What is Stagflation?
When economic activity slows, demand for goods and services falls; when demand falls, the manufacturer’s profit declines. Unemployment increases. But prices are low, and so is inflation.
Therefore, slow economic growth is expected to increase unemployment but should not result in rising prices (inflation).
But stagflation refers to slow growth and high unemployment along with high inflation. This is a rare economic situation.
Stagflation can result when the economy faces a supply shock, for example, a rapid rise in oil prices. In such a situation, prices increase, making production costlier and less profitable, thus slowing economic growth.
For households, stagflation means people are earning less money while spending more on everything. As consumer spending slows, corporate revenue falls, increasing the overall effect on the economy. This is why this phenomenon is considered bad, and there is no easy way out of it.
Given that COVID is retreating, businesses are reopening, and life looks to be returning to normal, the economy should be rising right now. Why isn’t this the case? One word answer – inflation. Rising prices of everything from food to gas to airline tickets are silently killing this economy. The Russia-Ukraine war further adds to long-term problems causing higher inflation and slowing growth.
Many economists and experts believe the world is on the brink of entering a “stagflationary” period. According to the World Bank’s latest Commodity markets outlook, the world has experienced the largest spike in energy prices since the 1973 oil crisis, as well as the largest increase in food and fertilizer prices since 2008. The World Bank has warned that price shocks caused by Russia’s invasion of Ukraine will last at least until the end of 2024.
Russia is the world’s largest exporter of natural gas and fertilizer, as well as the world’s second-largest crude oil exporter. Together with Ukraine, it contributes to roughly one-third of world wheat exports, 19% of corn exports, and 80% of sunflower oil exports.
What happens during stagflation?
Stagflation happens when inflation exists in tandem with slow economic growth and high unemployment. Typically, these economic conditions don’t occur together, i.e., unemployment and inflation tend to be inversely correlated. So, as unemployment rates increase, inflation usually decreases and vice versa.
Inflation and unemployment have historically had an inverse relationship, as depicted by the Phillips curve. Low unemployment is associated with higher inflation, whereas high unemployment is associated with lower inflation and even deflation. This inverse relationship makes logical sense. When unemployment is low, more consumers have more money to spend on things. Demand for commodities rises, and as demand rises, so do prices. During periods of high unemployment, customers buy fewer goods, which puts downward pressure on prices and reduces inflation.
Once, the US government imposed wage and price restrictions, which limited the prices that businesses could charge their customers. Despite rising production costs, businesses were unable to boost prices in order to bring revenues in line with costs. Therefore, in order to stay profitable, they were forced to decrease expenses by reducing payrolls. The jobs were lost, resulting in a positive correlation between inflation and unemployment.
Economists offer two explanations for why stagflation occurs. First, stagflation can occur when the economy is subjected to a supply shock. In such a situation, prices rise, making production more expensive and less lucrative, reducing economic growth. According to a second argument, stagflation might be caused by inadequate economic policies. For example, the government can enact a policy that harms industries while rapidly increasing the money supply. The occurrence of these policies at the same time may result in slower economic development and greater inflation.
Many people are concerned that today’s stagflationary conditions will continue to define the global economy, resulting in greater inflation, reduced growth, and perhaps recessions in many countries.
Causes of Stagflation
- The Covid-19 forced many sectors to lock down and disrupt global supply chains. For example, throughout the pandemic, there have been supply shocks in:
- Labor, with fewer people working
- Goods, for example, semiconductor shortages, started even before the pandemic.
- Services, as people postponed elective surgeries and other health-care procedures.
- Then came Russia’s invasion of Ukraine, which drove up the cost of oil, industrial metals, food, and fertilizers.
- And now, China has imposed severe Covid-19 lockdowns in major economic centers like Shanghai, causing more supply-chain delays and transportation bottlenecks.
- Demographic aging in advanced economies and emerging markets (such as China, Russia, and South Korea) will continue to reduce labor supply, which will cause wage inflation. Furthermore, because the elderly tend to spend their savings without working, the rise of this generation will contribute to inflationary pressures while limiting the economy’s growth potential.
- The ongoing reaction against immigration in advanced economies will restrict labor supply while pushing salaries upward.
- Similarly, the emerging cold war between the United States and China will have far-reaching stagflationary effects. Decoupling between China and the United States means fragmentation of the global economy, balkanization of supply chains, and restrictions on trade in technology, data, and information – all of which are key elements of future trade patterns.
- Climate change will also cause stagflation. Droughts, for example, harm crops, ruin harvests, and raise food prices, just as hurricanes, floods, and rising sea levels devastate capital stocks and disrupt economic activity.
- Reduced use of fossil fuels and rapid decarbonization has resulted in underinvestment in carbon-based infrastructure before renewable energy sources have reached a sufficient scale to compensate for a reduced supply of fuels. Sharp price increases in energy are unavoidable under these conditions.
- Then there’s cyberwarfare, which may create major industrial disruptions, as recent attacks on pipelines and meat processors have demonstrated. Such incidents are expected to become more frequent and severe over time. Firms and governments will need to spend hundreds of billions of dollars on cybersecurity to defend themselves, adding to the expenses that will be passed on to consumers.
- These factors will increase the backlash against extreme income and wealth inequalities, perhaps leading to increased fiscal spending to help workers, the jobless, vulnerable minorities, and the “left behind.”
- Large-scale armed conflicts pose a threat to global trade and industry. Today, Russia is pitted against Ukraine and the West. Tomorrow, Iran may go nuclear, North Korea could engage in further nuclear brinkmanship, or China could seek to capture Taiwan. Furthermore, the sanctions employed to deter and punish state aggressiveness are stagflationary.
- Finally, de-dollarization causes stagflation. It not only causes significant friction in international trade in products, services, commodities, and capital; it also pushes US competitors to diversify their foreign-exchange reserves away from dollar-denominated assets. It has the potential to build regional monetary systems over time, further splitting global trade and finance.
The new reality the world faces is a growing stagflationary storm.