Stagflation is a term used to describe a period of economic stagnation combined with high inflation. This combination can be very difficult to overcome, reducing purchasing power, decreasing economic growth, and leading to social unrest. Several different factors can contribute to stagflation.
Stagflation exists in the economy when inflation, slow economic growth and high unemployment exist simultaneously. These economic conditions are unfavorable and often do not occur simultaneously. Stagflation is rare primarily because unemployment and inflation are usually inversely correlated. This relationship means that inflation will usually go down when unemployment increases because there is less economic spending. The opposite is also true. Therefore, this relationship becomes unstable when Stagflation occurs. The unpredictability causes mistrust in the economy, which leads to long periods of Stagflation.
What Causes Stagflation?
Stagflation occurs due to a cocktail of economic ills. The economy begins to fail when it experiences supply shocks and ineffective fiscal and monetary policy. Poor fiscal policies combined with slow economic growth, high unemployment, and high prices will often lead to Stagflation.
- Supply shocks can affect the global economy; therefore, the Federal Reserve and Central Bank must be prepared for this. Strong economic fundamentals are required to cushion the consumers & businesses from anything that reduces the economy’s capacity to produce. Without the protection, producers cannot make goods and services at affordable prices.
- The labor employed by the company will then be reduced to remain competitive. During this period, fewer people in the economy will be working, which translates directly to less spending.
- When the money supply in the economy is increased, it will contribute to Stagflation. These conditions often trigger panic in society and are therefore met with haste by lawmakers. A rushed fiscal and monetary policy can also prompt Stagflation.
For example, when the United States experienced Stagflation in the 1970s, the Federal Reserve moved to tackle high Inflation. Prices were soaring, and the government introduced an ineffective monetary policy. They introduced a 90-day freeze on wages and prices, which led to consumers paying black market prices for few goods. The prices continued to soar because of the introduced 10% tariff on imports. Once the final measure of removing the US from the gold standard was introduced, the United States was officially in Stagflation.
What are the consequences of Stagflation?
Stagflation brings together slow growth, high unemployment, and soaring Inflation. These problems combined result in significant pressure on the economy. When Stagflation occurs, the economy is unambiguously harmed. Consumers make decisions to invest based on the high Inflation and uncertainty. The capital pouring into the economy shrinks, and damage is done to the fixed-income markets. When it is difficult to access loans due to rising interest rates, equity valuations become lower. These are all signs of a shrinking economy that is in decline.
For the individual consumer and their household, Stagflation reduces their discretionary income. Consumers will earn less but need to pay more for groceries and expenses.
Stagflation and its roots in capital misallocation
Capital Misallocation is one of the main factors influencing Stagflation. Capital that flows in one direction is often not protected against supply shocks. Policies created decades ago continue to force investors to deal with the legacy of Inflation. The two key results of capital misallocation are long-term asset price inflation and Inflation in the price of goods and services. When diverse investment levels are low in the economy, Inflation can reappear at any time as growth stagnates in specific sectors of the country. The overinvestment in some areas is referred to as a misallocation of capital. It is considered an attempt to design a ‘new’ economy.
Misallocation of capital can lead to Stagflation. This problem occurs because of a massive contrast in investment led by the demand for high returns on equity. This type of ‘rush’ investing leaves other sectors without real investment. Overinvestment makes capital cheap, creating hubris, bubbles, and leverage over others in different sectors of the economy.
The problem is when the economy overinvests into a fragile sector. Overinvested sectors may have potential; however, there is always a chance people will move on. The fate of the broad economy should not be placed in the hands of one sector. The so-called ‘old economy, ‘ focused mainly on tested and proven economic development methods, is critical. Capital is often equally invested when consumers live within their means and understand the impact of scarcity. Without this understanding, the economy will experience less growth and more Inflation because of capital misallocation.
The consequences of an overinvested sector failing are severe for investors. When choosing your business’s most appropriate returns on equity (RoE), sober thinking is required. Choosing sectors with unsustainable returns will eventually collapse when there is a supply shock.
Globalization and Misallocation of Capital
As globalization occurs, limiting capital misallocation to one country is often difficult. Countries with similar economies usually follow profitable investing trends across the region. International investment benefits can be overshadowed by the slowing global synchronization of macroeconomic policy cycles. To avoid capital misallocation, investors should give chances to the areas in the economy that look less glamorous. These low-risk and low-profit areas have more sustainable business models for the long term.
Consequences of Misallocation of Capital
When capital is cheap to get, this does not often translate to higher investments. When large companies generate profits, that capital is distributed as cash back to shareholders. Businesses mainly focus on providing a high level of RoE through high dividend policies and share buy-back programs. Mergers & acquisitions are generally paid for with debt, meaning specific economic sectors are doubling in size.
FAQ
How is Stagflation different than Inflation?
Inflation is a characteristic of an economy facing Stagflation. An economy faces Inflation when there is excess money supply in the economy, leading to a shortage of products. The inflation problem is combined with slow growth and unemployment to cause Stagflation.
What happens to real estate in Stagflation?
During Stagflation, the cost of construction increases. It becomes more expensive to build a house, but consumers are also earning less money. This problem can lead to an economic slowdown in the real estate market. Most consumers won’t be willing to sell their homes because the currency is unstable. Most consumers also won’t be able to afford the homes on the market. This situation will lead the real estate market to an impasse.
