What is Stagflation

Stagflation is a condition of slow economic growth and relatively high unemployment, or economic stagnation, accompanied by rising prices, or inflation. It can also be defined as inflation and a decline in gross domestic product (GDP). Stagflation is an economic problem defined in equal parts by its rarity and by the lack of consensus among academics on how exactly it comes to pass.

1:18

Stagflation

BREAKING DOWN Stagflation

Stagflation can prove to be a particularly tough problem for governments to deal with due to the fact that most policies designed to lower inflation tend to make it tougher for the unemployed, and policies designed to ease unemployment raise inflation. 

Usually, when unemployment is high, spending declines, as do the prices of goods. Stagflation occurs when the prices of goods rise while unemployment increases and spending declines.

Stagflation is also considered an unnatural phenomenon since inflation shouldn't happen when an economy is weak. In most cases, weak or slower economic growth should prevent inflation from happening. 

Where Does "Stagflation" Come From?

The term "stagflation" was first used during a time of economic stress in the United Kingdom by Iain Macleod in the 1960s while he was speaking in the House of Commons. At the time, he was speaking about inflation on one side and stagnation on the other, calling it a "stagnation situation." It was later used again to describe the recessionary period during the 1970s following the oil crisis. 

Stagflation led to the emergence of the Misery index. This index, which combined the total rate of inflation with unemployment, served as a tool to show just how badly people were feeling when stagflation hit the economy. 

Theories on the Causes of Stagflation

There are two main theories on what causes stagflation. One theory states that this economic phenomenon is caused when a sudden increase in the cost of oil reduces an economy's productive capacity. Because transportation costs rise, producing products and getting them to shelves gets more expensive and prices rise even as people get laid off. 

Another theory is that the confluence of stagnation and inflation are results of poorly made economic policy. Simply allowing inflation to go rampant, and then suddenly snapping the reins on inflation is one example of poor policy that some have argued can contribute to stagflation, while others cite harsh regulation of markets, goods and labor combined with allowing central banks to print excessive amounts of money are cited as another possible cause of stagflation. 

This happened in Zimbabwe in the early 2000s. Rather than implement traditional policy measures, the government started printing excessive amounts of money in order to deal with the country's rampant inflation rates. But this reached such high levels that the country started to experience hyperinflation, and ended up scrapping its currency and adopting the U.S. dollar as legal tender. 

Jane Jacobs saw the inability of the major economic schools of thought to come to a conclusion on why stagflation occurred in the first place as a symptom of misplacing their scholarly focus on the nation as the primary economic engine as opposed to the city. It was her belief that in order to avoid the phenomenon of stagflation, a country needed to provide an incentive to develop "import-replacing cities" — that is, cities that balance import with production. This idea, essentially diversifying the economies of cities, was critiqued for its lack of scholarship by some, but held weight with others. 

Contemporary economists like Olivier Blanchard cite both supply shocks on the prices of goods and worker output, as well as incorrect predictions made by Keynesian economics as the cause of stagflation and the inability of economics to understand it.

Example of Stagflation

Stagflation happened in the United States during the 1970s, when the country underwent a recession that saw five quarters of negative GDP growth. Inflation nearly tripled in 1973 and hit double digits between 1974 and 1975, and unemployment hit 9% by May 1975. 

But what caused all this? Most people pointed fingers at the oil shock that took place in 1973. The Organization of Petroleum Exporting Countries (OPEC) issued an embargo against Western countries. This caused the global price of oil to rise dramatically, therefore increasing the costs of goods and contributing to a rise in unemployment.

Some point fingers to the policies set in place by President Richard Nixon, which may have led to the recession of 1970 — a possible precursor to the period of stagflation. Nixon removed the United States from the gold standard, put on tariffs on imports and froze wages and prices for 90 days. 

But overall, there has been little consensus on what exactly caused the economic problem. Each school of economics offers its own understanding on what exactly went wrong and why. 

Can Stagflation Ever Happen Again?

There is little to show that the events that took place in the 1970s will occur again, even though the 2007-2008 financial crisis may have renewed fears of economic stagnation. People were concerned that the Federal Reserve's monetary policies and Congress' fiscal policies (which included the economic stimulus package) would lead to inflation and high spending.

But those fears haven't come to pass. In fact, the Fed is more committed to consistency in its direction when it comes to inflation, rather than use a stop-and-go approach to monetary policy. And many economists say it's very unlikely that wages and prices will be constrained as they were in the 1970s.