Stagflation: The Concept that Challenges Economists and Markets

TL;DR Stagflation combines two economic enemies into one: high unemployment, weak or negative economic growth, and simultaneous price inflation. Governments face a dilemma because the tools to solve one problem often worsen the other. For cryptocurrency investors, this may mean short-term pressure but long-term hedging opportunities.

Understanding Stagflation: A Paradoxical Economic Concept

The term stagflation was coined in 1965 by Iain Macleod, a British politician and Chancellor of the Exchequer, by merging two words: “stagnation” and “inflation.” This macroeconomic concept describes an economy that simultaneously experiences minimal or negative growth, high unemployment, and a constant rise in consumer prices.

The paradox is that these problems should not occur together according to traditional economic theory. Normally, employment and growth are positively correlated with inflation. But when stagflation arrives, governments and central banks find themselves trapped: every solution they attempt to apply exacerbates one of the other problems.

The Dilemma of Economic Policies

Traditionally, economists have had separate tools for each crisis:

Against the recession: Increasing the money supply lowers interest rates, making it cheaper to obtain loans. Businesses invest more, employment grows, and the economy expands.

Against inflation: Reducing the money supply by raising interest rates makes loans more expensive, slows down spending, and reduces demand, which puts downward pressure on prices.

However, when both problems hit simultaneously, applying a solution intensifies the other. This is what makes combating stagflation one of the biggest challenges for economic policymakers.

Common Causes of Stagflation

Incompatibility between Fiscal and Monetary Policy

Central banks manage the money supply through monetary policy, while governments influence the economy through spending and taxes (fiscal policy). When these policies are not aligned—for example, a government raises taxes reducing available spending while the central bank injects liquidity—the result can be rampant inflation combined with weak growth.

The End of the Gold Standard and Fiat Coin

After World War II, most economies abandoned the gold standard, moving to fiat currency systems. While this gave greater flexibility to central banks, it also removed the natural limit on money issuance, increasing the risk of unchecked inflation.

Supply Chain Pressures

A significant increase in production costs—especially in energy—can trigger stagflation. If energy becomes more expensive and goods become costlier to produce, prices rise. At the same time, consumers have less money available to spend on other items, which slows overall growth.

The Historical Case: The Oil Crisis of 1973

The concept of stagflation is not theoretical; it had real manifestations in 1973. The Organization of Arab Petroleum Exporting Countries (OAPEC) imposed an oil embargo in response to the Yom Kippur war, causing a drastic drop in supply.

The price of oil skyrocketed, causing shortages in the supply chain and price increases for consumers. Inflation rose dramatically in the United States, United Kingdom, and other Western nations.

Central banks responded by lowering interest rates to stimulate growth. But this measure, by keeping money cheap, did not curb inflation. With high energy costs eating into the budgets of consumers and businesses, many Western economies found themselves trapped in a lethal combination: high inflation and a stagnant economy.

Approaches to Combat Stagflation

There is no single consensus on how to resolve stagflation. Economists disagree according to their school of thought:

Monetarists: They prioritize controlling inflation by reducing the money supply, even though this may further slow growth in the short-term. Growth is addressed later, once inflation is under control.

Supply Economists: They propose reducing production costs, improving energy efficiency, and investing in technology. This would increase aggregate supply, reduce prices, and simultaneously stimulate employment.

Defenders of the Free Market: They suggest allowing supply and demand to self-adjust. Although it might eventually work, it would take years or decades while the population suffers the consequences.

Impact of Stagflation on Cryptocurrency Markets

For investors in digital assets, stagflation presents a mixed scenario:

Short-Term - Bearish Pressure: During phases of acute inflation, governments often raise interest rates to curb it. This makes high-risk and high-return investments—such as cryptocurrencies—less attractive. Investors pull capital towards safe assets. At the same time, weak growth reduces the purchasing power of retailers and large investors, decreasing the demand for cryptos.

Long Term - Hedging Potential: Once inflation is controlled, governments typically inject liquidity through quantitative easing and rate reductions. In this environment, assets like Bitcoin—with limited and fixed supply—could serve as a hedge against the loss of purchasing power of fiat currencies. Many investors argue that Bitcoin represents a store of value in inflationary periods.

However, this hedging strategy works best over long-term horizons. In the short-term, the volatility and increasing correlation between cryptocurrencies and stock markets can neutralize this protective effect.

Conclusion

Stagflation represents a unique challenge because it combines crises that historically did not coincide. The tools designed for one exacerbate the other, trapping policymakers in a dilemma with no perfect solutions.

For economists and investors, understanding stagflation and the concept behind its dynamics is crucial. Cryptocurrency markets, although still developing, are not isolated from these macroeconomic realities. Persistent inflation, restrictive monetary policy, and weak economic growth put pressure on these assets, but also create windows of opportunity for those who understand long term economic cycles.