Stagflation
Based on Wikipedia: Stagflation
In 1965, a British politician stood before Parliament and coined a word that would haunt economists for decades. Iain Macleod, warning his colleagues about a brewing economic nightmare, mashed together "stagnation" and "inflation" to create "stagflation." His invention captured something that wasn't supposed to exist—an economic monster that violated the rules.
We now have the worst of both worlds—not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of "stagflation" situation. And history, in modern terms, is indeed being made.
He was right about the gravity. What he couldn't have known was that this awkward portmanteau would become one of the most feared words in economic policy, triggering a complete rethinking of how governments manage their economies.
The Impossible Combination
To understand why stagflation shocked economists, you need to understand what they believed before it arrived.
Picture a seesaw. On one end sits inflation—rising prices across the economy. On the other sits unemployment. For decades, economists treated these as naturally opposed forces. When unemployment dropped, more people had money to spend, pushing prices up. When unemployment rose, demand fell, and prices stabilized or dropped. You could have one problem or the other, but not both simultaneously.
This relationship had a name: the Phillips Curve, after the economist William Phillips who documented it in 1958. It wasn't just academic theory. Policymakers used it as a practical guide. Need to cool inflation? Accept some unemployment. Need to create jobs? Tolerate some price increases. The tradeoff seemed reliable, almost mechanical.
Then the 1970s arrived and broke everything.
Suddenly, prices were soaring and people were losing jobs at the same time. The seesaw was pointing up at both ends—which is to say, it wasn't a seesaw anymore. It was something new, something the textbooks said couldn't happen.
When the Oil Stopped Flowing
The story of how stagflation conquered the Western world begins, like many stories of global disruption, in the Middle East.
In 1967, the Six-Day War erupted between Israel and its Arab neighbors. When Israeli forces reached the Suez Canal, Egypt's President Gamal Abdel Nasser—aligning with the Soviet Union—closed the canal to shipping. For eight years. Oil tankers that had taken the shortcut from the Persian Gulf to Europe now had to sail around the entire African continent, adding weeks and enormous costs to every barrel.
But this was just the prelude.
In October 1973, Egypt attempted to retake the Sinai Peninsula in what became known as the Yom Kippur War. The United States, under Richard Nixon, provided Israel with $2.2 billion in emergency military aid. The response from oil-producing Arab nations was swift and punishing: the Organization of Arab Petroleum Exporting Countries, known as OAPEC, slashed production and declared an embargo on oil exports to the United States and other countries supporting Israel.
Oil prices didn't just rise. They quadrupled.
Think about what that means for an industrial economy. Virtually everything depends on energy. Manufacturing requires power. Transportation requires fuel. Agriculture requires both. When the price of oil quadruples, the cost of making and moving things explodes across every sector of the economy.
This is what economists call a "supply shock"—a sudden disruption that makes it more expensive to produce goods and services. Unlike demand shocks, which you can address by cooling or stimulating consumer spending, supply shocks put policymakers in an impossible position.
The Policy Trap
Imagine you're running a central bank in 1974. Inflation is raging because oil costs have blown up every business's expenses. The traditional response would be to raise interest rates, making borrowing more expensive, which slows spending, which brings prices back down.
But here's the problem: the economy is also sinking into recession. Businesses are laying people off because they can't afford their energy bills. Families are cutting back because everything costs more. The traditional response to a recession would be to lower interest rates, making borrowing cheaper, encouraging spending and investment.
You cannot do both. Raise rates to fight inflation, and you make the recession worse. Lower rates to fight the recession, and you pour gasoline on the inflation fire.
This is the stagflation trap, and throughout the 1970s, central banks stumbled into it repeatedly. Many chose to fight the recession first, pumping money into their economies. The result was predictable in hindsight: a price-wage spiral where higher prices led workers to demand higher wages, which led businesses to raise prices further to cover their increased labor costs, round and round.
Seeds Planted Earlier
The oil shock makes for a dramatic villain, but the full story is more complicated. The seeds of stagflation were actually planted years before OAPEC's embargo.
Look at the numbers from the late 1960s. Between 1968 and 1970—years before the oil crisis—unemployment in the United States rose from 3.6 percent to 4.9 percent while inflation simultaneously climbed from 4.7 percent to 5.6 percent. The Phillips Curve was already breaking down.
What was happening?
Two economists, Milton Friedman and Edmund Phelps, had actually predicted this. Their argument was elegant but devastating to conventional wisdom: the Phillips Curve only works when people aren't expecting inflation.
Here's the logic. If workers expect prices to stay stable, they'll accept modest wage increases. But if workers start expecting five percent inflation next year, they'll demand at least five percent raises just to stay even—plus whatever real increase they think they deserve. Businesses, facing higher labor costs, raise prices. Those price increases confirm workers' expectations, leading them to expect even more inflation, leading to even larger wage demands.
Expectations become self-fulfilling prophecies.
By the late 1960s, Americans had experienced several years of mild but persistent inflation. They started baking those expectations into their behavior. The old Phillips Curve relationship, based on decades when people expected price stability, was becoming obsolete.
Nixon's Freeze
On August 15, 1971, President Nixon took a drastic step: he imposed mandatory wage and price controls across the American economy. Businesses couldn't raise prices. Workers couldn't demand wage increases. For a while, it seemed to work. Inflation appeared to subside.
But price controls don't eliminate the pressures causing inflation. They just suppress the symptoms while the disease continues spreading beneath the surface. It's like holding down the lid on a boiling pot—the water doesn't stop boiling, it just can't release steam.
When the controls were lifted in mid-1973, all that suppressed pressure erupted. Inflation surged to 8.5 percent. And then, just months later, OAPEC declared its embargo.
The combination was catastrophic. The underlying inflationary pressures that had been building since the late 1960s, artificially suppressed by Nixon's controls, exploded just as the oil shock arrived. What might have been a manageable stagflation became the worst economic crisis since the Great Depression.
The Collapse of the Old Order
The early 1970s weren't just economically turbulent—they were the end of an entire international financial system.
Since 1944, most of the world's major currencies had operated under the Bretton Woods system, named after the New Hampshire resort where it was designed. Under this arrangement, the United States dollar was tied to gold at a fixed rate of $35 per ounce, and other currencies were tied to the dollar. Exchange rates between currencies were stable and predictable. If you were a business planning international trade, you knew what your foreign earnings would be worth.
But maintaining fixed exchange rates requires discipline. A country that inflates its currency too quickly will find traders selling that currency and buying gold instead, draining its reserves. By the early 1970s, the United States had been inflating faster than the system could handle. Nixon's solution, announced on the same night as the wage-price controls, was to suspend the dollar's convertibility to gold.
The Bretton Woods system didn't die immediately, but this was its mortal wound. By 1973, major currencies were "floating"—their values determined by markets rather than government agreements. The gold standard, which had provided monetary discipline for generations, was abandoned entirely.
The consequences rippled everywhere. Oil had always been priced in dollars. When the dollar floated and began losing value against other currencies, oil-producing countries found their revenues buying less and less. This gave them additional motivation to raise prices, not just for political revenge but for economic self-preservation.
Waiting in Lines
For ordinary Americans, stagflation wasn't an abstract economic phenomenon. It was waiting in line for hours to fill your gas tank, unsure if the station would run dry before you reached the pump. It was watching your grocery bill climb month after month while your neighbors lost their jobs. It was a creeping sense that the postwar prosperity machine had broken and nobody knew how to fix it.
The price controls that Nixon had imposed created their own distortions. When you cap prices below market levels, shortages inevitably follow—sellers have no incentive to increase supply to meet demand. Gas stations ran out of fuel. Industries couldn't get raw materials. The controlled economy became an economy of rationing and queues.
Meanwhile, the money supply was growing at nearly 15 percent per year in the early 1970s. Inflation in consumer prices typically lags money supply growth by a year or two, so the effects of this monetary expansion were still working their way through the system even as the oil shock hit.
It was a perfect storm: supply constraints from the oil embargo, demand pressures from excessive money creation, distortions from price controls, and uncertainty from the collapse of the international monetary order. All at once.
The Death of Keynesian Consensus
John Maynard Keynes, the British economist whose ideas had dominated policy since the 1930s, died in 1946. He never used the word stagflation and never saw the conditions it describes. But his intellectual legacy became one of stagflation's casualties.
Keynesian economics, in its postwar form, offered governments a reassuring toolkit. During recessions, governments should spend more and central banks should create more money, stimulating demand and creating jobs. During booms, governments should pull back, preventing the economy from overheating into inflation. Fine-tuning was the goal—skilled technocrats adjusting policy dials to keep the economic engine running smoothly.
Stagflation revealed the limits of this approach. When the problem isn't insufficient demand but constrained supply, stimulating demand just creates inflation without growth. When people expect inflation, creating money doesn't boost real economic activity—it just accelerates the price spiral.
By the mid-1970s, prominent economists were declaring that none of the major macroeconomic models—Keynesian, monetarist, or neoclassical—could adequately explain what was happening. The intellectual consensus that had guided policy for a generation was in ruins.
New Ideas Rise
Into this void stepped alternative schools of thought that had been lurking at the margins of economics.
Monetarism, championed by Milton Friedman, argued that inflation was fundamentally about money supply. Control the growth of money, and you control inflation. The stagflation experience seemed to confirm this: countries that had expanded their money supplies rapidly were experiencing the worst inflation.
Supply-side economics focused on the other half of the equation. Rather than manipulating demand through government spending, policymakers should focus on removing barriers to production—cutting taxes, reducing regulations, freeing markets. If stagflation came from supply constraints, the solution was to unleash supply.
These ideas would find their fullest expression in the policies of Margaret Thatcher in Britain and Ronald Reagan in the United States during the 1980s. Whether you view those policies as salvation or disaster often depends on your politics, but their intellectual origins trace directly back to the stagflation crisis.
Two Stories About What Went Wrong
Economists today generally offer two explanations for the 1970s stagflation, and most acknowledge that both probably contributed.
The first story emphasizes supply shocks. Oil is so fundamental to modern economies that a sudden quadrupling of its price amounts to a massive tax on all economic activity. Businesses face higher costs, which they pass to consumers. Production becomes less profitable, so output falls. You get inflation and stagnation together not because of any policy error but because the physical resources the economy depends on suddenly became scarce.
The second story emphasizes policy mistakes. Central banks, facing recessions, responded with easy money even as inflation was building. Governments imposed price controls that distorted markets. The Bretton Woods system's collapse removed an important source of monetary discipline. In this telling, the oil shock was a trigger, but the gun was loaded by misguided policy.
The evidence suggests both factors mattered. The oil shock alone might have caused a temporary spike in prices, but the policy response—attempting to maintain full employment through monetary expansion even as inflation expectations were shifting—turned a shock into a decade-long crisis.
The Neo-Keynesian Response
Keynesian economics didn't disappear after the 1970s. Instead, it evolved. Neo-Keynesian and New Keynesian economists developed more sophisticated models that could account for supply shocks and changing expectations.
A key distinction emerged between "demand-pull" inflation—caused by too much spending chasing too few goods—and "cost-push" inflation—caused by rising production costs that get passed through to prices. Traditional Keynesian policies work well against demand-pull inflation: if people are spending too much, you raise interest rates or cut government spending to cool things off.
But cost-push inflation is different. When prices rise because oil costs more, reducing demand doesn't solve the underlying problem. The oil still costs what it costs. Attempting to squeeze inflation out of a supply-shocked economy through demand management mainly succeeds in creating unemployment.
This distinction helps explain the policy trap of the 1970s. Policymakers who had been trained to manage demand were suddenly facing supply-side problems, and their familiar tools made things worse rather than better.
The Neoclassical Alternative
Some economists drew a more radical conclusion from stagflation: maybe monetary policy doesn't affect real economic activity at all.
The neoclassical view—sometimes called the "classical dichotomy"—holds that real quantities like employment, output, and growth are determined entirely by real factors: technology, resources, labor supply, regulations. Money, in this view, only determines nominal quantities like prices. Print more money, and prices rise proportionally, but nothing real changes.
If you accept this framework, stagflation isn't mysterious at all. It's simply two separate phenomena happening simultaneously. "Stagnation" comes from real factors—perhaps the oil shock making production less efficient, or government regulations hampering business. "Inflation" comes from nominal factors—central banks creating too much money. The two aren't causally connected; they just happened to coincide.
This view has elegant simplicity but struggles to explain why monetary policy changes clearly do affect real activity in the short run. When the Federal Reserve raises interest rates, unemployment really does increase, at least temporarily. The classical dichotomy may hold in the long run, but economies don't live in the long run—they live through the painful adjustments between equilibria.
Could It Happen Again?
The economist Olivier Blanchard, writing in 2009, noted that sharp increases in oil prices could potentially trigger another period of stagflation. At the time, it hadn't happened—but the possibility remained.
In some ways, the world is better prepared now. Central banks learned painful lessons about the importance of anchoring inflation expectations. They're more likely to respond quickly to rising inflation rather than letting it become embedded in psychology. Economies are also less oil-intensive than in the 1970s, so energy shocks matter less per unit of economic output.
But supply shocks can take many forms beyond oil. A global pandemic disrupting manufacturing and shipping, for instance. Trade wars restricting access to crucial materials. Climate change disrupting agriculture. Any of these could create the conditions where production costs spike while output falls.
The 2020s have offered some stagflationary warnings: pandemic-induced supply chain disruptions combined with aggressive monetary stimulus created inflation pressures that many predicted. Whether those pressures resolve into something like 1970s stagflation or something more manageable remains to be seen.
The Lasting Legacy
The stagflation of the 1970s changed economics and economic policy in ways that persist today.
Central banks became fiercely focused on controlling inflation, accepting that this might sometimes require tolerating higher unemployment. The idea that you could simply choose your preferred point on the Phillips Curve—trading off inflation for jobs as circumstances warranted—was abandoned. Inflation expectations became a central concern, with policymakers working hard to convince the public that they would never let inflation get out of control.
Government intervention in the economy became more suspect. The failure of price controls, the limitations of demand management, and the apparent success of deregulation in some sectors all contributed to a shift toward market-oriented policies. Whether this shift went too far is still debated, but its origins in the stagflation experience are clear.
Perhaps most importantly, stagflation humbled economists. The confident technocratic management of the postwar period gave way to a recognition that economies are complex systems that don't always behave as models predict. When Iain Macleod stood before Parliament in 1965 and warned that "history, in modern terms, is indeed being made," he was right in ways he couldn't have anticipated.
The impossible had happened. And that possibility—that our economic models might be fundamentally incomplete—remains a warning for anyone who thinks they've figured out how the economy really works.