21 December 2022 | ZebPay Trade-Desk
A Primer on Stagflation
Economic stagnation occurs when the economy’s growth rate is insufficient to meet the needs of its people. Stagflation is characterised by high inflation. It occurs when an economy grows so slowly that unemployment rises. Meanwhile, prices continue to rise as if businesses are selling everything they can produce. There is less demand for goods and services, which could lead to even more unemployment.
In a stagflationary environment, individuals do not know how much capital they will be able to spend in the future. Because no one knows what their income will be after a certain period, inflation makes it difficult to plan and invest in the present. This adds to the uncertainty and slows growth. Thus, stagflation is a combination of two reasons: economic stagnation and inflation.
Stagflation was most evident in the 1970s when several developed economies experienced slow economic growth, high unemployment, and rising inflation as a result of global fuel shortages. It can also occur as a result of monetary or fiscal policy, such as when the United States decoupled its dollar from the gold standard during the 70s.
A supply shock occurs when prices rise without any change in aggregate demand or inventory. These shocks can be caused by human actions. For example, a state conflict may increase oil prices or another essential input into the manufacturing process, resulting in cost-pull inflation, which is inflation caused by an increase in costs due to rising wages and raw materials. Supply shocks can also include price increases caused by natural disasters. Simply put, a change in the manufacturing process reduces the supply of goods or services, resulting in demand-pull inflation.
Monetary policy errors are mistakes made by central banks in managing their country’s money supply. Let’s assume they make an excessive amount of money available for lending due to low-interest rates. In that case, interest rates will fall, putting upward pressure on consumer wages and prices. However, in the presence of extremely high interest rates, a decline in economic activity may result in stagflation.
Crypto Industry Dynamics During Stagflation
To understand whether crypto investments perform well during stagflation, consider how traditional markets behave during inflation or stagflation. Stagflation is inherently bad for traditional markets, and because crypto markets have a high correlation with general indexes, negative sentiment can spread to crypto assets. In general, traditional investors may be more accepting of economic uncertainty than those investing in crypto assets, which come with higher volatility. As a result, there may be less demand for crypto assets than usual during stagflation.
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Stagflation can also hurt crypto markets by reducing retail investor interest in buying digital assets. Finally, high inflation directly affects how much money people have to buy crypto assets.
However, depending on one’s crypto investment strategy, one may choose to invest in these assets instead of investing in traditional financial instruments. Crypto run on a blockchain is not tied to a specific country’s monetary policy like how fiat currencies are. If inflation rises in one country but not another, investors can still benefit from the gains made from crypto investments even if their local currency depreciates due to inflationary pressures.
Investors often look for a way to protect their assets from stagflation, especially in countries like Venezuela or Argentina where hyperinflation is occurring. Hyperinflation occurs when the prices of essential goods and services in an economy rise rapidly and uncontrollably. This is where crypto investing works, providing an alternative means of payment and protection against hyperinflation. People can choose to escape hyperinflation by diverting some of their investments to Bitcoin (BTC).
How Does Bitcoin Work During Stagflation?
BTC will be viewed through an equivalent lens as gold, which has historically acted as a hedge against inflation. First, BTC is decentralised which means that it is beyond the management of central authorities. Governments do not have any control over it, making it nearly resistant to potential corruption and financial policy errors.
Secondly, BTC is a rare commodity and deflationary as a maximum of twenty-one million can be circulated. Because of this scarcity and finite nature, it’s also called a “store of value”
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In general, once interest rates rise, the costs of risky assets fall. Since the crypto market has created a vital correlation with stock markets, a lot can rely on if and when BTC will break its correlation. This will take some time, additionally given that there is institutional acceptance. Inflation can be a catalyst for BTC and crypto adoption. This could happen if the debt economy we have built turns out to be unsustainable. If Bitcoin is viewed as another hedge against a failing economic system, price and adoption will rise throughout economically unsure times. A tipping point might occur once public confidence in BTC exceeds confidence within the current economic system.
What Can Be Done During Stagflation?
The first instrument is tax policy. Expansionary fiscal policies can increase public spending to increase aggregate demand and boost economic growth. The government can cut spending to reduce demand for goods and services, which could stem inflation. The second tool is monetary policy, which involves managing interest rates to stimulate the economy. Central banks apply low interest rate policies to reduce borrowing costs. Interest rate policy can also reduce the money supply, which over time can help boost economic growth.
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The third tool is an attempt to reduce unemployment through an active labour market. However, there is a risk of built-in inflation here, as demand for wages increases in labour markets to cope with the rising cost of living. This often results in companies raising the prices of goods and services to offset increased labour costs. Selling bonds or other financial instruments can reduce the money supply from circulation.
Crypto assets can also directly help combat stagflation by allowing people to invest without an intermediary. Better access for people to international markets can help improve global economic conditions and lead to more sustainable growth.