Inflation, Deflation, and Stagflation Explained
Everyone thinks they know what inflation is because most people associate it with the devaluation of the national currency against major currencies and the rise in prices. While this definition is correct, to fully understand it, we need to grasp that a free economy is one where supply meets demand.
What is inflation? It is often said that inflation is a cancer that periodically clings to the global economy or the economy of a country.
When demand becomes increasingly high, supply raises prices. It's exactly like the stock market: if many stocks are bought, sellers reconsider and raise their prices.
Conversely, if many stocks are sold, buyers reconsider and purchase them at lower prices. This is also how inflation works. When demand rises and prices follow, we are witnessing an inflationary phenomenon.
Inflation is usually tied to a specific currency. We talk about inflation in dollars, inflation in the Argentine peso, or inflation in the Venezuelan bolívar. The most famous instance of inflation, however, doesn’t come from a poor economy, but from Germany in the 1920s.
In Germany in the 1920s, after World War I, due to the enormous debts Germany had to pay to the Allied countries as war reparations—under the Treaty of Versailles—and until Germany managed to borrow 2 billion dollars from the Americans, prices spiraled out of control.
The central bank was forced to print more money, and to give you an example, a loaf of bread that cost a little over 100 marks in 1921, reached 4.5 billion marks by 1923. This led to the creation of banknotes worth one trillion marks.
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But there is also the phenomenon of deflation. When demand decreases, supply has to lower prices, resulting in increasingly lower prices. Deflation is perhaps even more dangerous than inflation.
Why? With economic growth, more goods and services are automatically produced, GDP increases, so the goods and services a country produces increase, and prices rise because there are more of them. Demand also increases as wages rise along with economic growth. However, as long as inflation stays below 2%, it is actually healthy and beneficial.
America maintained an inflation rate of around 2% for a long time and performed well, experiencing spectacular economic growth. The same was true in China, after Mao Zedong, during the era of Deng Xiaoping, where inflation remained relatively low while achieving double-digit economic growth year after year.
In addition to inflation and deflation, there is another phenomenon called stagflation.
Stagflation means that there is inflation, but there is no economic growth. As I mentioned earlier, when the production of goods and services increases, so do prices. But sometimes, this economic growth stops, yet prices continue to rise.
Out of the three phenomena, stagflation is the most dangerous. Why are we discussing them today? First, as a lesson, by briefly telling the history of these economic phenomena, but also because there is a risk that the global economy could soon face stagflation.
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After the pandemic in 2020, following the sharp drop in February, March, and April, the economy slowly began to recover starting in May, growing spectacularly.
The first place where inflation can be seen is in stock prices. Profits increase, companies produce more and sell at higher prices. Take Tesla’s growth during the pandemic as an example: the crisis didn’t stop them from producing more cars and selling them at increasingly higher prices, causing their stock prices to skyrocket.
But how long can these stock prices keep rising? Usually, they far outpace inflation because greed kicks in. In conversational terms, that’s exactly what happened in 1929. After the boom decade of the 1920s in the United States—when one in five Americans owned a personal car and one in five families owned a car—things spiraled out of control.
There was also a lot of money coming from Prohibition—black money, money that was invested as well, contributing to the boom in the real estate market.
Everyone was trying to produce more and more. Companies produced more, stockpiled goods, but eventually, they couldn’t sell those stocks. As a result, company profits declined, and even if they continued to sell, they were only selling what was in stock.
Production dropped sharply, and the stock market crash preceded the Great Depression of 1929-1932.
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To give you some context, the Dow Jones index in 1929, before Black Tuesday on October 29th, was at 650 points. By 1932, it had fallen to 41 points—a decline of over 90%.
Just as the rising prices of the time were reflected in the spectacular growth of the stock market, the stock market crash was an indicator of the Great Depression and the economic crisis of 1929-1932.
The idea is this: the stock market always shows us when we are in an inflationary period; the prices of some stocks have tripled, quintupled, or increased tenfold. What’s strange is that no one seems worried, but greed is always huge.
No one is concerned until that inevitable crash happens. Then, people believe—just like they do now with cryptocurrencies—that even if prices fall by 50%, they’ll bounce back quickly. These things can happen—until they don’t.
The Dow Jones index, before Black Tuesday, was at around 600 points. By 1932, after three years, it had fallen by more than 90%, to 41 points. To regain its pre-crash level of 600 points from 1929, it took until 1965.
Only in 1965, after 35 years, did prices return to the levels seen in 1929.
Now that we clearly understand what inflation, deflation, and stagflation mean, it would be good to dedicate a future article to discussing the exact and concrete situation in Europe and the United States.
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