Last week, BBC Radio 4 in England was headlined by the news that inflation in the UK was running at 9%, followed by an interview with an economist that said a recession was imminent, with no explanation why. At the same time in the U.S. Jay Powell, the Chairman of the Federal Reserve Board, said the Fed was prepared to fight inflation even if it meant “ a small increase” in unemployment.
What was kind of shocking in much of the press coverage of rising prices, was the incoherent discussion of the connection between rising prices and a possible recession. In particular the BBC seemed not to understand the connection between WHAT POLICYMAKERS DO and the risk of recession, and rather talked as if the economy was something like the weather–in other words things just happen, and we have to grin and bear it.
What the public should understand is that the most likely reason we have a recession is because policymakers- and in particular central banks– choose to bring one on. And the main reason policymakers would choose to do that is because the financial sector and those whose money they invest would rather have a recession than risk further inflation.
And further, the public should understand that the choice between bringing on a recession to slow inflation and taking actions like the windfall profits tax the United Kingdom recently adopted to blunt the impact of fuel price increases is the difference between going directly at the sources of rising prices in the economy or alternatively making the entire economy and working people in particular suffer in order to protect Wall Street, the City of London, and energy company profits.
Why is this?
While understanding how whole economies work can be quite complicated, the basic relationships aren’t that hard to understand. First its important to get it that inflation is near universal around the world today. This should tell us that it is not necessarily the product of any one set of economic decision makers, or any single central bank. Rather it is about the balance between the global supply of goods and services, and the global demand for those goods and services, expressed in money that consumers and investors are willing to spend.
Again, in broad brush terms, prior to COVID we had a global economy that while it had some serious long term structural issues, seemed relatively healthy in that unemployment and inflation were both at fairly low levels in comparison with the recent past. When COVID hit, the global economy shrank dramatically– businesses stopped operations under government orders, and customers stopped spending on many things they had been spending on– entertainment and travel and personal services most of all, but also many manufactured goods. With unemployment in double digits in a matter of days, the global economy faced the threat of a downward spiral, where collapsing demand fed on itself, causing more businesses to close and demand to fall further.
In response, governments and central banks around the world lowered interest rates to near zero and handed out money to people who were not working at previously unheard of levels. While unorthodox, these measures were absolutely necessary and more or less worked. While millions couldn’t go to work, they didn’t lose their homes or go bankrupt or starve, and total demand remained relatively robust, though still below pre-COVID levels, and largely prevented a downward spiral.
However, as the public health situation normalized and consumer confidence grew, consumers began to spend more and more of the cash they had on hand. But at the same time, COVID did not really go away, and the result was that global productive capacity could not keep pace with demand. Many workers were still sick, large parts of the critical Chinese economy were still in lockdown, there were unique problems in the critical computer chip business, and the rapidly increasing demand for manufactured goods in particular was putting serious strains on neglected infrastructure worldwide.
So as a result, last summer and fall as demand for manufactured goods rose, supply could not keep pace. The result was rapidly increasing prices for all kinds of manufactured goods, and inflation rates in much of the world higher than anyone had seen since the early 1980’s. However, as the economist Mark Zandi pointed out early in 2021, by the later fall of 2021 supply chains were starting to clear, COVID’s grip on the workforce was easing, and as a result inflationary price pressures were starting to ease.
The question at this time, and throughout this period, faced by central banks like the Federal Reserve and the Bank of England is whether to make money more expensive and harder to get by raising interest rates. When demand is driving up prices in the face of limited supplies of goods and services, it is always possible to stop that by taking away demand by taking money out of the economy. Central banks do that by raising interest rates, which is the price of money. But if central banks raise rates too much, the result is recession. Why? Because with higher interest rates fewer people borrow money to both invest and spend, and those that do borrow borrow less, and economic activity shrinks.
John Maynard Keynes is famous for having understood this dynamic best and earliest, and having urged economic policymakers to understand that money can become frozen in the form of savings– that just because money is saved doesn’t mean that it is invested.
During the fall, central banks, seeing pricing pressure easing as more manufacturing capacity came on line worldwide, were very cautious about large increases in interest rates. Central banks resisted the pressure for steep increases in interest rates coming from representatives of the monied classes, who fear inflation eroding their piles of money much more than they fear unemployment they will never personally have to endure.
What makes these decisions really hard is that a price rise as a result of a lack of supply of a given good is not inflation. Its a good becoming more expensive relative to other goods. Central banks don’t want to provoke a recession in response to a relative price increase of some goods over others. But what if the goods whose prices are rising are built into the price of everything? That was the challenge presented by Russia’s attack on Ukraine.
Russia’s attack on Ukraine created a sudden price increase globally in energy markets dependent on Russian oil and gas, AND on global food markets dependent on Ukrainian grain and other food products. Suddenly there was a lot less of very basic commodities, and huge uncertainties about when supplies would return to normal, or whether they would constrict further. And on top of that, the war itself created demand for a range of products, all dependent on both energy and food as inputs, further pushing up demand.
So instead of upward pressures on prices easing as global supply chains returned to normal, there was another and more severe upward push, driven by food and fuel prices, which has taken inflation rates on a monthly basis from 6-7% in the original post-COVID period to 8-9%.
There is nothing about these rates of inflation that per se mean that a recession is coming. Rather these inflation rates mean that the pressure on central banks to trigger a recession intentionally by increasing interest rates to levels high enough to make borrowing largely cease, is growing by leaps and bounds. By and large that pressure though is coming from people allied with the financial sector or right wing politicians.
There is also the reality that rapidly rising prices for food and energy act as an economic brake much like high interest rates– they change the economic calculus for all kinds of activities. But the scale of this impact is limited- the total annual impact of the increase in oil prices on the U.S. economy is $248 billion, about 1% of GDP, and the impact of food price increases is less, and to some degree the money from both goes to U.S. firms and workers. By comparison US GDP grew at a rate of 6.9% in the last quarter of 2021. A 1% or so drop from that level is scarcely a recession (usually seen as requiring negative growth).
So in the end, the question of whether inflation leads to recession depends in the short run on whether central banks choose to make it so.
In the longer term, however, inflation of the kind we are experiencing is driven by the ability of supply to meet demand. And here we come to issues of investment and innovation. Putting it simply, if we envision the global economy as static at its current Ukraine war era capacity of energy and food production, then the only way to get inflation under control really is to reduce demand for food and energy to the deep recession levels of the COVID pandemic.
But the world is not static. Higher energy prices leads inevitably to more energy production– both fossil fuel energy from more expensive sources (deeper, less accessible sites), and the development of renewable energy resources that can now be competitive at higher production costs. Something similar is true in terms of food production– it now makes sense to farm more marginal soils. And in significant ways, technological innovation in both food and energy will be accelerated in these circumstances.
These dynamics raise critical policy issues, particularly around fossil fuel pricing and production. This week the United Kingdom’s conservative government announced a windfall profits tax on energy companies, but based on a complex calculation that sought to reward those companies for making more investments. Of course the energy companies had been arguing against the tax by saying they needed outsize profits to fund new investments. But do we really don’t want those companies making new investments if those investments are in more fossil fuel production? That is the reason there is a powerful argument both in terms of reducing the likelihood of recession and slowing climate change to impose windfall profits taxes immediately and to give no concessions for further investments in the fossil fuel sector.
But we should not forget that in periods of rising prices, decisions get made that can reorganize economic and political power for decades, with very destructive consequences.
The last time there was significant inflation in the U.S. economy, in the late 1970’s, the Federal Reserve raised interest rates to double digit levels, causing a collapse in U.S. manufacturing that in certain ways the U.S. has never recovered from. The areas worst affected by the Federal Reserve’s policies at that time are the same areas that voted disproportionately for Donald Trump in 2016 and again in 2020. There was fear at that time the U.S. economy was locked into cycles of inflation and recession from which there was no escape.
The Reagan Administration’s response it called “supply side economics,” meaning it was attempting to address inflation by increasing the production of goods and services. How did it attempt to do that? By cutting taxes and increasing military spending, funding both with borrowed money. Doesn’t make sense, does it? That’s because despite the talk of supply side economics and encouraging private investment, what Reagan really did was classic Keynesian economics, creating demand with aggressive fiscal policy– government borrowing– taking the place of the private sector credit the Federal Reserve had crushed.
But Reagan’s right wing Keynesianism had a profound political tilt. By giving the borrowed money to military contractors and to the wealthy through regressive tax cuts, while at the same time the Fed’s high interest rates destroyed American industry, and with it the economic foundations of the industrial middle class, the result was an economy with a structural lack of effective demand due to wage stagnation, an economy that didnt work without infusions of credit– either in the form of government deficits or household borrowing to fund consumption.
Today, in this period of what economists call supply shock inflation, because there has been a shock to the supply of energy and food, prices are rising much faster than wages in most of the world. At the same time though, a relatively healthy labor market has meant that workers have had SOME ability to extract wage increases from employers.
The financial sector and the wealthy WANT to destroy worker bargaining power, and rising prices that have nothing to do with workers are their excuse. If a recession happens, it will be because these interests have won the argument at the Federal Reserve and the Bank of England. What really should be done is to blunt the impact of the energy and food supply shock by a combination of windfall profits taxes and new investments in renewable energy– a genuine supply side economics, and modest, careful interest rate increases designed to prevent an inflationary spiral BUT NOT to crush demand.
The worst possible thing to do would be to let the energy companies take full advantage of Putin’s oil price increases, WHILE rapidly increasing interest rates. That would bring on both recession and climate catastrophe. But while central banks on both sides of the Atlantic have exercised admirable constraint in the face of political pressures from the rich, the signals coming from the central banks and the politicians on both sides of the Atlantic are that such a destructive pattern of radical action on interest rates and passivity on energy prices is exactly where they are headed absent serious pushback from the majority of people who DO NOT want a recession.