Stagflation: When the economy is paralyzed between inflation and recession

TL;DR Stagflation represents the most challenging economic scenario to manage: high unemployment, stagnation of economic growth, and simultaneous rising prices. While the tools to combat recession worsen inflation and vice versa, investors—especially in the cryptocurrency market—are faced with complex choices about where to allocate their capital.

Stagflation: A Paradoxical Challenge for Economists and Politicians

The term stagflation combines two words: stagnation and inflation. This macroeconomic concept was introduced in 1965 by British politician Iain Macleod and describes a situation where the economy grows very little or even contracts, unemployment remains high, and at the same time, the prices of goods and services increase significantly.

Under normal circumstances, high employment and economic growth are positively correlated with inflation. However, stagflation breaks this traditional logic. The greater complexity arises from the countermeasures: the tools to individually address recession often worsen inflation, while anti-inflation strategies further hinder growth.

Measured through a country's Gross Domestic Product (GDP), economic growth typically reflects employment rates. When GDP stagnates and inflation accelerates simultaneously, the consequences can deteriorate into a widespread financial crisis.

How do the causes of stagflation arise?

Stagflation emerges when the purchasing power of the currency erodes while the economy slows down and the supply of goods and services contracts. The origins vary according to the historical context and the different economic schools, including monetarist, Keynesian, and new classical.

The clash between economic policies

Central banks, such as the American Federal Reserve, control the money supply through monetary policy. Governments, on the other hand, directly influence the economy through fiscal policy and public spending decisions. A conflicting combination of these two approaches can generate uncontrolled inflation and stagnant economic growth.

A concrete example: the government raises taxes, reducing citizens' disposable income, while at the same time the central bank practices quantitative easing (literally “money printing”) and lowers interest rates. The first intervention depresses growth; the second fuels inflation through a greater availability of circulating currency.

The abandonment of the gold standard

Before World War II, most major economies pegged their currencies to gold reserves according to the gold standard system. This practice was gradually abandoned in the post-war period, replaced by fiat currency (legal tender without physical backing).

The removal of this constraint has eliminated any theoretical limit on the available money supply. While this has granted greater flexibility to central banks, it has also created significant risks regarding inflation levels, resulting in increases in consumer prices.

The impact of energy costs and supply chains

A net increase in production costs—particularly in the energy sector—represents another catalyst for stagflation. This phenomenon is known as supply shock (supply shock).

When goods become more expensive to produce and prices rise, while consumers have less money available to cope with rising energy costs (heating, transportation), the probability of stagflation significantly increases.

Stagflation and cryptocurrency markets: A complex link

The effects of stagflation on cryptocurrencies are difficult to predict with certainty, although it is possible to make hypotheses by analyzing different scenarios.

Economy in contraction: Immediate impact on investments

When the economy grows slowly or contracts, consumers have less income to invest. For retail investors, this means reduced cryptocurrency purchases and increased sales to generate liquidity for daily expenses. Large institutional investors tend to reduce exposure to high-risk assets, including stocks and cryptocurrencies, accelerating the outflow of capital from the sector.

Monetary tightening and interest rate increase

Governments generally address inflation first, then economic growth. Controlling inflation typically occurs through reducing the money supply by increasing interest rates. Higher rates make loans more expensive and encourage bank savings rather than spending.

This environment penalizes high-risk and high-return investments. Cryptocurrencies, considered speculative assets, experience reductions in demand and price during phases of rising interest rates and decreasing money supply.

Bitcoin as inflation protection: Limited utility in the short term

Many investors argue that Bitcoin effectively functions as a hedge against inflation. Holding wealth in fiat currency without generating interest leads to the erosion of real value. Bitcoin, with its capped supply and programmed issuance system, represents a lasting store of value over time for many.

Historically, this strategy has worked well for those who accumulated Bitcoin and other cryptocurrencies during periods of sustained inflation and economic growth. However, this protection may fail in the short term, especially during periods of stagflation. Additionally, the increasing correlation between cryptocurrencies and traditional stock markets further complicates the picture.

Economic strategies to combat stagflation

It is possible to counter stagflation, but the choice of policies depends on the economic school adopted.

( Monetarist approach: Priority to inflation

Monetarists believe that controlling the money supply is the top priority. They would first reduce the money supply by limiting overall spending. This leads to lower demand and falling prices. The downside: it does not encourage economic growth, which would need to be addressed later with more accommodative monetary policies combined with expansive fiscal interventions.

) Supply economists: Increase productive efficiency

One alternative is to increase the economic supply by reducing production costs and improving efficiency. Controlling energy prices, investing in productive efficiency, and providing subsidies to production help to lower costs, increase aggregate supply, decrease prices for consumers, stimulate economic production, and reduce unemployment.

The solution of the free market: Long term, high social costs

Some economists believe that the best cure is the market's self-correction. Supply and demand balance naturally as consumers cannot afford goods at high prices. This reduces demand and inflation. The free market also efficiently allocates labor, reducing unemployment.

The biggest disadvantage: this mechanism takes years or decades to work. Meanwhile, the population faces very difficult living conditions. As John Maynard Keynes observed: “In the long run, we are all dead.”

Stagflation During the 1973 Oil Crisis: A Historical Lesson

In 1973, the Organization of the Petroleum Exporting Countries ###OPEC### declared an oil embargo against a selected group of nations, in response to their support for Israel in the Yom Kippur War.

The drastic reduction in oil supply caused spikes in crude prices, creating shortages in supply chains and generally raising consumer prices. The inflation rate underwent enormous increases.

In the United States and the United Kingdom, central banks lowered interest rates to stimulate economic growth. Lower rates encouraged borrowing and incentivized spending over saving. However, the traditional mechanism for combating inflation would involve cutting interest rates combined with policies that encourage saving, not spending.

As energy costs constituted a significant portion of consumer spending and the reduced rates did not sufficiently stimulate growth, many Western economies went through a period of high inflation combined with economic stagnation: exactly stagflation.

Conclusion: A challenge without an easy solution

Stagflation represents an anomalous situation for economists and policymakers. Under normal circumstances, inflation and negative growth do not coexist. The tools to combat economic stagnation tend to worsen inflation, while anti-inflation strategies hinder growth.

In periods of stagflation, it is essential to consider the macroeconomic context as a whole: the money supply, interest rates, the balance between supply and demand, the employment rate. Understanding these multiple factors allows both policymakers and investors to make more informed decisions and protect themselves from the intrinsic risks of this paradoxical economic situation.