What is Stagflation?

Over the years, economists have tagged stagflation “impossible,” although it has occurred a couple of times since the 1970s oil crisis that infected the world with a high unemployment rate as well as inflation. In 2022, for instance, there have been rising speculations that the United States might enter a short period of stagflation, such that economic policymakers are most likely to exacerbate one of its consequential factors while trying to correct another.

Stagflation is a peculiar example of how real-world economic crises can be worsened by the negligence of popular economic theories and policy prescriptions.

Understanding Stagflation

Stagflation is a simultaneous appearance in an economy characterized by slow growth, and a high unemployment rate accompanied by inflation. The word “stagflation” was first used by British Politician Iain Macleod in a 1965 House of Commons Speech to describe an economy facing the combined effects of inflation and stagnation. The United Kingdom was on the brink of an economic collapse at the time.

The word was then revived in the United States during the 1970s oil crisis which brought a negative decline in five consecutive quarters of GDP growth. Not only did inflation double massively between 1972 and 1973, but the unemployment rate climaxed to 9% by the end of 1973. The effects of stagflation were calculated by a misery index which can track the real-world effects of stagflation on a country and its people by summing up the inflation rate and unemployment rate.

History of Stagflation

Since stagflation was once believed to be an impossible threat, economic theories that were part of the 20th-century academic and policy circles ruled it out of their models. Not to mention that Phillips Curve was already in existence, an economic theory based on the context of Keynesian economics, which referred to the macroeconomic policy as a linkage between unemployment and inflation.

Stagflation, however, became more evident during the Great Depression and the ascendance of Keynesian economics, such that economists argued that most policies designed to lower inflation end up aggravating unemployment, while policies designed to lower unemployment increase inflation.

Possible Causes of Stagflation

There is no single or real agreement among economists on the causes of stagflation, although a series of arguments have been put forward over the years to explain its occurrence.

Oil Price Shocks

A popular theory suggests that stagflation is caused when the productive capacity of an economy is affected by an immediate hike in the price of oil. A great example is the oil crisis of the 1970s which made the Organization of Petroleum Exporting Countries (OPEC) issue an embargo against Western countries, thereby leading to a dramatic rise in the price of oil all over the world. This also affected the cost of products and contributed immensely to the growth of unemployment. Additionally, transportation costs rose which made the production and storage of goods expensive. According to critics of this theory, the sudden oil price shocks like that of the 1970s have no connection to the consecutive periods of recession and inflation that occurred after the embargo.

Poor Economic Policies

Another theory states that poorly made economic policies lead to stagnation and inflation, which combines to cause stagflation. When regulation of goods and services is made harsh and almost unbearable, stagflation is bound to happen. Such a case can be attributed to former president Richard Nixon’s policies which instituted tariff bans on imports and froze wages and prices for three months in a bid to initiate deflation. Although the policy worked in the beginning, the sudden acceleration of prices led to economic downturns.

Loss of the Gold Standard

Certain monetary factors may play a big role in stagflation. Take for example, when Richard Nixon removed the final remnants of the gold standard, crashing down the Bretton Woods system that controlled currency exchange rates, it brought an end to most practical constraints on financial expansion and currency devaluation.

Possible Cure for Stagflation

As previously said, stagflation is a combination of three negatives: slower economic growth, a high unemployment rate, and inflation. In the logic of economics, such a case isn’t supposed to happen because prices should increase when people have less money to spend.

All this said, there is no possible definitive cure for stagflation, at least not yet. But economists and theorists are somewhat certain that a cure will be to increase productivity to a point where there’s higher growth without incurring additional inflation, which allows for a tightening of monetary policy to curb inflation. Beyond that, it’s imperative to note that the key to preventing stagflation is for economic policymakers to try as much as possible to avoid it.

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