Stagflation: How the Economic Monster Threatens Your Wealth

What is stagflation?

Stagflation is a rare but deadly economic condition in which unemployment remains high, economic growth stagnates or declines, while prices continue to rise. The term was coined by British politician Ian Macleod in 1965, combining the words “stagnation” and “inflation.”

Typically, high employment rates and economic growth are positively correlated with inflation. However, in the paradox of stagflation, these two forces appear simultaneously — and therein lies the problem. When an economy's GDP performance is poor while inflation is skyrocketing, severe stagflation can trigger a financial crisis.

Why is Stagflation Difficult to Resolve?

Traditional economic policies are facing an embarrassing dilemma.

To combat economic recession, central banks typically increase the money supply and lower borrowing costs (by cutting interest rates). This stimulates consumption and investment, creating job opportunities.

But to control inflation, decision-makers need to tighten the money supply, raise interest rates, making borrowing more expensive, thereby cooling demand and lowering prices.

When stagflation arrives, governments find themselves in a deadlock—remedies for recession exacerbate inflation, while measures to curb inflation worsen economic downturns. This is why many central banks and governments are at a loss when faced with stagflation.

Where does stagflation come from?

Contradictory fiscal and monetary policies

Central banks, such as the Federal Reserve, influence the economy by adjusting the money supply, which is known as monetary policy. The government implements fiscal policy through taxation and spending policies.

When these two policies conflict with each other, disaster can occur. For example, the government increases taxes and reduces disposable income for residents, while the central bank is implementing quantitative easing and cutting interest rates. The result is: government policies hinder growth, while the central bank increases liquidity, leading to inflation.

Abuse of fiat currency system

After the war, most major economies abandoned the gold standard and turned to fiat currency (currency not backed by precious metals). This shift, while giving central banks more room for adjustment, also removed the constraints on the money supply. The unrestricted issuance of paper currency often leads to skyrocketing prices.

supply-side shock

The sharp rise in production costs—especially energy costs—can also trigger stagflation. When oil prices soar, everything gets more expensive from production costs to the consumer end. If household incomes shrink due to energy expenses, the danger of stagflation increases significantly.

Impact on the Cryptocurrency Market: What Investors Need to Know

What does a decline in purchasing power mean?

When economic growth slows or shrinks, consumers have less cash on hand. They will reduce investments in risk assets, including stocks and cryptocurrencies, and prioritize paying for daily expenses. Large investment institutions will also cut back on their exposure to high-risk assets. As a result: demand for cryptocurrencies declines and prices come under pressure.

Central bank policy double-edged sword

Governments usually take the initiative to combat inflation by raising interest rates and tightening the money supply. At this stage, high-risk, high-reward investments (including cryptocurrencies) become less attractive. People prefer to keep their money in banks to earn higher interest.

However, once inflation is under control, the government will shift to stimulating growth by implementing quantitative easing and lowering interest rates. At that time, the cryptocurrency market often experiences a rebound as liquidity is loosened again.

Is Bitcoin really an inflation hedge?

Many investors claim that Bitcoin is a good hedge against inflation. Due to its fixed and capped supply, it is seen as a store of value - theoretically capable of protecting purchasing power during periods of inflation.

However, this logic may fail in a stagnant inflation environment. Especially in the short term, when economic recession and risk aversion increase, cryptocurrencies often correlate highly with the stock market and decline together. Historical data suggests that Bitcoin's performance as an “inflation hedge” may not be as ideal as its long-term supporters claim.

Historical Lessons: The Oil Crisis of 1973

In 1973, the Organization of Arab Petroleum Exporting Countries imposed an oil embargo on several countries in protest of their support for Israel. The sharp decline in oil supply led to skyrocketing prices, disruption of global supply chains, and soaring costs.

The central banks of the United States and the United Kingdom subsequently lowered interest rates in an attempt to stimulate growth. However, as oil and energy make up a large portion of household spending, simply lowering interest rates cannot offset the impact of high energy costs. As a result, Western economies are trapped in a dual dilemma of high inflation and economic stagnation—this is a classic case of stagflation.

Three Ways to Combat Stagflation

Currency School's plan

Monetarists believe that controlling prices is the most important thing. They will first contract the money supply to reduce overall spending, which will hit demand and lower prices. However, in the short term, this is not conducive to growth; growth stimulation needs to be achieved later through expansionary policies.

supply-side reform

Another approach is to increase the supply side of the economy. By reducing costs, improving efficiency, regulating energy prices (if possible), investing in production efficiency, and providing subsidies, production costs can be lowered and supply increased. This can not only reduce consumer prices and stimulate production but also reduce unemployment.

market self-regulation

Some advocates of the free market believe that the best approach is to let the market self-regulate. When goods become too expensive, consumer demand will naturally decrease, and prices will eventually fall; the labor market will also automatically balance the unemployment rate. However, this process can take years or even decades, during which the living standards of the people will decline significantly. As Keynes said: “In the long run, we are all dead.”

How should investors respond?

Stagflation is testing the resilience of economists and policymakers, as well as investors. Traditional hedging tools may fail, and the “safe-haven” properties of cryptocurrencies have also become questionable.

The key is to closely monitor the macro environment—pay attention to money supply, interest rate changes, supply and demand dynamics, and employment data. During periods of stagflation, diversification and risk management are more important than ever. Blindly trusting the hedging ability of any single asset class is dangerous.