Inflation and Stagflation: Difference?

As most of you have not doubt heard, inflation rates are being measured at levels we have not seen since early in the Reagan Administration. That was the “hell to pay” period in which the the no-nonsense Chairman of the Federal Reserve did the hard work to wring inflation out of the system in a way that held for the next forty years. But now people are starting to talk about “Stagflation”, which seemed like a good idea to wade back into this area for a little more “inflation education”. Lots of people use these terms and very few really understand them, so let’s get you fixed up.

I got into a detailed explanation of what is and what is not inflation. Inflation is always and everywhere a monetary phenomenon. More money than the economy can use results in inflation, or a situation where each unit of that money (a dollar, in our case) becomes worth a little bit less than it was before. And the corollary concept that is extremely important is this: prices can go up and down even without inflation, as anyone knows who has tried to buy gasoline or lumber after a hurricane or a new car when nobody can get computer chips.. The trick is recognizing that inflation (the general rising of all prices) and specific price changes because of market conditions (the raising of a specific price for a real, recognizable reason) are two completely different things that, unfortunately, often look the same (and often happen concurrently, making proper identification difficult).

So, what is the variant called “stagflation”? This requires a brief history lesson. Back in those august days of the 1960s when everyone knew everything (or thought they did), an economist named A. W. Phillips noticed a relationship between inflation and unemployment (a stand-in for recession). When inflation rose, unemployment went down, and vise versa. Mr. Phillips graphed the points and they looked like this.

A whole bunch of knowlegeble economists accepted the brilliance of this idea (called, for now-obvious reasons, The Phillips Curve) that just as we could fine-tune a dial on a radio, we could choose where we wanted to be in a tradeoff between inflation and unemployment/recession. Is the economy a little slow? Inflate and everything will soon be fine. Is inflation too high? Just slow the economy down a bit (also known as “do something that will throw some folks out of work”) and the rest will take care of itself.

This was the world as it was in about 1970. In that world, the idea that you could have inflation and recession (or stagnation) at the same time was blasphemy. So a whole bunch of people were really confused when, in 1974, we got a nasty recession at the same time we had increasing inflation. “Stagflation” was the catchy term that was batted around as lots of brainy people rubbed their chins and tried to understand.

The economy slowing down in a recession. These are two different things. You can have one, you can have the other, and (most importantly) you can have both, and in varying degrees. Inflation does not cause stagnation and stagnation does not cause inflation (there are some really technical, minor ways that each can have an effect on the other, but that goes beyond our broad-brush discussion here).

Stagnation (or recession), unlike inflation, is a real phenomenon caused by policies that deter economic actors from engaging in business activity. “Economic actors” are people like you and me, after being run through the economics jargon machine. Higher taxes (of certain kinds), increased business regulation (again, of certain kinds) and other things are within any government’s tool belt, and those tools can indeed induce people to act in ways that deter economic activity. A market economy like ours is not a magical black box that takes oxygen into one end and spits golden eggs out of the other. It is an aggregation of people making seemingly unrelated decisions, such as “should I open a second restaurant”, “should I buy a new car or keep my old one” or “should I get a job, get married and raise a family or should I stay in Mom’s basement getting high?” Whether the economy is healthy or stagnating depends on lots of things, not least a climate that encourages legitimate business activity or discourages it, coupled with the reactions of those of us on the ground.

So Inflation is here. Stagnation is kind of hanging around on the front porch, and how serious it is depends on who you are listening to. The good news is that inflation does not automatically lead to stagnation, as long as it doesn’t get out of hand. And the bad news is that killing inflation is often not undertaken until it has gotten out of hand, and is therefore generally unpleasant More often than not, it results in recession – if only because we all start reacting to faulty price signals again. Tightening money to curb inflation can, in a real sense, trick people into thinking that things are worse than they really are, and acting a recession into existence. It is like how way everyone can run to one side of the boat when others do so (whether there is anything to see there or not), resulting in the capsizing of an otherwise seaworthy boat.

The takeaway is that inflation and stagnation are two different concepts. Stagflation is either having both of them at once or a sign that the one using the word has not a clue about how to understand basic economics. And (just like with inflation and stagnation) you can have both of those things at the same time too. The good news is that, having read this, you won’t be one of those unfortunate souls.

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