Stagflation and Its Causes
Why Stagflation (Probably) Won't Reoccur
Stagflation is a combination of stagnant economic growth, high unemployment, and high inflation. It's an unnatural situation because inflation is not supposed to occur in a weak economy. Consumer demand drops enough to keep prices from rising. Slow growth in a normal market economy prevents inflation.
Stagflation occurs when the government or central banks expand the money supply at the same time they constrain supply. The most common culprit is when the government prints currency. It can also occur when a central bank's monetary policies create credit. Both increase the money supply and create inflation.
At the same time, other policies slow growth. That happens if the government increases taxes. It can also occur when the central bank raises interest rates. Both prevent companies from producing more. When conflicting expansionary and contractionary policies occur, it can slow growth while creating inflation. That's stagflation.
Stagflation in the United States occurred during the 1970s. The federal government manipulated its currency to spur economic growth. At the same time, it restricted supply with wage-price controls.
In 2004, Zimbabwe's policies caused stagflation. The government printed so much money it went beyond stagflation and turned into hyperinflation.
Stagflation in the 1970s
Unemployment peaked at 9 percent in May 1975, two months after the recession ended.
Inflation tripled in 1973, rising from 3.4 to 9.6 percent. It remained between 10 to 12 percent from February 1974 through April 1975. By looking at the nation’s inflation rate by year, you can get a history of the annual percentage change in prices throughout a business cycle.
How did this happen? Many experts blame the 1973 oil embargo. That's when OPEC cut its oil exports to the United States. Prices quadrupled, triggering inflation in oil. But that alone wasn't enough to cause stagflation. Instead, it was a combination of fiscal and monetary policy that created it.
It started with a mild recession in 1970. GDP was negative for three quarters. Unemployment rose to 6.1 percent. President Richard Nixon was running for re-election. He wanted to boost growth without triggering inflation.
On August 15, 1971, he announced three fiscal policies. They got him re-elected. They also sowed the seeds for stagflation. A video of Nixon's speech shows the announcement of significant economic policy changes such as the decision to end the Bretton Woods international monetary system.
First, Nixon instituted a 90-day freeze on all wages and prices. He set up a Pay Board and Price Commission to approve any increases after the 90 days. Conveniently, it would control prices until after the 1972 presidential campaign. That's how he planned to control inflation.
Second, Nixon imposed a 10 percent tariff on imports. He intended to lower the balance of trade and protect domestic industries. Instead, he raised import prices.
Third, he removed the United States from the gold standard. That had kept the dollar's value tied to a fixed amount of gold since the 1944 Bretton Woods Agreement. Most countries agreed to peg the value of their currencies to either the price of gold or the U.S. dollar. That had turned the dollar into a global currency.
The crisis occurred when the United Kingdom tried to redeem $3 billion for gold. The United States didn't have that much gold in its reserves at Fort Knox. So Nixon stopped redeeming dollars for gold. That sent the price of the precious metal skyrocketing and the value of the dollar plummeting. That sent import prices up even more. Learning the history of the gold standard will help you understand why the dollar then was backed by gold and why currently it isn’t.
These last two policies raised import prices, which slowed growth. Then growth slowed even more because U.S. companies couldn't raise prices to remain profitable. Since they couldn't lower wages either, the only way to reduce costs was to lay off workers. That increased unemployment. Unemployment reduces consumer demand and slows economic growth. In other words, Nixon's three attempts to boost growth and control inflation had the opposite effect.
The Federal Reserve's attempts to fight stagflation only worsened it. Between 1971 and 1978, it raised the fed funds rate to fight inflation, then lowered it to fight the recession. This "stop-go" monetary policy confused businesses. They kept prices high, even when the Fed lowered rates. That sent inflation up to 13.3 percent by 1979.
Federal Reserve Chair Paul Volcker ended stagflation by raising the rate to 20 percent in 1980. But it was at a high cost. It created the 1980-82 recession.
Why Stagflation (Probably) Won't Reoccur
In 2011, people became concerned about stagflation again. They worried that the Fed's expansive monetary policies, used to rescue the economy from the 2008 financial crisis, would cause inflation. At the same time, Congress approved an expansive fiscal policy. It included the economic stimulus package and record levels of deficit spending. Meanwhile, the economy was only growing 1 to 2 percent. People warned of the risk of stagflation if inflation worsened and the economy didn't improve.
This massive increase in global liquidity prevented deflation, a far greater risk. The Fed won't allow inflation to go beyond its inflation target of 2 percent for the core inflation rate. If inflation rose above that target, the Fed would reverse course and institute constrictive monetary policy.
The unusual conditions that created stagflation in the 1970s are unlikely to reoccur. First, the Fed no longer practices stop-go monetary policies. Instead, it commits to a consistent direction. Second, the removal of the dollar from the gold standard was a once-in-a-lifetime event. Third, the wage-price controls that constrained supply wouldn't even be considered today.