What is Stagflation

“For the engine which drives enterprise is not thrift, but profit.” — John Maynard Keynes

The year is 1931. The US economy is in crisis. Unemployment is on the rise. Investing for the future is an afterthought. And the government doesn’t have a clue on how to battle deflation. Yes — deflation. Unlike inflation, where you’re constantly worrying about price increases each day; with deflation, you’re looking at a broad-based decline in prices. You don’t know what’s happening around you. This stuff is unprecedented you think. The only problem is it’s not. See, most economists at the time believed this was the natural order of things. When the economy isn’t buzzing with activity anymore, people get fired and they tend to focus on saving money as opposed to spending it. And as demand for goods and services plateau, prices tend to decline in tandem. Also, businesses won’t have any real incentives to produce anymore. After all, if prices keep tanking each day, its fair to assume their margins aren’t plush. So they’re constantly thinking about downsizing, in effect, contributing to unemployment woes. And so, the cycle continues.

Thankfully, governments finally figured out how to reverse this cycle. They tried to kickstart growth by spending ludicrous amounts of money — on construction, on infrastructure, on creating new employment opportunities. They spent money they didn’t have. They borrowed from central banks who made billions of dollars accessible to these entities in the hope they could shock the economy back into action. And it worked. Once the government started pouring money into the real economy. Private corporates got in on the act as well. It seemed as if we had finally found the answer. But then during the 1970s, something strange happened.

And this was weird. Think about it. How can prices increase when people are unemployed and hardly thinking about splurging on stuff? It didn’t make any sense. However, economists weren’t going to give up. They believed you could explain this phenomenon by looking at oil. At the time, oil-producing nations had imposed an embargo on the United States. They refused to ship oil. And as supply dwindled, prices started shooting up rather quickly. This pushed costs across the board as producing energy was now rather expensive. And with production costs rising, retail prices had to inch up. Anyway, this prognosis was hotly debated but economists did concede that this was a unique case in every respect and coined a new term to explain the phenomenon — Stagflation*.

Stagflation and 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 and brought down the Bretton Woods system of international finance. 5 This removed commodity backing for the currency and put the U.S. dollar and most other world currencies on a 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 1970s, we should actually expect to see inflation persist during periods of economic stagnation as has indeed been the case.

Other economists, even prior to the 1970s, 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 policymakers 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 policymakers generally assume that prices will rise, and largely focus accelerating and decelerating inflation rather than inflation itself. The dramatic episodes of stagflation in the 1970s 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.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. 1 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 1970s 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 1970s, which does not explain the simultaneous rise in prices and unemployment that has accompanied subsequent recessions up to the present.