Stagflation: Policymakers in Pakistan face a significant challenge in dealing with Stagnating economy with inflation


Stagflation: What is Stagflation? Understanding its Origins, Effects, and Remedies

by Mir Hassan and Ali Abbas*

17 July 2023

Often it is a challenge for developing countries to balance economic growth and inflation. If economic growth is promoted and unemployment reduces, inflation starts growing. Similarly if Inflation is controlled by increasing the interest rates and promoting saving activities, economic growth falters and freezes, sometimes even declining. But is it possible to imagine a scenario where a country suffers both economic stagnation and inflation simultaneously? Well a country in the heart of South Asia is on the precipice of not only imagining it, but experiencing it firsthand. In recent years, Pakistan has experienced a concerning rise in stagflation (an economic phenomenon characterized by a combination of stagnant economic growth, high inflation rates, and high unemployment), posing a significant challenge for policy makers and necessitating a comprehensive understanding of its causes, consequences, and potential solutions.

The most significant and foremost cause of stagflation in Pakistan are supply-side constraints. Industries and factories face stagnant production due to energy shortages (rolling blackouts) and lack of accessibility to adequate resources. This, coupled with infrastructure bottlenecks (such as inadequate transportation networks, insufficient logistics facilities, and limited number of developed ports) and inefficient agricultural practices, limits the economy’s ability to expand production and meet growing demand, resulting in higher prices but lower output. Pakistan’s fiscal deficit, exacerbated by an imbalance between government expenditures and revenues, has put a significant strain on the economy. Inadequate revenue collection, corruption, incompetent use of allocated resources and mismanagement, subsidy burden, and excessive borrowing, has led to inflationary pressures on the country’s economy and has weakened the overall economic stability. The central bank’s struggle to strike a balance between controlling inflation and promoting economic growth has been a major contributing factor to stagflation. In some instances, tight monetary policies have hindered investment and economic activity, leading to sluggish growth, while loose policies have fueled inflationary pressures. Political instability also serves as a major hurdle to Pakistan’s economy as political rivalries and unstable government raises serious concerns in the minds of potential investors. The resulting unpredictable market conditions due to erratic and inconsistent government policies prevent many potential investors from investing in the country’s businesses or starting a new business in the country due to fear of losing their investment. Turbulent external influences have also greatly affected Pakistan’s economic situation such as global commodity price fluctuations (such as oil prices due to Russo-Ukraine conflict or Covid-19), exchange rate volatility, and geopolitical tensions have played a role in exacerbating stagflation in Pakistan. These external shocks impact the cost of imported goods and services, potentially leading to higher inflation.

Rise in stagflation aversely impacts on the nation all together, including its social, economic and political sectors. Soaring prices due to unbridled inflation significantly diminishes the purchasing power of average citizens, whilst increasing unemployment leaves many homes without a reliable source of income, with a significant portion of the population earning less than $3 a day. This deterioration in CPI index further increases the income gap as poorer low income households spend most of their income on essential goods and services, which becomes harder for them to afford with diminishing purchasing power and inflating prices. Conversely, households with higher incomes may be better equipped to absorb the impact of inflation and maintain their living standards. This widening of the gap between the rich and poor leads to social tensions and potential instability. Stagflation also negatively impacts the investment climate and overall business environment as uncertainty about future economic conditions and high inflation discourages potential investors (both domestic and foreign). Businesses become more cautious about expanding operations or making long-term commitments due to the unpropitious economic environment, as the returns on investments and chances of success are uncertain. Reduced investments result in lack of new businesses, which limits the country’s GDP, lowers job creation, and hinders the development of innovative industries and sectors, hampering long-term economic growth and social prosperity. Such volatile market conditions erode consumer and business confidence, which further dampens economic activity. Consumers, facing high inflation and economic uncertainty, become more cautious with their spending, prioritizing essential items over discretionary purchases. Reduced consumer confidence can have a ripple effect on businesses, as lower demand leads to reduced sales and profitability, causing businesses to become hesitant to invest in expansion or new ventures, exacerbating the stagnation in the economy. Stagnation also places a burden on government finances. Lower economic growth leads to reduced tax revenues, liming the government’s ability to fund essential public services, infrastructure projects, and social welfare programs. At the same time, the government may face increased spending demands, such as unemployment benefits or subsidies to mitigate the impact of spending demands, such as unemployment benefits or subsidies to mitigate the impact of stagflation on vulnerable populations. The combination of lower revenues and increased expenditures can result in widening fiscal deficits, potentially leading to higher levels of public debt.

Stagnation casts a deep and long shadow over Pakistan, but history has shown that the woe of stagnation can be beaten with determination, perseverance, and most importantly of all, competent governments and reliable monetary and fiscal policies (such as 1976 sterling crisis or the global oil crisis during the Yom kippur war). The most substantial effect the government can have is through Supply-side reforms. By investing in the development and improvement of infrastructure, improving transportation networks, energy systems, and digital infrastructure, the government can greatly alleviate the supply-side constraints and increase production capacity. Proper energy infrastructure and better irrigation systems will further enhance agricultural productivity and reduce the inflation on essential items such as food, as well as increase their availability. Investing in more accessible and quality education will also assist in controlling the increasing stagflation as better and more accessible education will enhance the productivity and employability of the workforce, as well as equip them with more technical skills, increasing the overall quality and availability of local human capital. This can facilitate the transition to more productive and high-value added industries, reducing unemployment and supporting economic growth. The government can also improve the fiscal management by prioritizing expenditures, focusing on key sectors such as education and infrastructure, and reduce unnecessary spending. Furthermore, the government should strengthen executive institutions and take a stiffer stance on tax collection. Expanding the tax base by reducing tax evasion, improving tax administration, and eliminating exemptions can generate additional revenue for the government which can help reduce the reliance on borrowing and stabilize public finances. Adequate monetary policies by the central bank can also control stagflation. The central bank should adopt a balanced approach to monetary policy that considers both inflation and growth objectives. Striking a balance between controlling inflation and promoting economic activity is crucial. The central bank can adjust interest rates to manage inflation and stimulate economic growth. In times of stagflation, it may be necessary to carefully evaluate the impact of interest rate adjustments on investment and borrowing costs to prevent further dampening of economic activity. Lastly, having political stability can significantly help reduce stagflation. Having political stability will reduce the hesitation of foreign investors as market and economic conditions will be more predictable and bring more economic opportunity from abroad. Government policies will also be more steady, which can be used to form safety nets for vulnerable citizens worst hit by inflation or unemployment. Government can also promote policies that promote exports, such as providing export incentives, improving trade infrastructure, and facilitating access to international markets, which can help reduce reliance of imports, improving balance of payments, and stimulate economic growth.

Stagflation presents considerable hurdles to Pakistan’s economy, impeding growth, amplifying unemployment, and intensifying inflationary pressures. Overcoming stagflation necessitates a comprehensive and multifaceted strategy that encompasses structural reforms, prudent fiscal management, effective coordination of monetary policies, substantial investments in human capital, and focused efforts towards diversifying the economy. By implementing these measures, Pakistan can effectively tacked stagflation and establish a resilient, sustainable economic future.

*Mir Hassan 🙁 Lecturer, Department of Public Administration, FMS, BUITEMS) and Ali Abbas: (Undergraduate, Department of Public Administration, FMS, BUITEMS)