Stagflation, or the combination of high inflation paired with minimal or no economic growth, is one of the most formidable adversaries of an economy. Stagflation is the two-headed monster that strikes when economic growth is slow or non-existent, and consumer prices increase simultaneously (also known as inflation).
What is stagflation?
Stagflation is a term used to describe an economy suffering from a combination of rising inflation and slow economic growth. The word stagflation actually combines two words – stagnation and inflation. When consumer prices and the cost of living increase quickly, an economy will experience inflation.
Stagnation is a more general term in this context, referring to an economy that is shrinking, remaining flat, or growing at a very slow rate. When a nation’s gross domestic product (GDP), a measurement of all the goods and services produced in the country, either fails to grow or actually shrinks, economists will say the nation is economically stagnant. The relevant definition here is “showing no activity; dull and sluggish.”
Stagflation occurs when these two conditions, high inflation and stagnant growth, occur in tandem.
Common features of an economy suffering from stagflation are:
- Higher-than-average unemployment rates. Higher unemployment means there are fewer workers to contribute to increasing supply; at the same time, unemployed individuals will be very conservative with their spending, reducing demand and tamping down economic growth.
- Reduced consumer spending. Because consumer spending is a critical component of economic growth, reductions in demand contribute directly to a reduced GDP.
- Increased money supply. When central banks expand money supply or create credit, this directly contributes to higher prices, fuelling the inflation portion of stagflation.
What causes stagflation?
In simple terms, inflation is the increase in the price of goods and services, which causes a decrease in the purchasing power of a dollar (or other currency). Sometimes, goods and services can become more expensive due to unforeseen circumstances, scarcity, or natural disasters. The 1973 oil embargo is a good example from recent U.S. history. At the time OPEC cut its oil exports to the U.S., oil prices quadrupled over the next six months and remained high even after the embargo ended.
A price increase on particular goods and services does not necessarily indicate an inflationary environment. Instead, inflation is seen as a sustained increase across prices in general, most often measured by the Consumer Price Index (CPI). Some goods are particularly important, though. A sudden price increase in an essential product like crude oil effectively raises prices not just at the gas pump but across the entire supply chain.
Fiscal and monetary policies
Monetary policy: Since central banks control the amount of money in circulation and the cost of lending money, the government can spur additional spending by keeping interest rates low or discourage spending by pushing interest rates up. When money costs less to borrow, people spend more, increasing demand. While this can help maintain economic growth, it can result in demand-pull inflation as a consequence.
Fiscal policy: How and when governments tax their citizens and spend money has a significant impact on GDP. Raising taxes tends to discourage the taxed behavior, sometimes deliberately. For example, in 2020, the state of New York imposed a $4.35 excise tax per pack of cigarettes on top of the federally-imposed $1.01 tax. The goal is obviously to curtail smoking. The effect might simply be to transfer money from the hands of citizens directly to the government.
Whether it’s on an overseas war or a construction project, government spending tends toward inefficiency. Research into the economic impact of government spending is a complex and highly politicized topic. However, the consensus seems to be that every $1 of government spending has a less-than-$1 overall economic impact (in specific cases, as much as 40-50% less). So $1 paid in taxes results in less than $1 in economic activity. By this simplified math, you can see how high tax rates can contribute to stagnant economic growth.
Supply & demand, a cornerstone of inflation
Most often, inflation is caused by changes in supply or demand. Economists generally recognize two different types of inflation.
If demand increases quickly or producers simply cannot meet existing demand, prices will rise. (In free markets, a simple analogy is that prices are set by auction, and the highest bidder wins.)
In 2021, for example, inflation rates went up as a result of both increased demand and constraints in supply. After a year of record savings, government stimulus, and reduced spending, consumers’ appetite for goods and services came roaring back.
As with low-interest rates, this renewed consumer spending sparked demand-pull inflation, where ravenous demand was met with inadequate supply.
When there are challenges on the supply side, another cause of inflation (known as cost-push inflation) comes into play. In this scenario, inflation is driven by an increase in supply price. In 2021, lingering labor shortages and disruptions in the supply chain have continued to hamper producers’ output, sending prices up. Sometimes, this can begin with a supply shock, where unexpected events cause sudden price fluctuations. When a supply shock occurs, the supply and demand equilibrium is thrown out of balance.
One of the most notable instances of a supply shock in 2021 was the price of lumber. In less than a year, the price of lumber more than doubled as low-interest rates and record household savings fueled incredible demand for homes and home improvement projects. Lumber producers failed to keep up with soaring demand, sparking a supply shock that drove prices to record highs.
Examples of high inflation & causes
The great inflation – 1965-1982
The aforementioned oil crisis in 1973 was a vital part of The Great Inflation from 1965 to 1982. During that period, the United States experienced inflation rates near 15%. When OPEC imposed its embargo, a supply shock ensued. Americans’ demand for oil remained high, but suddenly, the main oil suppliers weren’t selling to the U.S. Since the U.S. couldn’t produce or purchase nearly enough oil to meet that demand without OPEC, oil prices rose by more than 300% in just a few months.
When interest rates are low, and consumer spending is high, inflation tends to increase. Since the Federal Reserve (Fed) controls interest rates, some people believe that poor monetary policies were the root cause of The Great Inflation. In an effort to combat rising prices – particularly from the oil and energy crises in the 1970s – the Federal Reserve expanded the money supply. Increasing the money supply pushed prices higher, but since the economy’s growth wasn’t fast enough to balance out the influx of dollars, the economy wasn’t primed to stay ahead of inflation. Ultimately, this just resulted in more inflation and unemployment continuing to rise.
Soon, both inflation and unemployment rates were climbing, and the government found itself facing a serious dilemma. While the Fed did raise interest rates during The Great Inflation, monetary policy in the United States remained far too loose, with the government continuing to print money to try and fight inflation. When interest rates did increase, they often retreated too low, too quickly. Only later, at the tail-end of the 1970s, did the Fed raise rates enough to finally combat inflation. What came next was a brutal period of economic recession and high unemployment, beginning around 1980. Eventually, this led to inflation leveling off to under 4% by the end of 1982.
The end of the gold standard
Another factor that played a role in The Great Inflation was the United States’ decision to completely abandon the gold standard in 1971 by ending the practice of convertibility, through which U.S. dollars could be exchanged for gold.
While the move to leave the gold standard behind was designed to give the U.S. some power over the dollar in an attempt to control inflation, ending the gold standard altogether had a catastrophic effect. By allowing the now-unbacked currency to circulate without any direct ties to gold reserves, the U.S. government worsened inflation by devaluing the dollar.
Though stepping away from the gold standard did aid the U.S. in clawing its way out of The Great Depression, it allowed the government to be far too lax with its monetary policy (essentially issuing new dollars without an increase in reserves to back up those dollars), leading to worsening inflation through the 1970s.
When an economy experiences stagnation, it’s either declining, flat, or growing at a very slow pace. Economic stagnation is typically measured in several different ways. Gross Domestic Product (GDP), or the total value of all goods and services produced during a given timeframe, is the most common measure of an economy’s performance. Economists will often assess economic growth by comparing quarterly or annual performance. In addition to GDP, unemployment can also be utilized when gauging an economy’s strength. During a period of stagnation, unemployment is typically higher than average.
What causes stagnation?
There are several different causes for economic stagnation, some being more concerning than others. Particularly in advanced economies, one cause of stagnation is economic maturity. When the largest companies consolidate and dominate a market, it can suppress growth among smaller businesses and discourage competition. The existence of monopolies, companies that control an entire business sector without competition, can also lead to stagnation.
A similar phenomenon can be seen in developing countries, whereby political and economic change is shunned, and the status quo is maintained for too long. Without any incentive to innovate, these countries often find themselves suffering from chronic stagnation.
This can be particularly severe in developing nations that rely on exporting commodities for their wealth (Venezuela, Saudi Arabia). This paradox, where nations naturally rich in vital resources like oil or minerals often suffer severe stagnation, is called the “resource curse” or the paradox of plenty.
Earlier, we explored how government policy influences inflation. So, it’s no surprise that government policy also has the power to promote or fight stagnation.
While a tight monetary policy can help keep inflation rates down, one of the side effects is that it can severely limit economic growth. Less money in circulation means less money available for investment, hiring, etc.
When the government keeps interest rates high, individuals and businesses are less likely to borrow and spend. Governments can also impose embargoes, raise the prices of imported goods via tariffs, or increase taxes, leading to reduced business activity and slower economic growth.
Wars can take a toll on economies
Other forces that can engender stagnation include war, natural disaster, and disease.
In addition to the bloodshed and loss of life, war can deal blows to a country’s economy. Wars weigh heavily on a country’s economy, forcing governments to increase debt and spending, and redirect funds to war activities that would otherwise be invested in infrastructure. The phrase “blood and treasure” is often used to describe the price of wars, and it is, in fact, true.
When countries need to finance wars, they often take on more debt. For example, during the American Civil War, President Lincoln began issuing paper money to pay Union troops because the nation simply didn’t have enough gold and silver to pay them in “hard money.” Another example: During World War I, virtually every nation in Europe stopped issuing gold coins and instead switched to paper money for the duration of the conflict.
Massive government borrowing lowers the public appetite for government bonds, which results in higher interest rates on those bonds. Higher interest rates trickle down to consumers and borrowers like new homeowners, reducing consumption and business investment. On the other hand, wars often create a vast need for manufactured goods and supplies, sometimes summarized as “boots, beans, and bullets.” Generally speaking, the economic impact of wartime spending is actually less than the amount spent.
So, while war may appear to create jobs in the short term, the reality is that spending elsewhere would actually create more jobs and contribute to improving infrastructure.
Disease & natural disaster
When disease and natural disasters strike, economies – like people – are destined to suffer. Economic losses, from businesses and homes to crops and livestock (not to mention physical and mental health problems) accompany natural disasters and disease, often impacting thousands or even millions of people. As we’ve all seen and experienced in 2020 and 2021, a pandemic can cause widespread shutdowns, declining financial markets, and job losses or loss of job growth. With more people saving money due to these shutdowns and a general concern about future stability, fewer dollars were spent, slowing the rate of economic growth.
Furthermore, any event that disrupts transportation or communication, whether a hurricane or an AWS data center outage, slows down economic activity. This means less business activity, less spending, lower economic growth.
These sorts of disruptions, unlike wars, often come out of nowhere. They’re impossible to anticipate, difficult to assess, and we can’t even begin to count the cost until the disaster is safely behind us. This is the sort of event that’s rightly called a black swan.
Venezuela’s severe stagflation
One of the most severe cases of stagflation in the 21st century is occurring in Venezuela, where the economy is rapidly receding, and inflation rates have climbed into the millions. Once the wealthiest country in South America, Venezuela’s economy and democracy have gone by the wayside. Large swaths of its population have fled to neighboring countries; millions left behind are living in extreme poverty and are starving or food insecure.
Many people blame Venezuela’s authoritarian government for the country’s economic woes. Since current President Nicolás Maduro succeeded Hugo Chávez in 2013, Venezuela’s economy has shrunk by over 77%. While exploiting its most valuable natural resource (oil), Venezuela failed to adequately invest in its infrastructure. This is the paradox of plenty at work.
The socialist regimes in power have attempted to revive the nation’s economy through massive amounts of government spending. Rather than encourage economic growth, the enormous increase in money supply has only sent inflation spiraling out of control.
This, combined with U.S. sanctions on Venezuelan oil and ongoing political corruption, has led to mass migration and a lack of access to food, healthcare, and education. Ultimately, this combination of rising inflation and an economy that continues to contract have made Venezuela an unfortunate victim of severe stagflation.
Financial calamity: The collapse of big banking
Another cause of stagnation came during the failure of the U.S. banking systems in 2008. Riding the wave of economic prosperity powered by the dot-com bubble at the turn of the 21st century, banks grew lax, extending credit far too easily and underwriting subprime mortgages by the millions. By 2008, both the housing market and the stock market crashed, leaving the American financial system in ruin. The government was not entirely free of blame in this unfortunate series of events since many people argue the regulations put in place failed to protect the system from collapse.
Examples of stagnation
Persistently high unemployment rates are a telltale sign of stagnation, impacting economies both in their ability to produce more supply and because people struggling to find work spend less. During The Great Recession, unemployment in the United States reached 9.9%; that same year (2009), GDP declined by 2.6%. After The Great Inflation in the 1960s and 70s, disinflation policies (specifically, very high Federal funds rates) put into place in the early 1980s sent the U.S. into a recession where unemployment reached 10.8% in 1982.
Throughout the 1970s, when the Central Bank failed to curb rising inflation, stagnation left the U.S. economy lagging behind as purchasing power of the dollar sank even further. Even when the Fed jacked up interest rates to nearly 20%, inflation continued to plague the country. In its desperate attempt to stave off inflation, the Fed drove the U.S. economy into a recession in 1980. Though the recession eventually led to a recovery in 1983, the Fed lost credibility in the eyes of many Americans for allowing inflation to get so far out of hand.
In this case – as in others – the stagnation experienced in the U.S. during 1980-1982 was brought about by the inflation and subsequent push to fight it by raising rates. However, this episode taught us that the Federal Reserve could combat inflation if it has the political will to do so.
Less than a decade later, on the other side of the world, Japan suffered its own protracted period of stagnation. Known as “The Lost Decade,” the ten years between 1992 – 2001 were a time in which the Japanese economy contracted, stayed flat, or grew marginally. During that time, businesses took on excessive debt, adding equipment and employees as the push for growth continued. Soon, supply outpaced demand, which began quickly declining.
The Japanese population shifted to saving rather than spending, leaving businesses with unused equipment and employees. By the time the Bank of Japan raised rates to cool the markets, it was too late–the banks soon failed, most Japanese were avoiding unnecessary spending, and the economy remained reeled as stagnation set in.
What effect does stagflation have?
When stagflation takes hold of an economy, stocks are generally very volatile and can suffer quick, unexpected losses. Since the economy is stagnant and unemployment is often high, many businesses struggle to grow; hence, stocks can decline or grind along a plateau for a decade or more. Growth stocks, in particular, tend to be hard hit by stagflation since more of these companies’ earnings are expected in the future; instead, value stocks and price-makers (companies that have a monopoly and can essentially set market prices due to their size) are generally favored by investors during stagflationary times.
Similar to equities, bonds face an uphill battle when inflation rises. Bonds and inflation rates share an inverse relationship; bond prices decline when interest rates increase. Since bonds don’t take into account the impact inflation has on the value of a dollar, the value of the same bond can be less, even if the face value is the same. Especially with bonds with a later maturity date, inflation will have a more pronounced effect on the real value. Investors generally don’t want to invest at a fixed interest rate when inflation rises because higher inflation reduces the spending power of their return on investment.
In a stagflationary environment, corporate bonds also decline. The combination of inflation eroding the value of bonds and weaker revenues generated by corporations is more than enough to deter investors. While few people consider it a realistic possibility for the government to default on Treasury bonds, corporations can and do default on bonds (though it’s relatively uncommon). Stagflation can lead to companies defaulting on bonds and, in some cases, a credit crunch. Credit crunches occur when there is a steep decline in credit availability. This further contributes to stagflation because companies cannot secure the debt they need to fund growth.
Though equities and bonds don’t fare particularly well during stagflation, commodities like gold do. Stagflation causes the price of commodities like oil, food, and precious metals to increase. From novices to experts, virtually every investor acknowledges gold and precious metals as a hedge against stagflation. Unlike stocks and bonds, gold isn’t connected to a particular currency. So, if a currency loses part of its real value to inflation, precious metals like gold wouldn’t decline in value as a result.
When stagflation shook the United States in the 1970s and early 1980s, investors rushed to gold and silver as a shelter from the poor-performing equities and bonds markets. As you can see from the graph below, gold (yellow line) and silver (gray line) consistently outperformed the Dow Jones and S&P 500 (blue and red lines, respectively). Equities suffered from severe stagnation during the entirety of the 1970s and into the early 1980s, while gold and silver posted significant percentage gains in the hundreds and even thousands.
Gold, like any commodity or asset, varies in price based on supply and demand. The cost of gold can move due to several factors, like the ability of mining and refining companies to produce gold and demand for gold from central banks and investors. One of the most significant movers of gold prices is economic performance and inflation. When the economy performs poorly, and when inflation rates rise, investors turn to gold. When an economy is experiencing stagflation, gold prices head north as investors seek a safe haven in the yellow metal.
Stagflation in the modern era
In the U.S. today, we haven’t experienced a spell of stagflation as significant as what we saw in the 1970s. During that time, the U.S. economy was truly in shambles, and it cost a great deal of time, money, and effort for the country to finally recover.
The United States experienced notable inflation in 2021, with prices surging during the second half of the year. These high inflation rates don’t appear to be transient, and interest rates remain historically low. Supply chain issues have left businesses struggling to meet demand, the national debt is at an all-time high, and market experts are expressing concerns that stagflation is in our near future. Energy prices have gone haywire as of late, and there’s a supply crunch that seems to have wreaked havoc on nearly every industry.
While inflation appears poised to continue climbing, no one really knows whether these new, higher prices are here to stay. Perhaps there’s no reason to be alarmed, but it’s hard not to heed the warning signs in front of us since some of these same trends were a harbinger of stagflation in the 1970s.
Through all the twists and turns, gold and silver have continued to perform well. Though not nearly as extreme a situation as the one the United States confronted in the 1970s, gold and silver are still favored as a hedge and safe haven amid high inflation and stagnation. Even when the financial markets were humming along, gold and silver still held their own with consistent demand for both these metals. There are undoubtedly other alternative assets to consider as a hedge against stagflation. Still, gold and silver appear to be clear winners in filling the role of a safe haven against rising inflation and slow economic growth.