What Is Stagflation, and How Would It Affect the National Debt?
Stagflation is a unique and harmful economic phenomenon defined by the simultaneous presence of inflation, stagnant economic growth, and high unemployment. All three conditions rarely occur at the same time, but when stagflation does happen, it can have significant negative consequences for the economy and the national debt.
Why Is Stagflation Rare?
Typically, economies do not experience the three defining conditions of stagflation at the same time because they should counteract each other.
In economics, inflation and unemployment are usually negatively correlated, which means that when inflation is low, unemployment should be high, and vice versa. That is because a lower unemployment rate signals a demand for labor, leading to an increase in wages. When wages go up, inflation typically follows because the price of goods will increase to accommodate the greater labor costs.
However, the relationship between those factors has weakened over the past few decades due, in part, to evolutions in the conduct of monetary policy. Federal Reserve Chair Jerome Powell noted in 2019 that the linkage between employment and inflation has become “weaker and weaker and weaker” because the Fed’s multi-decade effort to steady inflation at 2 percent has created an expectation of steady inflation. In turn, that expectation has become a significant determinant of inflation itself, which weakens the influence of other forces. Economic globalization and other factors have also reduced the causal relationship between inflation and unemployment.
Has the United States Experienced Stagflation?
Stagflation is rare, but not unprecedented within the United States. In 1973, the Organization of the Petroleum Exporting Countries (OPEC) imposed an oil embargo on the United States due to a geopolitical dispute. In five months, crude oil prices quadrupled. That, in conjunction with the end of the gold standard, left the dollar vulnerable to rapid devaluation, and the U.S. economy felt the weight of those events. By 1975, the unemployment and inflation rates peaked at above 8 percent, and that same year, the economy did not grow. In order to tamp down inflation, Former Federal Reserve Chairman Paul Volcker intentionally raised interest rates to as high as 20 percent, plunging the economy into a recession. It wasn’t until 1983 that inflation fell below 5 percent, while the unemployment rate was 10.4 percent.
Is the U.S. at Risk of Stagflation Now?
The risks of stagflation are currently low, but there are warning signs to watch. Since the beginning of 2020, the nation has seen interest rates reach their highest levels in 20 years, inflation reach its highest mark since 1982, and the highest unemployment in over a decade. Along the way, the United States added approximately $17 trillion to the gross national debt. The economy has rebounded well from the COVID-19 pandemic, but elevated inflation persists, and the outlook for economic growth could be stronger. While recessionary expectations are presently low, recent weaknesses in the labor market, combined with persistent inflation, suggest that a near-term return to stagflation is unlikely, but not impossible.
How Would Stagflation Impact the National Debt?
The poor U.S. fiscal position means that if stagflation were to occur, it would present outsized risks compared to the 1970s.
The United States just saw its fifth annual deficit of at least $1.8 trillion since 2020. Increased deficit spending should be reserved for emergency economic and geopolitical circumstances, but massive deficits during relative calm have become routine. If the United States were to experience a bout of stagflation, it could have several consequences for the already ballooning debt:
- High Inflation Would Increase Interest Costs: To combat high inflation, the Fed typically raises interest rates, as it did in 2022. Higher interest rates increase borrowing costs for the government, which led to net interest costs on the debt nearly tripling from $345 billion in 2020 to more than $1 trillion in 2026.
- High Unemployment Would Lower Tax Revenues: Higher unemployment results in fewer taxpayers and decreased revenues. From 2007 to 2010, during the Great Recession, revenues from individual income taxes fell from 8.1 percent of gross domestic product (GDP) to 6 percent. Reduced revenues can further increase deficits.
- Lower Growth Would Increase the Debt-to-GDP Ratio: A slowdown in economic activity, coupled with greater expenses and reduced revenues, increases the debt-to-GDP ratio, putting our nation and economy in a more precarious position.
Conclusion
Stagflation is a rare, but not unprecedented, phenomenon for the American economy. The United States is not presently at a high risk for stagflation, but if it were to occur, the triple impact of high inflation, low unemployment, and low growth would have significant negative consequences for our already unsustainable national debt.
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Further Reading
What Are Interest Costs on the National Debt?
Interest costs are on track to become the largest category of spending in the federal budget.
Fed Raises Rates for First Time Since 2023 as Interest Costs Top $1 Trillion
High interest rates on U.S. Treasury securities increase the federal government’s borrowing costs.
With $40 Trillion in Debt, Is the U.S. Headed for More Credit Downgrades?
Three successive downgrades of the U.S. credit rating should alarm elected leaders, but our national debt remains on an unsustainable trajectory.