What is stagflation and why did economists think it would never occur?

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If you’ve been paying attention to the news, you’ve been hearing the term stagflation a lot. But what does it mean? And did you know economists used to think this phenomenon was impossible to occur?

Stagflation is a phenomenon where economic stagnation (usually measured by high unemployment or slow economic growth) occurs simultaneously with a general increase in prices (inflation). In simple terms, this means that economic development stalls at the same time as general prices increase.

In practical terms, these events can result in scenarios where employees do not get raises and can not find better working options available while, simultaneously, price increases erode your purchasing power forcing you to face an immediate future where your wages stall as you get less on a per dollar amount.

The first recorded events now described as stagflation first occurred in the 1970s and, very quickly, the same economists that first denied any real-world possibility of occurring were forced to observe that they were in fact not rare events whenever economic growth stalled or decreased. Today, most economists agree that stagflation events happen mostly due to two reasons: supply shocks and/or poor economic policies.

Supply shocks happen when the demand for a commodity or service rapidly increases or its supply drops, making production and industrial processes less profitable and leading to a general slow down in economic growth.

Supply and Demand — Supply shock

As for examples of poor economic policies, there are several main factors but we will be focusing on one of the most relevant: economies growing their money supply too quickly (ie, expansionary monetary policies).

Most people who now claim that developed economies are about to enter a stagflation period point to the general disruption of global supply chains caused by COVID and the Russo-Ukrainian war as an example of the first reason while pointing to the general response of “money printing” and emergency fund distributions as an example of the second.

Rising price levels seem to lead some credence to this claim but we have yet to see how much the economies are going to slow. Right now it seems likely but it will depend on many factors such as real estate prices holding and how Governments react worldwide.

So why did Economists consider stagflationary events to be an impossibility dreamt up in a university office?

In the years following the Second World War and massive growth periods, based on strong investment and consumption by both private and public sectors gave rise to a simplistic view of economics based on what is now called Keynesian economics.

The number of books published discussing this subject indicates that this is a complex issue (and that there is nothing economists like more than discussing subjects in circles) and that simplifying this concept will leave a lot of information outside its scope. However, in the same way, gravity can be oversimplified as “the force that attracts bodies to one another and towards their center” we can give you some cursory knowledge of what Keynesian economics are.

The oversimplified explanation of these economics states that an economy will grow if its total spending increases. Specifically (and especially at the advent of this theory) this increase in spending would be directed through the Government. Increasing Government spending would then increase demand and boost growth, increasing the economies’ output, employment, and inflation.

Given this predominant viewpoint economists did not think it would be possible for an economy to be simultaneously over and under heated (growth in prices with simultaneous decreases in economic growth and employment). Time has proven economists incorrect with periods of recession frequently being accompanied by high increases in prices.

The rise of real-world examples led to a rethinking of economics, fiscal, tax, and monetary policies with economists’ reasoning as to why these events occur (as discussed above) and how to redirect the economy to its normal path.

So how do we do this?

There is no clear-cut formula to escaping a stagflation trap so the best policy would be to try very hard to avoid it. Ideally, countries need to direct their policies in a way that is not killing economic growth while not causing runaway inflation. The problem with this is that policies that increase economic growth tend to also put inflationary pressure on prices.

Previous solutions required massive Governmental budgets for investment and consumption coupled with monetary policies that eased price pressure. This had an immediate impact of massively increasing National debt in most developed economies. These debt levels were never subdued. This puts into perspective whether Governments will be able to massively impact economic growth and what long-term impacts will this massive debt have.

What economists do agree on, however, is that inflation is the first point to address. This can be done by cooling monetary policies and increasing interest rates. However, these policies have significant negative effects on the economy’s growth rates meaning that you will be helping 50% of your problem while worsening the other 50%.

This means that we still must address how to reverse the track of economic growth. To boost economic growth with disadvantageous monetary policies (for economic growth) we need to find solutions for the supply side so increases in productivity spur economic growth. This means privatizing public businesses, reducing taxation on businesses and people thus reducing the public side presence while increasing the number of funds available for the private sector. However, in economies where all public assets have already been privatized and public debt is already at high levels, there isn’t much leeway as to how much Governments can further influence the economy. Since most countries did not use the good expansionary years to decrease their debt levels, most economies will find it hard to adjust and intervene appropriately.

Implementing wage and/or price controls will never be effective no matter what people may tell you. It does not work on a theoretical level. It does not work on a practical level. It does not even work from a moral perspective (I’m willing to debate the last one). Let me know if you want me to get further in-depth in this subject (or in any other for that matter).

All that is left to explore is how you can invest during stagflation in order to try to maximize returns and minimize portfolio loss and safeguard your personal finance situation.

In any scenario with high inflation levels, you want to try to avoid high cash balances. Since inflation essentially means your money will be worth less in the future than it is today, each moment that passes where your money is not earning returns, the worst off you will be. If inflation reaches a yearly level of 7% and you put all your funds in 1% return deposits, by the end of the year your portfolio will be worth approximately 6% less than it did in the beginning.

But if the economy is also set to suffer a downturn, there are no easy investments to be made. Most stocks will take a hit and what you want to do is avoid the biggest loser while still being able to enjoy some of the upsides that the most robust corporations can find in these periods.

Ideally, you want to find stocks that are inflation beaters and that tend to do well in these environments, investing in companies with solid fundamentals that are able to bounce back fairly quickly from market downturns.

What you want to avoid are growth stocks. The price of these stocks prices in a large factor of growth. Meaning that today’s price already reflects a fair expectation of growth. If the market is set to cool down, this means that growth expectations will likely be defrauded, and expectations will need to reset accordingly. There is no telling when rough market conditions will be too much for one of these corporations.

Additionally, there are several indicators that you want to be investing in corporations that have the ability to be price setters. These corporations have a high likelihood of being able to influence their selling price (even if it will always come at a cost such as reduced consumption) and are usually located upstream in the sector’s value chain. An example of price-setting stocks would be semiconductor producers and not computer manufacturers.

Other factors you should take into consideration are debt levels and credit rating. With the economy slowing down and inflation rising, should there be a credit crunch or a sudden increase in borrowing costs, there could be troubling times for overleverage firms or firms that already have a junk rating.

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