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).

Key Takeaways

  • Stagflation means a simultaneous increase in prices and stagnation of economic growth.
  • Stagflation was first widely recognized after the mid-20th century, especially in the U.S. economy during the 1970's, which experienced persistently rapid inflation and high unemployment.
  • Predominant economic theory at the time could not easily explain how stagflation could occur. Numerous other theories offer specific explanations for the 1970's stagflation, or stagflation more generally.
  • Since the 1970's, rising price levels during periods of slow or negative economic growth have become the norm rather than an exceptional situation.
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Stagflation

Understanding Stagflation

The term "stagflation" was first used during a time of economic stress in the United Kingdom by politician 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, when the U.S. underwent a recession that saw five quarters of negative GDP growth. Inflation doubled in 1973 and hit double digits in 1974; unemployment hit 9 percent by May 1975.

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

Stagflation was long believed to be impossible because the economic theories that dominated academic and policy circles ruled it out of their models by construction. 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 in the 20th century economists became preoccupied with the dangers of deflation and argued that that most policies designed to lower inflation tend to make it tougher for the unemployed, and policies designed to ease unemployment raise inflation.

The advent of stagflation across the developed world in the mid-20th century showed this not to be the case. As it result, stagflation is a great example of how real world economic data can sometimes run roughshod over widely accepted economic theories and policy prescriptions.

Since that time, as a rule, inflation persists as a general condition even during periods of slow or negative economic growth. In the past 50 years, every declared recession in the U.S. has seen continuous, year-over-year rise in the consumer price level. The sole, partial exception to this is lowest point of the 2008 Financial Crisis, an even then price decline was confined to energy prices while overall consumer prices other than energy continued to rise.

Theories on the Causes of Stagflation

Because the historical onset of stagflation represents the great failure of the dominant economic theories of the time, economists since then have put forth several arguments as to how stagflation occurs or how to redefine the terms of existing theories in order explain around it.   

One theory states that this economic phenomenon is caused when a sudden increase in the cost of oil reduces an economy's productive capacity. 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 rise, producing products and getting them to shelves got more expensive and prices rose even as people got laid off. Critics of this theory point out that sudden oil price shocks like those of the 1970’s did not occur in connection with any of the simultaneous periods of inflation and recession that have occurred since then.

Another theory is that the confluence of stagnation and inflation are results 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 fingers to the policies set in place by former President Richard Nixon, which may have led to the recession of 1970 — a possible precursor to the period of stagflation. Nixon put tariffs on imports and froze wages and prices for 90 days, in an effort to prevent prices from rising. The sudden economic shock of oil shortages and rapid acceleration of prices once the controls where relaxed led to economic chaos. While appealing, like the previous theory this is basically an ad-hoc explanation of the stagflation of the 1970’s, which does not explain the simultaneous rise in prices and unemployment that has accompanied subsequent recessions up to the present.

Other theories point to monetary factors that may also play a role in stagflation. Nixon removed the last indirect vestiges of the gold standard and brought down the Bretton Woods system of international finance. This removed commodity backing for the currency and put the U.S. dollar and most other world currencies on fiat basis ever since then, ending most practical constraint on the monetary expansion and currency devaluation. As support for their theories, proponents of monetary explanations of stagflation point to this event, as well as the historical record of simultaneous inflation and unemployment in fiat money based economies, and the countervailing historical record of extended periods of simultaneously decreasing prices and low unemployment under strong commodity back currency systems. This would suggest that under an unbacked fiat monetary system in place since the 1970’s, we should actually expect to see inflation persist during period of economic stagnation as has indeed been the case.

 

Other economists, even prior to the 1970’s, criticized the idea of a stable relationship between inflation and unemployment on the grounds of consumer and producer expectations about the rate of inflation. In these theories, people simply adjust their economic behavior to rising price levels either in reaction to or in expectation of monetary policy changes. As a result, prices rise throughout the economy in response to expansionary monetary policy, without any corresponding decrease in unemployment, and unemployment rates can 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, while having little effect on promoting real economic growth.  

Urbanist and author Jane Jacobs saw the disagreements between economists on why the stagflation of the ‘70s 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.

The de facto consensus on stagflation among most economists, financiers, and policy makers has been to essentially redefine what they mean by the term “inflation” in the modern era of modern currency and financial systems. Persistently rising price levels and falling purchasing power of money, i.e. inflation, are just assumed as a basic, background, normal condition in the economy, which occurs both during periods of economic expansion as well as during recessions. Economists and policy makers generally assume that prices will rise, and largely focus accelerating and decelerating inflation rather than inflation itself. The dramatic episodes of stagflation in the 1970’s may be a historical footnote today, but since then simultaneous economic stagnation and rising price levels in a sense make up the new normal during economic downturns.