, loans become more affordable due to lower interest rates. Large amounts of free money, in turn, stimulate economic expansion and job creation, which helps prevent a recession.

Economists and politicians, on the contrary, are trying to control rising inflation by reducing the money supply, thereby hoping to slow economic growth. They raise interest rates, making borrowing less affordable and forcing companies and consumers to cut their spending so that lower demand will stop prices from rising.

However, the situation may worsen so much that a recession occurs simultaneously with high inflation - this is called stagflation. Let's take a closer look at the concept of stagflation, as well as the reasons for its occurrence and possible solutions.

What is stagflation

Stagflation is a macroeconomic concept proposed in 1965 by British politician Ian MacLeod. The name is a combination of the words stagnation and inflation. This concept describes the state of an economy with minimal or negative economic growth, as well as high unemployment combined with rising prices (inflation).

Typical strategies to control one of these phenomena can lead to an exacerbation of the other, making stagflation a serious problem for the government or central bank. Typically, high employment levels are positively correlated with inflation, but not in the case of stagflation.

Typically, a country's economic growth is measured by its gross domestic product (GDP), which is directly related to its employment rate. If GDP levels are low and inflation is rising, prolonged stagflation could lead to a financial crisis.

Stagflation and inflation

As we mentioned earlier, stagflation is a combination of inflation and economic stagnation or negative growth. Inflation can be defined in different ways: it usually refers to an increase in the prices of goods and services, but it is also characterized by a general decline in the purchasing power of a currency.

Why does stagflation occur?

Stagflation occurs when the value of money declines along with a slowdown in economic growth and a decrease in the supply of goods and services. The causes of stagflation depend on the historical context and the economic approach to their consideration. There are many theories that explain the causes of stagflation, among which are the monetarist, Keynesian and new classical models. Let's look at them with an example.

The clash between the monetary approach and fiscal policy

Central banks, such as the US Federal Reserve, manage the supply of money and control the economy. The set of these controls is called monetary or monetary policy. Governments also influence the economy by regulating spending and taxation policies—fiscal policy. However, a clash between fiscal and monetary policies could lead to increased inflation and slower economic growth. The combination of measures to reduce consumer spending while increasing the money supply could eventually lead to stagflation.

For example, the government decides to increase taxes, as a result of which the population has less free money. During this time, the central bank conducts quantitative easing (printing money) and lowers interest rates. Government policies slow down economic growth while the central bank increases the money supply, leading to inflation.

Introduction of fiat currency

In the past, most of the world's major economies pegged their currencies to gold reserves. This mechanism was called the gold standard, but was abandoned after World War II. The abolition of the gold standard and its replacement with fiat currency eliminated the limitations associated with the supply of money. While this made it easier for central banks to control the economy, it risked triggering inflation and causing prices to rise.

Increased energy costs

A sharp increase in the cost of producing goods and services can also lead to stagflation. This relationship is especially characteristic of energy resources and is known as supply shortage. Consumers are also suffering from rising energy prices, primarily from rising oil prices.

If production of goods becomes more expensive, prices rise, and consumers have less free money due to utility and transportation costs, then stagflation is extremely likely.

How to fight stagflation

The fight against stagflation is carried out using fiscal or monetary policy, the choice between which depends on the economic school.

Monetarists

Monetarists (economists who believe that managing the money supply is most important) argue that inflation must be controlled first.

In this case, monetarists recommend reducing the supply of money, which leads to a decrease in overall spending. As a result, consumer demand decreases and prices for goods and services fall. However, such a policy does not stimulate economic growth; for this, it will be necessary to use a loose monetary policy in combination with fiscal policy.

Money Supply Economists

Another school of economics focuses on increasing supply in the economy by reducing costs and increasing efficiency. Energy price controls (if possible), efficiency investments, and production subsidies will help reduce costs and increase supply in the economy. As a result, it will be possible to reduce the prices of goods, which will stimulate economic growth and reduce unemployment.

Free market solutions

Some economists believe that the best way to combat stagflation is to leave it to the free market. Supply and demand will eventually stop prices from rising because consumers will not be able to buy increasingly expensive goods, and reduced demand will lead to lower inflation.

The free market also allows for efficient allocation of labor and reduced unemployment. However, the successful implementation of this plan may require years or decades of low living standards for the population. As the English economist John Keynes said, “In the long run, we are all dead.”

How stagflation could affect the cryptocurrency market

Assessing the impact of stagflation on cryptocurrency is quite difficult. However, we can make some predictions assuming that market conditions remain the same.

Minimal or negative growth

A weakly growing or weakening economy leads to stagnation or even reduction in income levels. This leaves consumers with less available cash, leading to less cryptocurrency investment and increased sales as retail investors need fiat money for day-to-day expenses. Slow or negative economic growth is also prompting large investors to reduce their high-risk assets, including stocks and cryptocurrencies.

Government measures to combat stagflation

Typically, the government first tries to control inflation and then solves the problems of growth and unemployment. Inflation can be controlled by reducing the money supply and raising interest rates.

As a result, liquidity decreases as people keep their money in banks and borrowing becomes more expensive. As interest rates rise, high-risk, high-return investments become less attractive, so during periods of rising interest rates and a tightening money supply, demand and prices for cryptocurrency may decline.

Once the government gets inflation under control, it will likely try to stimulate growth - usually through quantitative easing and interest rate cuts. In this case, an increase in the money supply will have a positive impact on the cryptocurrency markets.

Rising inflation

Many investors argue that Bitcoin can be a good hedge against inflation. In an environment of rising inflation, holding funds in fiat without accruing interest reduces the real value of money. In order to save their funds and even make a profit, many people turn to Bitcoin. Due to BTC's limited release and supply, investors view it as a good store of value.

This hedging strategy is primarily suitable for investors who have been accumulating Bitcoin and other cryptocurrencies for many years. Hedging will be particularly effective during or after periods of inflation and economic growth. However, using cryptocurrencies as an inflation hedge may not work in the shorter term, especially during periods of stagflation. Also, do not forget about the increased correlation between cryptocurrencies and stock markets.

Stagflation during the 1973 oil crisis

In 1973, the Organization of Arab Petroleum Exporting Countries (OPEC) declared an oil embargo on a group of countries in response to support for Israel in the Yom Kippur War. After a sharp reduction in oil supplies, oil prices rose, leading to supply shortages, rising food prices and rising inflation.

In the US and UK, central banks stimulate the economy by lowering interest rates. Lower interest rates make borrowing more affordable and encourage spending rather than saving. However, raising interest rates and encouraging consumers to save are often used to curb inflation.

Because oil and energy costs accounted for a large portion of consumer spending and rising interest rates did not stimulate enough growth, many Western countries experienced high inflation and stagnant economies during this period.

Conclusion

Stagflation is a unique phenomenon for economists and policymakers because inflation and negative growth rarely occur simultaneously. Tools to combat stagnation often lead to inflation, and strategies to control inflation often lead to slow or negative economic growth. Therefore, during stagflation, it is necessary to study the macroeconomic context and its factors, including the money supply, interest rates, supply and demand, and employment levels.