Stagflation: When inflation meets stagnation

Introduction

Stagflation is a phenomenon that combines the worst aspects of an economic crisis: high unemployment, slow or negative economic growth, and simultaneous rising prices. This term originated in 1965 from the pen of British politician Iain Macleod and refers to a combination of stagnation and inflation.

For cryptocurrency investors, this phenomenon is particularly relevant as its consequences directly affect the allocation of capital among different asset classes.

Paradox of Economic Policy

Economists and governments traditionally combat stagnation and inflation separately, using opposing tools. To stimulate the economy, central banks increase the money supply and lower interest rates, making loans cheaper. On the other hand, to control inflation, they reduce the money supply and raise rates.

The difficulty lies in the fact that these measures conflict with each other. When both phenomena occur simultaneously — that is, when stagflation arises — traditional solutions cease to work.

Causes of Stagflation

Conflict of monetary and fiscal policy

The clash between the monetary policy of the central bank and the budgetary policy of the government can lead to stagflation. For example, when the government raises taxes to cut expenditures, while the central bank simultaneously conducts quantitative easing and prints money. The result: the economy slows down, but inflation rises.

Transition from the gold standard to fiat currency

After World War II, the world abandoned the gold standard, when currencies were tied to gold. This removed the natural constraints on the money supply, allowing central banks to manage the economy more flexibly. However, at the same time, the risk of uncontrolled inflation increased.

Energy shocks

The sharp rise in energy resource costs creates a supply shortage. When production costs increase, prices rise, but consumers have less money to spend due to rising utility and transportation costs. This is a classic scenario for the development of stagflation.

The Impact of Stagflation on the Cryptocurrency Market

Cryptocurrencies respond to stagflation ambiguously, depending on the stage of the crisis.

At the stage of fighting inflation: Central banks raise interest rates and reduce the money supply. Under such conditions, liquidity decreases, people save money in banks, and loans become more expensive. High-risk and high-return investments, including Bitcoin and other cryptocurrencies, become less attractive. The demand for digital assets may sharply decline.

At the growth stimulation stage: Once inflation is under control, governments typically move to quantitative easing and interest rate cuts. An increase in the money supply positively affects the crypto markets as investors seek alternative places to allocate capital.

Bitcoin as a hedge against inflation: Many investors view Bitcoin as a means of protection against rising inflation due to its limited supply. However, this strategy is most effective for long-term investors who have accumulated cryptocurrency over the years. In the short term, especially during stagflation, this hedge may not work due to the increased correlation of cryptocurrencies with stock markets.

Historical Example: The Oil Crisis of 1973

In 1973, OPEC declared an oil embargo in response to support for Israel in the Yom Kippur War. The sharp reduction in oil supplies led to a dramatic increase in prices and a rise in food prices, causing a massive increase in inflation.

However, the central banks of the USA and the UK responded to this by lowering interest rates in an attempt to stimulate the economy. This move did not provide sufficient economic growth, so Western countries simultaneously faced high inflation and economic stagnation—a classic example of stagflation.

Approaches to Overcoming Stagflation

Monetarist approach

Monetarists prioritize controlling inflation by reducing the money supply. This lowers spending, reduces demand, and halts price increases. However, such a policy does not stimulate economic growth, which will need to be activated separately.

Supply-oriented economists

This direction focuses on increasing supply through cost reduction and efficiency enhancement. Control of energy resources, investments in productivity, and subsidies for production help lower prices and stimulate growth while reducing unemployment.

Market-based solution

Some economists believe that the best way is to not intervene. Supply and demand in a free market will eventually regulate prices, as consumers will stop buying expensive goods. However, this path may require years or decades of low quality of life for the population.

Conclusion

Stagflation is a unique challenge for economists and politicians, as its components require conflicting decisions. Tools to combat economic stagnation often exacerbate inflation, while price control methods lead to slowed growth. Successfully overcoming stagflation requires a deep understanding of the macroeconomic context, considering the money supply, interest rates, demand and supply levels, and labor market changes. For cryptocurrency investors, understanding these dynamics is critically important for predicting market movements.