Stagflation

Stagflation is a rare and difficult economic condition. It is a combination of three specific problems: high inflation, stagnant economic growth, and elevated unemployment. The term itself is a portmanteau, which means it blends two words together. It combines "stagnation," meaning a lack of growth, with "inflation," which is the rising cost of goods. This state is unusual because it breaks traditional economic rules. Most experts used to believe that inflation and unemployment moved in opposite directions.

To understand why this is a problem, one must look at the Phillips Curve. This is an economic theory suggesting an inverse relationship between inflation and unemployment. Usually, when inflation is high, unemployment is low. When unemployment is high, inflation tends to be low. Stagflation defies this pattern by making both numbers high at once. This creates a massive policy dilemma for government leaders. If they use monetary policy to stop inflation, they might increase unemployment. If they try to create more jobs, they might make inflation even worse.

Economists generally point to two main causes for stagflation. The first is a supply shock. A supply shock occurs when a sudden event makes it much harder or more expensive to produce goods. This often involves a scarcity of natural resources. The second cause is misguided government policy. This happens if a government grows the money supply too quickly while also creating rules that hurt industrial output. Often, these two causes happen at the same time. A supply shock makes production expensive, and then government policy makes the problem worse by adding too much money to the economy.

The history of stagflation is closely tied to the 1970s. The term was popularized by Iain Macleod, a British Conservative Party politician. He served as the Chancellor of the Exchequer starting in 1970. Macleod first used the word in a 1965 speech to the British Parliament. He was describing the economic distress happening in the United Kingdom. By the early 1970s, the problem became a global crisis. Many major market economies experienced stagflation between 1973 and 1982.

A major driver of this era was the 1973 oil crisis. This was a massive supply shock involving the Organization of Arab Petroleum Exporting Countries, or OAPEC. During the Yom Kippur War, OAPEC members cut oil production and placed an embargo on oil exports. They targeted countries that supported Israel, including the United States. This caused the price of oil to rise very sharply. Because oil is needed for almost all production, the cost of everything else rose too. At the same time, the money supply in the United States was increasing by nearly 15% every year.

This period also saw the failure of the Bretton Woods system. This was a global system of fixed exchange rates. During the mid-1970s, the system began to fail, and the gold standard was abandoned. This caused the prices of gold and oil to become very volatile. In the United Kingdom, policymakers struggled to respond. They often failed to realize that monetary policy was the primary way to control inflation. Instead, they tried using non-monetary tools. This led to inaccurate estimates of demand and further economic instability.

Stagflation forced a massive change in economic thinking. Before this, many followed Keynesian economics, named after John Maynard Keynes. These experts believed the Phillips Curve was a stable relationship. However, the 1970s proved that this relationship could shift. This led to the rise of new theories like monetarism and supply-side economics. Economists like Milton Friedman and Edmund Phelps argued that inflation expectations matter. They suggested that if people expect inflation, they demand higher wages. This creates a cycle that keeps inflation rising even when the economy is weak.