What Is Stagflation? (And Why It’s a Problem)

➤ What Is Stagflation?

Stagflation is when an economy faces two big challenges at the same time: slow growth (low GDP) and lots of people without jobs (high unemployment).

On top of that, prices for things we buy keep going up (inflation). This mix is tough for the people who make economic decisions because trying to fix one problem can make the other one worse.

Even though economists used to think stagflation couldn’t happen, it’s actually been a problem in rich countries since the 1970s, especially after the oil crisis.

In 2022, some folks were worried that the United States might not be in stagflation yet but could get there soon, even if just for a little while.

Forbes magazine said this could happen because the people in charge of economic decisions might try to tackle unemployment first and deal with inflation later.

➤ Stagflation History

The term “stagflation” was coined by British politician Iain Macleod in 1965 when the United Kingdom was facing economic troubles. He used this term to describe the challenging situation of both inflation and stagnation happening at the same time.

In the United States, stagflation made a comeback during the 1970s oil crisis, leading to a recession with five consecutive quarters of negative GDP growth. In 1973, inflation doubled, and by 1974, it reached double digits. Meanwhile, unemployment climbed to 9% by May 1975.

To measure the impact of stagflation on a nation’s people, economists developed a simple misery index, which added together the inflation rate and the unemployment rate.

Historically, stagflation was thought to be impossible. The dominant economic theories of the 20th century, including the Phillips Curve from Keynesian economics, suggested that policymakers faced a trade-off between unemployment and inflation. They believed that actions to reduce inflation would increase unemployment and vice versa.

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However, the emergence of stagflation in developed countries later in the 20th century challenged these theories. Stagflation serves as a prime example of how real-world experiences can defy widely accepted economic theories and policy recommendations.

Over the past 50 years, inflation has proven to persist even during periods of slow or negative economic growth. In the United States, every officially declared recession during this time has seen a year-over-year increase in consumer prices, with one partial exception being the lowest point of the 2008 financial crisis.

Even then, the decrease in prices was limited to energy and transportation, while overall consumer prices, excluding energy, continued to rise.

➤ Stagflation Causes

Economists don’t see eye to eye when it comes to explaining what causes stagflation. They’ve put forward various arguments to make sense of this economic puzzle, even though it was once believed to be impossible.

Sudden Oil Price Changes

One theory suggests that stagflation happens when the cost of oil suddenly shoots up, reducing an economy’s ability to produce goods and services. The 1970s oil crisis is a prime example of this.

In October 1973, the Organization of Petroleum Exporting Countries (OPEC) placed an embargo on Western countries, causing global oil prices to soar. This, in turn, made everything more expensive, leading to job losses.Critics of this theory argue that not all periods of inflation and recession happened alongside sudden oil price shocks like those in the 1970s.

Poor Economic Policies

Another theory points to the idea that bad economic policies can bring about stagflation. When there are strict regulations on markets, goods, and labor in an already inflation-prone environment, it can lead to stagflation.

Some people look at former President Richard Nixon’s policies as a potential cause. In an attempt to prevent rising prices, he imposed tariffs on imports and froze wages and prices for 90 days in 1970.

However, once these controls were lifted, prices shot up rapidly, causing economic chaos.While this theory makes sense for the 1970s stagflation, it doesn’t explain later instances of simultaneous rising prices and unemployment.

Gold Standard Loss

Other theories highlight monetary factors that could contribute to stagflation. One key event was when Nixon removed the remaining links to the gold standard, dismantling the Bretton Woods system that controlled currency exchange rates.

This move removed the backing of currency by physical assets like gold and put the U.S. dollar and most other world currencies on a fiat system. In simple terms, it ended the practical limits on how much money could be printed and how much a currency could be devalued.

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These are some of the theories that economists have proposed to explain the mysterious occurrence of stagflation. However, the exact causes remain a subject of ongoing debate and research.

➤ 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

➤ Stagflation Today

Among most economists and policymakers, there’s a sort of unspoken agreement about stagflation. They’ve pretty much decided to change the way they think about inflation in the modern world of money and finance.

They see rising prices and the decreasing value of money, which is what we call inflation, as something that happens all the time, whether the economy is doing well or poorly.

Economists and policymakers tend to work on speeding up or slowing down how fast prices go up instead of worrying too much about inflation itself.

The big cases of stagflation back in the 1970s might be just history now. But since then, having both a sluggish economy and prices that keep climbing seems to have become part of the usual ups and downs in the world of economics.

➤ What Is Stagflation FAQ

What Causes Stagflation?

Economists debate the underlying causes of stagflation.

In most cases, stagflation emerges when a supply shock takes place. This refers to an unexpected event, like disruptions in the oil supply or shortages of essential components.

For instance, during the COVID-19 pandemic, the flow of semiconductors was disrupted, slowing down the production of various goods, including laptops, cars, and appliances.

Such shocks can impact the key elements of stagflation: inflation, employment, and economic growth.

Why Is Stagflation a Problem?

Stagflation combines three negative aspects: slower economic growth, higher unemployment, and rising prices.

This combination defies traditional economic logic since prices usually shouldn’t go up when people have less money to spend.

What Cures Stagflation?

There’s no one-size-fits-all cure for stagflation. Economists generally agree that boosting productivity is crucial. Increased productivity can lead to higher growth without additional inflation, making it possible to then apply tighter monetary policies to control the inflationary aspect of stagflation.

However, implementing this solution is easier said than done. Therefore, the key to preventing stagflation is for economic policymakers to proactively take measures to avoid its onset.

➤ Final Thoughts

So, what is stagflation? Well, stagflation is a perplexing economic phenomenon that combines stagnant growth, high unemployment, and rising prices, that continues to challenge economists and policymakers alike.

While its root causes remain a subject of debate, one thing is clear: the economic landscape has evolved since the 1970s, and stagflation is no longer an anomaly but a recurring feature of economic downturns.

As we navigate the complexities of modern economies, understanding stagflation’s causes and consequences becomes increasingly important. Supply shocks, poor economic policies, and changes in monetary systems all contribute to the emergence of stagflation, making it a dynamic and multifaceted issue.

To address stagflation effectively, proactive economic policymaking and a focus on productivity are crucial. By learning from historical experiences and adapting to the evolving economic landscape, we can better prepare for and respond to the challenges posed by stagflation in the 21st century.

In summary, stagflation reminds us that the world of economics is far from predictable, and that continuous learning and adaptation are essential tools in managing the complexities of our economic systems.

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