Stagflation: when the economy hits a dead end

Many economists refer to stagflation as one of the most paradoxical phenomena in macroeconomics. It was named in 1965 by British politician Ian Macleod, combining two words — “stagnation” and “inflation.” This state occurs when the economy simultaneously suffers from slowing growth and unemployment, while prices for goods and services continue to rise. The paradox is that standard tools for combating one problem often exacerbate the other.

Why Stagflation is an Economic Knot

High employment and rising prices usually go hand in hand. However, during stagflation, the gross domestic product remains weak or even contracts, while the unemployment rate is high and inflation picks up speed. This creates a dilemma for policymakers.

When the central bank tries to stimulate the economy through quantitative easing and lowering interest rates, it increases the money supply. Loans become cheaper, consumers and businesses start to spend more. But an excess of money with a lack of goods and services inevitably leads to a rise in prices.

On the other hand, to combat inflation, central banks raise interest rates and reduce the money supply. People start to save instead of spending, demand falls, and in theory, prices should decrease. However, this also freezes loans and investments, which slows down economic growth and increases unemployment.

Reasons that give rise to stagflation

Stagflation occurs when a supply shortage is added to an economic downturn. The value of money falls, production becomes cheaper, and the output of goods and services decreases simultaneously.

Confrontation of monetary and fiscal policy

When the central bank conducts a soft monetary policy ( lowers rates, prints money ), and the government simultaneously tightens fiscal policy ( raises taxes, cuts spending ), a contradiction arises. The reduction in household income slows down the rise, but the amount of money in circulation increases — there is pressure on prices.

Transition to fiat currency

After World War II, most major economies abandoned the gold standard in favor of fiat currency. This gave central banks the freedom to manage the money supply, but at the same time opened the way to uncontrolled inflation. Without the physical limitation of gold, the money supply can expand without restrictions.

Energy crisis and supply shortage

The most vivid example is the oil crisis of 1973. OPEC declared an embargo on oil supplies in response to the support of Israel during the Yom Kippur War. Energy resource prices soared. Production became more expensive, prices for food and transport rose, and consumers, having spent money on utilities and gasoline, cut back on other purchases. The gross domestic product of Western countries stagnated, while inflation accelerated.

How Different Economic Schools View the Exit

Monetarist approach

Monetarists, including supporters of Milton Friedman, insist on prioritizing the fight against inflation. They recommend reducing the money supply, which decreases demand and forces consumers and businesses to cut back on spending. Prices fall, but this requires pain: consumer spending decreases, economic growth freezes. At the same time, there is a need to use fiscal stimuli to support employment.

Supply Orientation

Another school of thought believes that we should not restrain demand but rather expand supply. Reducing production costs, investing in efficiency, subsidizing production, and controlling energy resource prices — all of this should increase output volumes. The growing supply should automatically put downward pressure on prices while simultaneously stimulating job creation.

Market Fundamentalism

Some economists suggest simply letting the market self-regulate. Demand will drop when prices rise too high, and people will stop buying expensive goods. Supply will recover, competition will lower prices, and unemployment will decrease as workers transition to more attractive sectors. However, this process can take years or decades of mass poverty — as John Keynes noted, “in the long run, we are all dead.”

Stagflation and Cryptocurrency Markets

The impact of stagflation on cryptocurrencies is ambiguous and depends on the phase of the crisis.

First phase: decline and demand deflation

At the first stage, when the economic pro is frozen, consumers and retail investors cut back on spending. They need cash for current needs. Cryptocurrencies, being a risky asset, are the first to lose value. Large institutional investors also rotate their portfolios, avoiding high-risk assets like stocks and Bitcoin.

Second phase: political measures

Governments are beginning to combat inflation by raising interest rates and reducing the money supply. This decreases liquidity and makes high-yield risky assets less appealing. Demand for cryptocurrencies is falling further.

But as soon as inflation is brought under control, central banks usually move to quantitative easing and lowering rates. Here, the money supply begins to grow again, and cryptocurrencies start to recover. Investors seeking hedges against inflation turn their attention to Bitcoin and other assets with limited supply.

Long Hedge

Many consider Bitcoin as a store of value due to its limited supply. During periods of high inflation, holding cash without interest reduces its real value. Investors who have accumulated cryptocurrencies over the years may benefit from long-term hedging. However, in the short term, especially during acute stagflation, the high correlation of cryptocurrencies with stock markets means that they fall along with stocks.

What to Remember About Stagflation

Stagflation remains a rare but dangerous phenomenon. History shows that fighting it is very difficult at the same time. Tools that work against stagnation exacerbate inflation. Methods for combating inflation deepen the recession.

The solution requires a deep analysis of macroeconomic factors: money supply volumes, interest rate levels, demand and supply dynamics, labor market trends. Each stagflation situation is a product of its time and requires a special approach. There is no universal remedy for stagflation, which makes it one of the most complex puzzles for central banks and government bodies.