Stagflation: The Economic Storm that Confuses Investors and Central Banks

The Modern Economic Dilemma

When an economy simultaneously faces massive unemployment, economic contraction, and galloping inflation, it finds itself in a scenario that seems straight out of an inverted economics textbook. This phenomenon is precisely stagflation: a term coined in 1965 by British politician Iain Macleod that describes the worst possible economic scenario.

Unlike traditional economic cycles, where inflation and unemployment maintain a predictable inverse relationship, stagflation breaks all the rules. It's as if someone were simultaneously pressing the accelerator and the brake of an economy, causing blockages everywhere.

Understanding Stagflation: Definition and Characteristics

Stagflation represents the toxic convergence of three serious economic problems: minimal or negative economic growth, high unemployment, and consumer price inflation. These three elements should not coexist according to conventional economic models.

The concept gained relevance because it challenges established economic wisdom. Normally, when growth is strong, unemployment decreases but inflation increases. When governments combat inflation through monetary tightening, the economy slows down and unemployment rises. However, in stagflation, all these calamities occur together.

The Gross Domestic Product (GDP) stagnates or declines, indicating that the economy is not generating enough opportunities. Households face less disposable income precisely when prices are rising, severely eroding purchasing power. This combination could precipitate a wider financial crisis if it persists.

The Roots of Stagflation: Multifaceted Causes

Contradictory Economic Policies

Governments and central banks simultaneously implement two types of policies that, in theory, should complement each other but in practice can lead to stagflation.

Monetary policy is controlled by institutions like the Federal Reserve, which manages the money supply. Fiscal policy is executed by governments through spending and tax decisions. When these policies move in opposing directions, the results are perverse.

A classic example: a government raises taxes to reduce public spending (slowing down the economy), while the central bank implements quantitative easing by injecting money (fueling inflation). The result is economic contraction with rising prices.

The End of Gold Backing and Fiat Currency

After World War II, most economies abandoned the gold standard, where currencies were tied to physical gold reserves. This transition to fiat money removed any technical limits on monetary issuance.

While this granted greater flexibility to central banks, it also introduced the risk of uncontrolled inflation. With no restrictions on how much money could be printed, inflation could accelerate unchecked.

Disruptions in Energy Supply

A particularly powerful catalyst is the increase in supply costs, especially energy. When oil prices soar, production costs rise across the economy. Companies pay more for fuel, transportation, and energy services, passing these costs on to final prices.

At the same time, consumers are facing increases in their heating, transportation, and basic service bills, leaving them with less income to spend on other goods. When the supply of goods contracts while prices rise, and workers' incomes are eroded, the conditions for stagflation are set.

The Precedent of 1973: Oil Embargo

The 1970s provide the most famous example of stagflation. In 1973, the Organization of Arab Petroleum Exporting Countries (OAPEC) imposed an oil embargo in response to the Yom Kippur War, drastically reducing global supply.

The price of oil nearly quadrupled overnight. This sent price shocks throughout the entire Western economy: more expensive transportation, more expensive heating, more expensive industrial production.

Ironically, the central banks of the United States and the United Kingdom lowered interest rates to stimulate growth, a strategy that would normally work. However, without enough supply of goods ( due to energy costs ), the abundant money simply raised prices. Economies simultaneously experienced double-digit inflation and negative growth: stagflation in its rawest form.

Conflict Strategies: Economic Responses

The Monetarist Vision

Monetarists argue that controlling inflation should be the absolute priority. Their prescription: aggressively reduce the money supply to cool down demand, which eventually puts downward pressure on prices.

The obvious limitation is that this recessive medicine does not stimulate growth or reduce unemployment. A contracted economy will remain contracted until expansionary policies are implemented.

The Supply Approach

Other economists argue that the central problem is the insufficient supply of goods and services. Their solution: control energy costs, invest in efficiency, provide subsidies to producers. If supply increases while costs decrease, prices naturally fall, stimulating demand without creating inflation.

This strategy directs growth without necessarily exploding the monetary aggregates.

The Free Market Solution

Some economists argue that interference is counterproductive. Allowing supply and demand to adjust naturally, without intervention from central banks or governments, will ultimately restore equilibrium.

The problem: this readjustment can take decades, leaving millions of people in desperate economic conditions in the meantime. As Keynes observed: “in the long run, we are all dead.”

Stagflation vs. Simple Inflation

While inflation simply implies a widespread increase in prices (eroding the purchasing power of money), stagflation adds the additional dimension of economic stagnation.

In normal inflationary contexts, economic growth can partially offset the erosive effect of inflation for some populations. During stagflation, there is no such buffer. Real wages fall while the economy contracts, creating a simultaneous squeeze scenario in income and spending.

Impact of Stagflation on Cryptocurrencies

Demand Contraction for Risk Assets

When economic growth slows down or enters negative territory, consumers and businesses have less capital available. Under these conditions, they withdraw from speculative and high-risk assets, including cryptocurrencies.

Institutional investors are also recalibrating their portfolios, reducing exposure to anything that does not generate predictable returns. Cryptocurrencies, being volatile assets without established cash flows, are experiencing net capital outflows.

Interest Rate and Liquidity Cycles

Governments typically combat stagflation by prioritizing inflation control over growth. This means raising interest rates to reduce the liquidity in circulation.

When interest rates rise, keeping money in banks becomes attractive again (earning yield), and taking on debt for speculative investments becomes expensive. The demand for cryptocurrencies collapses under these conditions.

However, once inflation is controlled, governments typically reverse the strategy, lowering rates and injecting liquidity. In that phase, capital flows back into alternative assets such as cryptocurrencies.

Bitcoin as Inflation Hedge

Many Bitcoin advocates argue that it acts as a hedge against inflation due to its fixed supply of 21 million coins. Unlike fiat money which can be printed indefinitely, Bitcoin is deflationary by design.

During periods of sustained inflation, this feature has attracted capital towards Bitcoin as an alternative store of value. Historically, long-term accumulators of Bitcoin have experienced gains during and after severe inflationary cycles.

However, in the short term during stagflation, Bitcoin faces headwinds: the economic contraction pressures prices downwards, while inflationary hedging pushes them upwards. Additionally, the increasing correlation between cryptocurrencies and stock markets means that when stocks move during contractions, cryptocurrencies follow suit.

Final Reflection

Stagflation represents an economic puzzle without perfect solutions. Every tool available to combat one dimension of the problem exacerbates another. Policymakers find themselves trapped in an impossible triangle: they cannot simultaneously stimulate growth, reduce inflation, and maintain healthy employment rates.

The specific macroeconomic context, including factors such as the money supply, interest rate behavior, supply-demand dynamics, and employment rates, determines how a particular stagflation will unfold and which measures will be most effective.