Stagflation: The Biggest Nightmare of Investors and Economists

TL;DR Stagflation combines high unemployment, economic stagnation, and rampant inflation simultaneously. It is an economic paradox where traditional crisis-fighting tools counteract each other. For crypto investors, this means instability and decreased demand.

When the economy hits a dead end

Economic growth and inflation traditionally move in opposite directions. To stimulate a weak economy, central banks increase the availability of money and lower interest rates – as a result, companies borrow more cheaply, consumers spend more, and employment grows. On the other hand, when prices are soaring, policymakers combat this by restricting the money supply and raising interest rates – this slows down the economy but curbs inflation.

Stagflation is an economic horror: recession with rising prices. Both people are losing jobs and witnessing the erosion of their purchasing power. Every attempt to solve one problem worsens the other – which is why stagflation is so difficult for governments and central banks to manage.

What is stagflation?

The term “stagflation” was first used in 1965 by Iain Macleod, a British politician. It is a combination of the words “stagnation” and “inflation” describing an economy that is simultaneously losing growth momentum ( or contracting ) and experiencing rising consumer prices, with high unemployment.

This phenomenon is remarkable because usually an increase in unemployment and a decrease in GDP reduce demand, and therefore should lower prices. Meanwhile, in stagflation, prices are rising. High price levels will force investors to make serious decisions, and a potential financial crisis is becoming increasingly imminent.

Why does this economic aberration occur?

Contradictory political decisions

Governments and central banks do not always act in harmony. The government may raise taxes ( which reduces consumer spending ), while at the same time the central bank is conducting quantitative easing by printing money. Government policy lowers economic growth, while the central bank pumps money into the economy, driving inflation. The effect? The worst possible combination.

End of the gold standard

Before World War II, currencies were tied to gold reserves – this naturally limited the money supply. After the implementation of fiat currency systems ( based on trust, without gold backing), central banks gained greater freedom. Unfortunately, this freedom also opened the door to inflationary disturbances and price instability.

Supply shocks and energy prices

When production costs rise sharply – for example, due to an increase in oil prices – companies raise the prices of goods. However, consumers have less money due to higher expenses for energy, transportation, and heating. Supply decreases, prices rise, and the economy comes to a standstill. This unique networking of causes creates ideal conditions for stagflation.

How do economists propose to fight stagflation?

Monetarist approach

Economists focusing on controlling the money supply argue that inflation must first be tamed through restriction. The problem: restrictive monetary policy often stifles economic growth and increases unemployment. The solution for growth must wait until later.

Supply-side economics

Another school of thought advocates for increasing efficiency through investments, grants, and reducing energy costs. This should increase aggregate supply, lower prices, and stimulate employment – all at the same time.

Market solution

Some economists see salvation in the free market: supply and demand will balance themselves, consumers will buy less due to high prices, inflation will decrease, and labor will be effectively allocated. Downside: this process can take decades, leaving society in difficult conditions.

Stagflation and the Cryptocurrency Market: What Awaits Investors?

The impact of stagflation on the crypto ecosystem is complex and multi-faceted.

Shrinking disposable income

When the economy weakens, people have less money. Investments in cryptocurrencies become less attractive – money must cover everyday expenses. Large institutional investors are also withdrawing from high-risk assets, including Bitcoin and other cryptocurrencies.

Central bank policies are putting pressure on crypto prices.

Normally, when inflation rises, governments raise interest rates. Higher rates mean less money in circulation, and borrowing becomes more expensive. In such an environment, speculative investments, including crypto, lose their appeal. Demand falls, and with it, cryptocurrency prices.

However, when inflation is brought under control, the policy reverses: quantitative easing and low interest rates. This usually supports cryptocurrency prices due to an increase in the money supply.

Bitcoin as collateral? Not always

Many believe that Bitcoin is an excellent hedge against inflation due to its limited supply. This thesis has proven true during periods of high inflation and simultaneous economic growth – investors held Bitcoin for years and reaped the benefits.

However, during stagflation itself – when inflation is high but the economy is weak – the scenario changes. Bitcoin may lose value along with stocks instead of rising, as the workforce shrinks, unsecured money is present, and investors seek cash. An additional factor is the increasing correlation between crypto markets and stock exchanges – when stocks fall, crypto falls along with them.

Lesson from 1973: OPEC Embargo and the First Major Stagflation

History provides an excellent example. In 1973, OPEC (Organization of the Petroleum Exporting Countries) imposed an oil embargo on countries supporting Israel in the Yom Kippur War. Oil supply drastically decreased, prices skyrocketed, and shortages appeared throughout the supply chain.

Inflation has exploded. The USA and the UK responded with interest rate cuts to stimulate growth. Lower rates were supposed to encourage spending. But it didn't work enough – high energy prices are too much of a strain on consumers. The result: the UK and the USA have found themselves in a stagflation trap with high inflation and economic stagnation at the same time.

Summary: An Economic Labyrinth with No Clear Exit

Stagflation is a situation that escapes classical economic tools. Economic growth and inflation usually do not go hand in hand – but then the rules of the game change. Every step towards solving one problem usually worsens the other.

For investors, especially those interested in cryptocurrencies, stagflation presents a particular challenge. It is not an environment conducive to risky assets. The key to understanding the impact of stagflation on markets is to observe the broader macroeconomic context - interest rates, money supply, employment indicators, and trends in demand and supply. In times of such uncertainty, education and a diversified strategy become more valuable than gold.