What Is Stagflation, What Causes It, and Why Is It Bad?

Stagflation

Investopedia / Jiaqi Zhou

What Is Stagflation?

Stagflation is an economic cycle characterized by slow growth and a high unemployment rate accompanied by inflation. Economic policymakers find this combination particularly difficult to handle, as attempting to correct one of the factors can exacerbate another.

Once thought by economists to be impossible, stagflation has occurred repeatedly in the developed world since the 1970s oil crisis.

In mid-2022, many were saying that the United States had not entered a period of stagflation, but might soon experience one, at least for a short period. In June 2022, Forbes magazine argued that a period of stagflation was likely because economic policymakers would tackle unemployment first, leaving inflation to be dealt with later.

Key Takeaways

  • Stagflation is the simultaneous appearance in an economy of slow growth, high unemployment, and rising prices.
  • Once thought by economists to be impossible, stagflation has occurred repeatedly in the developed world since the 1970s.
  • Policy solutions for slow growth tend to worsen inflation, and vice versa. That makes stagflation hard to fight.
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Stagflation

Understanding Stagflation

The term stagflation was first used by British politician Iain Macleod in a speech before the House of Commons in 1965, a time of economic stress in the United Kingdom. He called the combined effects of inflation and stagnation a "'stagflation situation."

The term was revived in the U.S. during the 1970s oil crisis, which caused a recession that included five consecutive quarters of negative GDP growth. Inflation doubled in 1973 and hit double digits in 1974. Unemployment reached 9% by May 1975.

The effects of stagflation were illustrated by means of a misery index. This index, a simple sum of the inflation rate and the unemployment rate, tracked the real-world effects of stagflation on a nation's people.

History of Stagflation

Stagflation was once believed to be impossible. The economic theories that dominated academic and policy circles for much of the 20th century ruled it out of their models. In particular, the economic theory of the Phillips Curve, which developed in the context of Keynesian economics, portrayed macroeconomic policy as a trade-off between unemployment and inflation.

As a result of the Great Depression and the ascendance of Keynesian economics, economists became preoccupied with the dangers of deflation and argued that most policies designed to lower inflation tend to increase unemployment, while policies designed to lower unemployment raise inflation.

The advent of stagflation across the developed world later in the 20th century showed that this was not the case. Stagflation is a great example of how real-world experience can run roughshod over widely accepted economic theories and policy prescriptions.

Since that time, inflation has proved to be persistent even during periods of slow or negative economic growth. In the past 50 years, every declared recession in the U.S. has seen a continuous, year-over-year rise in consumer price levels.

The sole, partial exception to this is the lowest point of the 2008 financial crisis—and even then the price decline was confined to energy and transportation prices while overall consumer prices other than energy continued to rise.

What Causes Stagflation?

There is no real consensus among economists about the causes of stagflation. They have put forth several arguments to explain how it occurs, even though it was once considered impossible.   

Blame Oil Price Shocks

One theory states that stagflation is caused when a sudden increase in the cost of oil reduces an economy's productive capacity.

The oil crisis of the 1970s is the prime example. In October 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.

Because transportation costs rose, producing products and getting them to shelves became more expensive and prices rose even as people were laid off from their jobs.

Critics of this theory point out that sudden oil price shocks like those of the 1970s did not occur in connection with any of the simultaneous periods of inflation and recession that have occurred since the embargo.

Blame Poor Economic Policies

Another theory is that the confluence of stagnation and inflation is the result of poorly made economic policy. Harsh regulation of markets, goods, and labor in an otherwise inflationary environment are cited as the possible cause of stagflation.

Some point to former President Richard Nixon's policies, which may have led to the recession of 1970—a possible precursor to other periods of stagflation. Nixon put tariffs on imports and froze wages and prices for 90 days in an attempt to prevent prices from rising. Once the controls were relaxed, the rapid acceleration of prices led to economic chaos.

While appealing, this is an ad-hoc explanation of the stagflation of the 1970s which does not explain later periods that showed a simultaneous rise in prices and unemployment.

Blame the Loss of the Gold Standard

Other theories point to monetary factors that may also play a role in stagflation.

Nixon removed the last indirect vestiges of the gold standard, bringing down the Bretton Woods system that had controlled currency exchange rates.

This decision removed commodity backing for the currency and put the U.S. dollar and most other world currencies on a fiat basis, ending most practical constraints on monetary expansion and currency devaluation.

Stagflation vs. Inflation

Whatever the explanation, we have seen inflation persist during periods of economic stagnation since the 1970s. 

Even before the 1970s, some economists criticized the notion of a stable relationship between inflation and unemployment. They argue that consumers and producers adjust their economic behavior to rising price levels either in reaction to—or in expectation of—monetary policy changes.

As a result, prices rise in response to expansionary monetary policy without any corresponding decrease in unemployment, while unemployment rates rise or fall based on real economic shocks to the economy.

This implies that attempts to stimulate the economy during recessions could simply inflate prices without promoting real economic growth.  

Urbanist and author Jane Jacobs saw the disagreements between economists on the causes of the stagflation of the ‘70s as a misplacement of scholarly focus on the nation rather than the city as the primary economic engine. She believed that 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 the diversification of the economies of cities, was critiqued for its lack of scholarship by some, but held weight with others.

Special Considerations

The de facto consensus on stagflation among most economists and policymakers has been to essentially redefine what they mean by the term inflation in the era of modern currency and financial systems. Persistently rising price levels and falling purchasing power—i.e., inflation—are just normal conditions of good and bad economic times.

Economists and policymakers generally assume that prices will rise, and largely focus on accelerating and decelerating inflation rather than on inflation itself.

The dramatic episodes of stagflation in the 1970s may be historical footnotes today. But, since then, simultaneous economic stagnation and rising prices appear to be part of the new normal of economic downturns.

What Causes Stagflation?

Economists argue about the root causes of stagflation.

In general, the stage is set for stagflation when a supply shock occurs. This is an unexpected event, such as a disruption in the oil supply or a shortage of essential parts. Such a shock occurred during the COVID-19 pandemic with a disruption of the flow of semiconductors that slowed the production of everything from laptops to cars and appliances.

Such a shock can affect all of the factors that make up stagflation: inflation, employment, and economic growth.

Why Is Stagflation Bad?

Stagflation is a combination of three negatives: slower economic growth, higher unemployment, and higher prices.

This is a combination that isn't supposed to occur, in the logic of economics. Prices shouldn't go up when people have less money to spend.

What Is the Cure for Stagflation?

There is no definitive cure for stagflation. The consensus among economists is that productivity has to be increased to the point where it will lead to higher growth without additional inflation. This would then allow for the tightening of monetary policy to rein in the inflation component of stagflation.

That is easier said than done, so the key to preventing stagflation is for economic policymakers to be extremely proactive in avoiding it.

Article Sources
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  1. Forbes. "Stagflation: Causes and When It Will Come."

  2. UK Parliament. "Economic Affairs Volume 720: Debated on Wednesday 17 November 1965."

  3. Smithsonian, National Museum of American History, Behring Center. "Energy Crisis."

  4. U.S. Bureau of Labor Statistics. “Databases, Tables & Calculators by Subject: (Seas) Unemployment Rate.”

  5. Charles Schwab. "Is 1970s-Style Inflation Coming Back?"

  6. U.S. Bureau of Labor Statistics. "Historical CPI-U," Page 4.

  7. United States Department of Labor. "Consumer Price Index: December 2008."

  8. Office of the Historian, Foreign Service Institute, United States Department of State. "Oil Embargo, 1973–1974."

  9. National Bureau of Economic Research (NBER). "NBER Macroeconomics Annual 2001, Volume 16."

  10. Federal Reserve Bank of St. Louis. “Full Text of Papers of Richard M. Nixon : Address to the Nation Outlining a New Economic Policy: The Challenge of Peace.”

  11. Federal Reserve History. "Nixon Ends Convertibility of US Dollars to Gold and Announces Wage/Price Controls."

  12. University of Toronto. "Jane Jacobs Among the Economists."

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