Steve Bain

How to Beat Stagflation (with a case study)

Beating stagflation, a combination of stagnant economic growth, high unemployment, and persistent inflation, is particularly challenging because the usual tools to combat inflation in the short-term can worsen unemployment, while tools to stimulate growth can worsen inflation.

However, the long-term solution to beat stagflation ultimately hinges on reducing inflation first as the main priority. This is because persistently high inflation will destabilize the economy via purchasing power erosion, and distortions to market forces, making it impossible to sustain low unemployment and stable growth over time.

There are three main approaches that governments can take towards beating stagflation, and these are best implemented in combination with each other. They are fiscal policy, monetary policy, and supply-side reforms.

How to beat Stagflation with Fiscal Policy

Fiscal policy must be used to reduce, or better still eliminate, deficit spending i.e., excessive government spending in amounts over and above what the government generates in tax receipts. Additionally, there may be opportunities to invest in productive projects that can stimulate economic recovery:

  • Reducing government deficits - Governments should avoid excessive spending that fuels inflationary pressures. While there may be temptation to stimulate the economy during a period of stagnant growth, indiscriminate spending can exacerbate inflation. A more disciplined fiscal approach entails cutting unnecessary spending, eliminating wasteful subsidies, or reducing public sector wages, all of which can support the central bank's efforts to bring inflation under control.
  • Targeted investment - Fiscal policy should focus on investment in productivity-enhancing areas like infrastructure, research and development, and education, rather than on broad-based stimulus. These investments help boost long-term growth potential without contributing directly to demand-driven inflation. However, even here there needs to be a great deal of care taken, because these projects can easily go over budget and end up consuming more resources than they can justify.

How to beat Stagflation with Monetary Policy

The government, or more precisely the Federal Reserve, must conduct a tight monetary policy to reduce inflation as a preliminary step towards beating stagflation in the long-run. It must:

  • Tighten interest rates - To control inflation, central banks need to raise interest rates, even though this may temporarily increase unemployment. Higher interest rates reduce consumer and business demand by making borrowing more expensive. This can initially slow down growth, but it is essential for cooling off inflation.
  • Control the money supply - Central banks can also reduce the money supply by selling government bonds or increasing reserve requirements for banks, which reduces excess liquidity in the economy. Less money in circulation means less upward pressure on prices.

How to beat Stagflation with Supply-Side reforms

Stagflation stems from supply-side contractions in the economy, so measures to improve the supply-side can simultaneously reduce both inflation and unemployment. The key areas to focus on are the labor market, energy sector, and regulatory framework.

  • Labor market reforms - Policies that improve workforce skills and productivity can help increase output, which helps to simultaneously reduce inflation and boost jobs. Training programs, investment in education, and more flexible labor market regulations can help businesses to avoid redundancies and expand production.
  • Energy sector reforms - Many stagflation episodes, such as in the 1970s, were triggered in part by energy price shocks. By diversifying energy sources (e.g., improving energy efficiency, and securing strategic energy reserves), economies can reduce the risk of inflationary spikes linked to energy costs.
  • Regulation and market competition - Increasing competition through deregulation in sectors where excessive controls hamper efficiency can reduce costs. Cutting red tape, for instance, can help businesses operate more smoothly, leading to lower costs for goods and services over time.

Productivity and Expectations

Productivity growth is the key to reducing inflation in a sustainable way. If an economy can produce more goods and services with the same or fewer inputs, inflationary pressures will naturally subside, as increased supply can meet demand without driving prices up. Encouraging innovation, adopting new technologies, and enhancing capital investment are crucial to driving this productivity growth.

Policymakers may be tempted to adopt short-term measures like wage and price controls to combat inflation, but these often have long-term negative consequences. While they might temporarily reduce inflationary pressures, such controls tend to create inefficiencies, distort markets, and can lead to shortages and reduced investment. Instead, focusing on real solutions like improving supply chains and enhancing competition should be prioritized.

A critical factor in controlling inflation is managing inflation expectations. When businesses and consumers expect inflation to persist, they adjust their behavior (demanding higher wages, raising prices) which perpetuates inflation. Central banks and governments need to make credible commitments to reducing inflation in order to shift expectations and break the inflationary cycle.

Communication from policymakers is key - signaling that inflation is the top priority can help anchor inflation expectations, making it easier to achieve long-term stability.

Summary: Inflation Reduction is the Key to Beating Stagflation

While prioritizing inflation reduction may lead to a temporary rise in unemployment, this is necessary to create the foundation for future growth. Once inflation is brought under control, the economy can stabilize, and the central bank can gradually lower interest rates, allowing for more sustainable growth. Lower inflation improves business confidence, encourages investment, and stabilizes wages, setting the stage for lower unemployment in the long run.

In conclusion, the long-term battle against stagflation requires prioritizing inflation reduction, even if this involves difficult trade-offs in the short term, such as higher unemployment.

By controlling inflation, policymakers can lay the groundwork for stable and sustainable economic growth, which will eventually lead to lower unemployment. The focus should be on tightening monetary policy, maintaining fiscal discipline, and implementing supply-side reforms to boost productivity and reduce inflationary pressures at their source.

Case Study: How did Nixon try to combat Stagflation in the 1970s?

Nixon's approach to combating stagflation largely failed to prioritize reducing inflation as the primary solution, contributing to its persistence throughout his presidency. His policies were often short-term fixes that either addressed symptoms, rather than causes, and they tended to worsen the inflationary environment.

Wage and Price Controls (1971)

Nixon implemented temporary wage and price controls to combat inflation. While these controls initially appeared successful in curbing rising prices, they were a superficial solution. Once lifted, inflation surged again, exacerbated by economic distortions like shortages and reduced business investment. The controls did not address the underlying drivers of inflation, such as excess demand and supply bottlenecks.

Ending the Gold Standard

The decision to take the U.S. off the gold standard in 1971 (the "Nixon Shock") allowed the dollar to devalue, making U.S. exports more competitive in the short term. However, this move also fueled inflation by raising the cost of imports, particularly oil, which would later contribute to the 1973 oil crisis. Although it provided temporary relief, it undermined long-term inflation control by encouraging higher prices for goods and energy.

Expansionary Fiscal and Monetary Policy

Nixon’s expansionary fiscal policies (increased spending and tax cuts) combined with his pressure on the Federal Reserve to keep interest rates low, fueled further inflation. Instead of tightening monetary policy to cool off inflation, Nixon prioritized stimulating growth and maintaining political support, which deepened the inflationary spiral. This loose monetary policy conflicted with the need to tackle inflation head-on.

Response to the 1973 Oil Shock

Nixon's response to the 1973 OPEC oil embargo was inadequate. While he imposed price controls on gasoline, these controls led to shortages and long lines at gas stations, doing little to reduce inflation. His Project Independence aimed at energy independence, but it was a long-term goal that did not resolve the immediate crisis.

Why Nixon failed to beat stagflation

Nixon’s policies reflect a failure to prioritize inflation reduction, which is crucial for resolving stagflation in the long term. His reliance on price controls, loose monetary policy, and expansionary fiscal measures temporarily masked inflation but ultimately worsened it. By focusing on short-term political gains and economic stimulus rather than tightening policies to control inflation, Nixon’s approach prolonged stagflation and contributed to the severe economic difficulties that followed.

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