Understanding Stagflation: When the Economy Freezes

EXECUTIVE SUMMARY Stagflation represents a paradoxical economic scenario where simultaneous productive stagnation, high unemployment, and rampant inflation coexist. Unlike other economic problems that can be addressed in isolation, this combination creates a dilemma for governments and central banks, as traditional corrective measures for one issue often exacerbate the other.

The Economic Paradox: What Really Happens?

When economists talk about stagflation, they describe a condition in which the economy simultaneously experiences:

• Economic contraction or minimal growth (typically measured by Gross Domestic Product)
• Persistently high unemployment rates
• Accelerated increase in consumer prices

This term, coined in 1965 by British politician Iain Macleod, is a contraction of “stagnation” and “inflation.” What makes it particularly problematic is that it challenges conventional economic logic: normally, periods of low growth coincide with stable or decreasing prices, not with rampant inflation.

The central challenge lies in the fact that economic policy tools work in contradictory ways. Expanding the money supply favors growth but fuels inflation. Contracting the money supply controls prices but deepens the recession. Any action that resolves one problem almost always worsens the other.

Root Causes: Why These Conditions Arise

Conflict between Government Policies

Governments execute fiscal policy (decisions on spending and taxes), while central banks manage monetary policy (control of the money supply). When these act misaligned, they can generate unintended consequences.

A typical example: a government raises taxes to reduce public spending, leaving citizens with less purchasing power. At the same time, the central bank implements quantitative easing and lowers interest rates to stimulate lending. The result is that the money supply grows while real demand contracts, putting upward pressure on prices without generating employment or productive growth.

The End of the Monetary Anchor

After World War II, most economies abandoned the gold standard, which limited the amount of currency that could be issued. The transition to fiat money systems (not backed by gold) allowed for greater flexibility for central banks, but also eliminated a natural mechanism for inflation control. With no restrictions on issuance, the risks of rampant inflation increased significantly.

Supply Shocks

When production costs skyrocket —particularly in energy— companies face shrinking margins. If they cannot fully pass these costs onto consumers, they cut back on investment and employment. At the same time, final prices rise due to higher costs, generating inflation without growth.

Different Approaches to Combat Stagflation

Monetarist Perspective

Monetarists prioritize controlling inflation, assuming that reducing the money supply is fundamental. Their strategy: contract the money in circulation to reduce overall spending, lower demand, and put downward pressure on prices. The weakness: this approach does not generate economic growth or immediate employment, it only offers short-term price stability.

Offer Focus

Other economists propose to tackle the problem from the production side: reducing costs, improving efficiency, and increasing productive capacity. Subsidies for key sectors, investments in technology, and energy price controls are typical tools. If the economy produces more with fewer resources, prices naturally fall and employment recovers without the need for inflation.

Free Market Solution

A third group argues that stagflation self-corrects over time if markets are allowed to operate without intervention. The logic: when prices rise too high, demand naturally falls, pushing prices back down. Unemployment incentivizes job searching, and eventually the labor market rebalances. The problem: this process can take decades, during which the population suffers greatly.

The Historical Precedent: Oil Crisis of 1973

Stagflation is not theoretical. In 1973, the Organization of Arab Petroleum Exporting Countries (OAPEC) imposed an oil embargo in response to the Yom Kippur War. Global oil supply collapsed, prices skyrocketed, and the supply chain collapsed.

The United States and the United Kingdom responded by lowering interest rates to stimulate lending and spending. The theory was that cheaper money would boost demand and recovery. However, with expensive energy limiting real purchasing power and central banks constantly injecting money, both economies fell into stagflation: severe unemployment combined with double-digit inflation. The 1970s are remembered precisely for this toxic combination.

Implications for Cryptocurrency Markets

Stagflation generates complex dynamics in the crypto ecosystem. Reactions vary depending on the phase:

Initial Phase: Rising Interest Rates

When governments fight inflation by raising interest rates, two things happen simultaneously:

1. Attraction of capital towards safe assets: Government bonds and bank deposits suddenly offer real returns. Investors pull funds from risky assets, including cryptocurrencies.

2. General monetary contraction: Less money in circulation means less liquidity available for speculation. Bitcoin and other cryptocurrencies, being risk assets, suffer systematic sell-offs.

Stimulus Phase: Quantitative Easing

Once inflation is controlled, governments typically inject money again to stimulate growth. During these phases, liquidity returns to speculative markets, including cryptocurrencies, generating bullish pressure.

The Debate on Bitcoin as a Hedge

Many investors view Bitcoin as a hedge against inflation, citing its limited supply of 21 million units. The argument: in contexts of eroding purchasing power, BTC preserves value better than fiat currencies.

Historically, investors who accumulated Bitcoin during subsequent inflationary periods saw real gains. However, during the most severe recession phases (when unemployment is the dominant issue), Bitcoin also falls, increasingly correlating with the stock markets. Anti-inflation hedging works better in long-term cycles than in acute crises.

Final Reflection: A Dilemma Without Easy Solutions

Stagflation represents one of the biggest challenges for governments and central banks because it questions the fundamental assumptions of modern economic policy. Traditional tools were designed for scenarios where inflation and recession do not coexist.

In times of stagflation, decision-making must consider multiple variables simultaneously: money supply, interest rate structure, productive capacity, employment dynamics, and expectations of future inflation. There is no universal answer; it all depends on the specific context, the underlying causes, and the political cost that each society is willing to bear.