How to Control Stagflation

Stagflation is an economic condition that combines slow growth and relatively high unemployment with rising prices, or inflation. The standard macroeconomic remedies for inflation or unemployment are considered ineffective against stagflation. In fact, there is no universal agreement on the best way to stop stagflation.

The problem is that the normal responses to the two major components of stagflation—recession and inflation—are diametrically opposed.

Recession and Inflation

Governments respond to recessions through expansionary monetary and fiscal policies. That is, they pump more money into the economy. More money means cheaper money. Businesses are encouraged to borrow, grow, and hire. Consumers use credit more and consider major purchases.

Inflation requires the opposite response. The government restricts the supply of money in the system in order to make it more expensive to borrow. Businesses and consumers borrow less and spend less. The overall economy slows down. With demand declining, prices stop rising.

But what can policy-makers do when a recession coincides with higher inflation? It's the worst of both worlds, and it's supposed to be impossible.

When the Impossible Happens

New Zealand economist A.W. Phillips studied inflation and unemployment data in the United Kingdom from 1861 through 1957. He found a consistent inverse relationship between rising prices and rising unemployment.

Phillips concluded that periods of low unemployment forced an increase in the price of labor which was passed on to consumers. That is, labor shortages lead to higher costs of living.

Conversely, Phillips noted, recessions slowed the rate of wage inflation. With more workers competing for fewer jobs, employers could pay lower wages. These were reflected down the line in the prices paid by consumers. Prices fell or at least stayed steady.

This inverse relationship between the level of unemployment and the rate of inflation was represented in a model that came to be known as the Phillips Curve.

Using the Phillips Curve

Prominent 20th-century Keynesian economists and government policy buffs such as Paul A. Samuelson and Robert M. Solow believed that the Phillips Curve could be used to monitor the trade-off between inflation and unemployment and keep the business cycle in balance.

Nevertheless, the U.S. entered into a period of stagflation in the 1970s, when it experienced simultaneous increases in consumer prices and unemployment. Confronted with a reality that was thought to be impossible, Keynesian economists struggled to come up with an explanation or a solution.

How Economists Proposed to Fight Stagflation

The search for a weapon to fight stagflation led in part to the rise of supply-side economic theories as an alternative to Keynesian economics.

Milton Friedman, who had argued during the 1960s that the Phillips Curve was built on faulty assumptions and that stagflation was possible, rose to prominence when events proved him right.

Friedman theorized that once people adjusted to higher inflation rates, unemployment would rise again unless the underlying cause of unemployment was addressed.

Control Inflation First

He argued that traditional expansionary policy would lead, in turn, to a permanently increasing inflation rate. He argued that the bank must work to stabilize prices in order to prevent inflation from spinning out of control.

If the government deregulated the economy, he said, the free market would allocate labor towards its most productive uses.

Most neoclassical or Austrian views of stagflation, such as those of economist Friedrich Hayek, are similar to Friedman's. Common prescriptions include the ending of expansionary monetary policy and allowing prices to adjust in the free market.

Modern-day Keynesian economists such as Paul Krugman argue that stagflation can be understood through supply shocks and that governments must act to correct the supply shock without allowing unemployment to rise too quickly.

The Political Battle

The most obvious fixes for stagflation tend to be deeply unpopular in the U.S. For example, if the price of oil is a key cause of out-of-control prices, privatization or price controls might be imposed. If higher wages are blamed for inflation, the government might limit wage increases.

In the absence of any government action, stagflation might correct itself in time. In the 1970s, stagflation was at least partially caused by a sudden surge in the global price of oil, imposed by the oil-producing nations of the Mideast. Over time, the cost of oil returned to more normal levels and the economy began to emerge from its slump.