What is stagflation and its meaning in History
April 24, 2023
Here we’re going to find out what stagflation is, its meaning and definition, looking at the historical example of the 1970s: what are the consequences and possible solutions?
What is stagflation: meaning and definition
What is stagflation? Its meaning is the combination of two macroeconomic ‘monsters’, inflation and economic stagnation. Basically, it is when general price increases mix with recession, i.e. no or slow growth in a country’s real Gross Domestic Product (GDP), and high unemployment.
Simply put, the definition of stagflation is a condition of recessionary inflation that is as anomalous as it is difficult to combat. In fact, in the natural economic cycle, the rise in prices should coincide with the growth in productivity and employment levels (expansion phase), just as the decline in these factors is simultaneous in the contraction phase. Thus, post-war monetary policies simply sought a trade-off between inflation and GDP.
British politician Iain Macleod, however, observed the coexistence of high prices and recession in ’65 and coined the term stagflation:
“We now have the worst of both worlds—not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of ‘stagflation’ situation. And history, in modern terms, is indeed being made.”
This situation refutes the regular business cycle shown earlier, represented by the Phillips curve: wages should have a higher growth rate the lower the level of unemployment. Also, higher incomes should drive consumption which, by the law of supply and demand, should increase product prices. To sum up, when unemployment falls (stimulating GDP growth) inflation should rise, and vice versa.
Stagflation turns the tables: the economist Milton Friedman predicted the recessionary period of the 1970s, one of the harshest even in the history of inflation, showing that the Phillips curve was only valid in the short term. In the long run, in fact, workers would ask for compensation to be adjusted to the inflation forecast, bringing unemployment back to the original rate but with higher consumer prices.
The consequences of stagflation: the example of the 1970s
The meaning of stagflation and its consequences were ignored by the Central Banks who, in order to stimulate economic growth, adopted extremely expansive (dovish) measures in the post-war period. Basically, to push consumption, so as to support GDP and employment, they granted loans at low interest rates. The increase in the circulating amount of money, however, happened too fast and caused the inflation rate to rise excessively.
To prevent rising prices from reducing workers’ purchasing power and aggregate demand, some states introduced an automatic wage adjustment mechanism. This exposed the economy to the risk of a price wage spiral and stagflation, which in fact happened: faced with higher costs, companies increased product prices, hence inflation, and reduced employment and production.
Explaining what stagflation is and what it means with examples, however, we cannot only mention wage costs, because other events contributed to exacerbating the phenomenon in the 1970s. First, the failure of the Bretton Woods agreements and the Gold Exchange Standard, the system that fixed an exchange rate for each fiat currency against the dollar, itself pegged to gold reserves ($35 per ounce of gold). In 1971, US President Nixon abolished the international conversion between dollars and the commodity: currency ratios began to fluctuate, and gold and oil prices became very volatile.
In particular, the value of oil rose rapidly, mainly due to supply shocks: in 1973, the members of OPEC (Organisation of Petroleum Exporting Countries) approved an embargo on the sale of crude oil to the US. The real meaning of stagflation is to be found in this decision, because it was extended to all other western countries that supported Israel in the Yom Kippur war.
In this conflict, Egypt and Syria tried to retake the Sinai Peninsula, which had been conquered by the Israelis during the Six Day War (1967), which was also followed by the closure of the Suez Canal for eight years. In the early 1980s, the war between Iraq and Iran caused another drop in oil production and a rise in its price.
To understand what stagflation is and its consequences, therefore, we have to consider ‘exogenous’ causes to the economy, which is already subject to high inflation. The rising value of oil and raw materials made production processes more expensive and less profitable: just imagine moving goods when petrol was overpriced. This slowed economic growth (GDP) and companies were forced to lay off workers, increasing the unemployment rate.
How to fight stagflation? Past and future solutions
Having learned what stagflation is from its meaning and definition, we could also look for a solution in historical examples. In the 1970s, many European governments, in order to deal with the oil crisis, used fuel rationing coupons, or called for generalised stops in petrol consumption, such as during the so-called ‘bicycle Sundays’.
The oil embargo imposed by OPEC lasted a few months, but prices continued to rise thereafter. Thus, governments resorted to debt to finance public spending, while companies began to relocate. Relocating activities, where labour costs were lower, was a solution to the consequences of stagflation: it counteracted the price-wage spiral, rebalancing the labour market and increasing productivity.
The meaning of stagflation, unfortunately, is still relevant: OPEC+ has reduced production in 2023, which has led to an upward revision of oil price forecasts. Similarly, the conflict in Ukraine hinders supply and increases the cost of gas and raw materials. Finally, our purchases are still subject to high inflation, due to the huge amount of money injected into state economies during the Covid period.
Having understood what stagflation is, we can see some common elements with the past: before the risk proves to be real, how can we deal with it? The ECB acts on consumer prices: it reduces circulating money by raising interest rates so as to induce savings. By decreasing aggregate demand, prices should fall, but this penalises economic growth (GDP). The goal is soft landing, lowering inflation without causing recession, but restrictive policies such as Quantitative Tightening may not be enough.
In any case, to the great dilemma ‘is it better to control inflation or unemployment’, finding a solution is not up to the common citizen, but that does not prevent you from preserving your purchasing power. In this respect, compared to other traditional assets such as gold, oil and shares, research has shown that Bitcoin better protects against inflation.
Now that we know what stagflation is and what it means, therefore, all that remains is to consider the best options for defending our capital should it occur: by looking at some charts, assess for yourself whether the recurring purchase of BTC might be right for you. Don’t forget, however, to take into account the risks involved in buying and holding cryptocurrencies.