Stagflation in Economics: History, Causes & Characteristics
A period of stagflation can stunt economic growth through high inflation rates and high unemployment rates simultaneously. Consumers can prepare their finances ahead of time.
What Is Stagflation?
Stagflation is a period where economic growth stagnates, and inflation rises. This is characterized by high unemployment rates, rising prices and a decline in gross domestic product (GDP). For the typical consumer, stagflation causes their purchasing power to decrease, making it hard to meet basic needs.
Explore what stagflation is, its causes and its history.
Stagflation occurs when an economy experiences stagnation and inflation at the same time. Unlike recessions, however, stagflations do not have any economic thresholds that determine whether the economy is experiencing one. Instead, it is simply characterized by three economic trends that rarely coincide: weak economic growth, high inflation rates and high unemployment rates.
Governments may find it challenging to overcome a mixture of these issues. This is because policies aimed to reduce unemployment are likely to aggravate inflation, while actions intended to reduce inflation are likely to raise unemployment levels.
Additionally, stagflation is considered a unique occurrence since inflation should not happen in a weak economy. Typically, slow economic growth should cause consumer demand to drop enough to limit price increases. However, if the economy is slow and the prices of goods increase, it can be difficult for the economy to grow.
For the average consumer, stagflation could mean a slow disaster. The rising price of goods and services will increase the cost of living, as money earned will no longer be able to buy basic needs. Businesses are also likely to avoid hiring and pause on any investments — all of which can keep wages too low to battle inflation.
Characteristics of Stagflation
Stagflation is often accompanied by three economic indicators: high inflation, high unemployment and low economic activity. These factors usually do not come together, making stagflation challenging to endure.
- High Inflation - Inflation refers to an increase in the prices of common goods and services, and high inflation means that the cost of goods is rising more rapidly than the average salary can meet. This reduces money's value and purchasing power, which can cause consumers to dip into their savings or limit their spending.
- High Unemployment - The unemployment rate is the indicator used to determine the percentage of unemployed individuals in a labor force. A high rate means that more people have no jobs, making it difficult to stimulate an economy and drive spending. Additionally, an economy in stagflation can cause businesses to reduce hiring.
- Low Economic Activity - Low economic activity indicates that an economy is barely experiencing any growth. In terms of stagflation, low economic activity results from high unemployment rates and high inflation, along with several other factors such as loss of consumer confidence and a decrease in manufacturing orders.
History of Stagflation
Prior to the 1960s, the idea of stagflation was impossible to economists. Inflation and unemployment were thought to be polar forces since a high unemployment rate would mean there would be less to spend, and therefore, prices would fall or stay the same.
However, between 1965 and 1982, American economists experienced their first-ever stagflation, where inflation hit over 12% and unemployment reached above 7% in 1974. This was known as the Great Inflation. It was fueled by several causes — fiscal and monetary policies, the oil shocks of 1973 and 1979, lack of constraint on inflation rates and a loss in the Federal Reserve’s credibility. Together, these factors pushed the American economy into its first stagflation that lasted for 17 years.
In 1964, inflation was only 1%, while unemployment was at 5%, marking the last year before the stagflation occurred. This steadily rose by the mid-1960s, as the Federal Reserve implemented monetary policies that were generally thought to maintain low levels of unemployment by keeping modestly higher inflation rates.
However, these policies were unsuccessful, leading to an inflation rate of 5.46% in 1969. The Oil Shock of 1973–1974 exacerbated the situation, where the Organization of Arab Petroleum Exporting Countries (OAPEC) conducted an oil embargo that ceased U.S. oil imports from participating OAPEC nations. This led to higher consumer prices and an inflation rate of 11.05% in 1974, along with altering the world price of oil.
In 1980, the inflation rate spiked again, reaching 13.55%. The introduction of credit controls caused this in early 1980 along with the Monetary Control Act, which deregulated institutions that accept deposits. Eventually, inflation started to fall as the economy recovered in the second half of 1980.
The high inflation rate and economic shocks during the Great Inflation rocked the United States, resulting in stagnant and even negative growth for almost two decades. By Q4 of 1973, the real GDP sat at 5,731 and fell to 5,551 by Q1 of 1975 — a loss of 180 points. Fortunately, the economy rebounded to Q1 1973 levels by late 1975.
By 1980, when the Federal Reserve imposed more strict credit controls, the real GDP briefly fell from 6,842 in Q1 of 1980 to 6,693 in Q3 of the same year.
The Misery Index
During the Great Inflation, economist Arthur Okun created the misery index. This is an indicator of how much economic distress people are experiencing. It considers the possibility or reality of unemployment and the increased cost of living. The misery index takes into account both the inflation (πt) and unemployment rate (ut). The formula below shows how the misery index is calculated.
Unemployment measures the unhappiness of those who have lost their jobs and are having trouble finding employment. Conversely, inflation is used as a measure of unhappiness because it refers to the gradual increase in the price of goods and services, which raises the cost of living. The higher the index, the more the average individual feels miserable.
For instance, let's say the unemployment rate is 5% and the inflation rate is 4%. Using the formula, the misery index would be 9%.
At the time of creation, the misery index provided a lot of insight for economists, who initially believed that high unemployment and inflation rates could not occur together.
The graph below looks into the unemployment rate and consumer price index for all urban consumers for all items in the U.S.
The primary difference between a recession and stagflation is economic growth. A recession often indicates that an economy is shrinking or contracting and inflation rates are low. An economy in stagflation is similar to a recession but with a prolonged high inflation rate. The latter can hamper growth and take years to recover from.
What Causes Stagflation?
The Great Inflation has taught economists that stagflation can occur for two reasons: poor economic policies and price increases in energy sources. Both of these things can happen independently or at the same time and reinforce each other, thus spurring stagflation.
Poor Economic Policies
Poor monetary or fiscal policies can contribute to stagflation — and even start it. For instance, if the government increases taxes for small businesses, employers will face higher taxes and higher operating costs, which can cause them to cut back on labor and raise the price for consumers. This can inadvertently increase unemployment and inflation at the same time.
In the 1970s, for instance, the Nixon administration introduced wage and price controls between 1971 and 1974, while the Ford administration implemented a Whip Inflation Now (WIN) program, both of which failed or only slowed inflation temporarily.
Nixon’s attempt to curb stagflation is well-known throughout economic history, dubbed the “Nixon Shock.” This is where he set a 90-day freeze on wages and prices, which would control prices even after his presidential campaign. After the 90-day freeze, he implemented a Pay Board and Price Commission to approve any increases. He also imposed a 10% tariff on imports and removed the United States from the Gold Standard. Both actions backfired, as it set the price of gold higher and the value of the dollar lower, which increased import prices even more.
Price Hikes in Energy Sources
When energy costs rise, the cost of everything else follows — resulting in a supply shock. In economics, supply shocks refer to the reduction in the economy's capacity to produce goods and services at a given price. For instance, oil is essential to the energy sector, as most factories and services cannot function without it. This means that if oil costs rise, everything else is likely to follow.
The Oil Shock of 1973 is one example of this, making the 1970s stagflation much worse. As a result of President Nixon’s request for Congress to provide $2.2 billion in emergency aid to Israel during the Yom Kippur War, the Organization of Arab Petroleum Exporting Countries (OAPEC) imposed an oil embargo against the U.S. In response to the embargo, the U.S. stopped importing oil from participating OAPEC countries, and a series of production cuts changed the world oil price, nearly quadrupling from $2.90 to $11.65 per barrel. While the OAPEC lifted the embargo in March of 1974, the higher oil prices remained.
A spike in oil prices can significantly drive up costs for other goods and services, resulting in higher inflation. Case in point, the inflation rate in 1973 doubled from 1972 from 3.27% to 6.18%. In 1974, inflation rates hit 11.05%.
Stagflation in History
Stagflation poses a severe risk to an economy — stunting growth and causing years of hardship for businesses and individuals. For instance, the Great Inflation lasted nearly two decades, pushing the American economy into a period of constantly changing fiscal and monetary policies and high inflation.
The Great Inflation
Between 1965 and 1982, the U.S. experienced its first stagflation dubbed “The Great Inflation.” In the early 1960s, fiscal and monetary policies stimulated growth in employment by keeping interest rates moderately high. This was brought about by the belief that high inflation rates and high unemployment were opposites and could not coincide.
However, the Federal Reserve failed to consider how the trade-off between lower unemployment and higher inflation is risky, given how it may require ever-higher inflation to maintain. This led to unprecedented levels of inflation rates, where it rose from 1.58% to a peak of 13.55%, while unemployment hit a high of 9% in 1975.
Within the same period, the Oil Shocks of 1973 and 1978 occurred. The first crisis of 1973 was caused by an Arab oil embargo, while the Iranian revolution caused the second. These back-to-back supply shocks caused oil prices to quadruple during the first crisis and triple during the second. Since energy is an integral part of most industries, this caused prices for general goods to rise and contributed to the high inflation rates.
To reduce inflation and unemployment, the Nixon administration imposed wage and price controls between 1971 and 1974, along with removing the the United States from the Gold Standard.
The Ford administration started the Whip Inflation Now (WIN) program, which involved voluntary anti-inflationary initiatives. However, this only slowed down inflation temporarily. Both Nixon's and Ford's attempts lowered the average consumer's confidence, affecting high inflation rates.
In November of 2008, Zimbabwe experienced the second-highest hyperinflation on record, reaching an estimated 79,600,000,000%. This was caused by the federal government printing more money in response to several economic shocks.
Before Zimbabwe experienced hyperinflation, the nation’s economy was stuck in a period of stagflation. In 1982, unemployment reached 10.8%, steadily rising until it hit 94% in 2008. Furthermore, in the 1990s, the government faced high national debt, a decline in economic output and export earnings and a lack of confidence in politics and the economy in general. In 1999, the country experienced periods of drought, which affected the agricultural industry.
Then, in the early 2000s, the country redistributed large agricultural tracts. However, this resulted in negative growth as the individuals who owned these lands did not know how to farm properly, which again impacted the agricultural sector and raised the prices of common goods.
The Zimbabwe government decided to print more money to address these economic shocks, which lowered the value of the Zimbabwean dollar and eventually led to hyperinflation that peaked in 2008.
Stagflation can be a challenging concept for the average consumer. Review some commonly asked questions below to gain greater insight.
MoneyGeek reached out to several experts to get their insight on stagflations and how the average consumer can prepare and protect their finances.
- What are the key differences between recessions and stagflations?
- What are signs that stagflation is letting up in an economy?
- Simply put, stagflation is made up of high inflation and a slowing economy. However, conventional methods by central bankers to address either one tend to exacerbate the other. How have central bankers been dealing with stagflation in recent years?
Certified Financial Planner at Stewardship Concepts Financial Services, LLC
Founder, President & Portfolio Manager of Monetta Financial Services
Tax Strategist at Estate CPA & Partner at Sundin & Fish, PLC
Professor of Economics at the University of California, Irvine
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