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14 December 2022

What’s worse, inflation or a recession?

We might have to pick our poison.

By Maria Koumenta

The challenges that the UK economy is facing are well understood, so I will be brief: even if inflation eased to 10.7 per cent this month, it is still at a 40-year high, and many households are worried about making ends meet. It is clear to economists that supply-side issues are the cause of our predicament, namely Vladimir Putin’s war on Ukraine affecting fuel prices, supply chain issues exacerbated by China’s zero-Covid policy, and trade bottlenecks resulting from Brexit. We are facing a recession, although it is perhaps not as significant a downturn as expected, on account of a 0.5 per cent increase in GDP during October.

What is less well articulated in the debate is the policy choices that underpin the situation we are in. Economists use a fancy word to think about policy choices at our disposal. We call it the “counterfactuals” – meaning what an alternative “world” would look like in the presence of alternative courses of action. 

At this point, I would like to warn the reader that neither of the alternatives I am about to discuss are ideal. In fact, it is a choice between two evils; demand-side economic policies that sustain the supply-side inflationary pressures outlined above or policies that lead us to an economic recession. Inflation, which was effectively chosen when the government helped people with the cost of fuel and matched benefits to inflation, was the right policy choice in my view.

Recessions are defined as periods of sustained negative economic growth indicated by contracting GDP, higher unemployment and lower consumer spending. What this means is that incomes are declining due to redundancies or stagnating due to reductions in working hours, and consumer demand drops because we all have less spending power. The effect of a recession on jobs and aggregate demand should not be underestimated. The economic and societal consequences of joblessness are severe and scarring, and economic history tells us that it should be avoided.

With regards to inflation, yes prices are high, but employment is sustained across the workforce and some purchasing power is afforded to some, thus sustaining economic output. Inflation is also a relatively better option in tight labour markets – when there is a scarcity of workers – as is currently the case in the UK. Even during inflationary times, tight labour markets are associated with more progressive wage growth, which affects those at the lower end of the income distribution. The cost of recessions in terms of wages and employment are more regressive. Inflation, however, is a form of income redistribution in the short run, but does not directly reduce incomes in the aggregate. One person’s cost is another person’s income. As prices rise, this leads directly to higher incomes for somebody in the economy, thus sustaining more economic activity than would have been the case in a recession.

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That said, inflation negatively and disproportionately affects those at the bottom end of income distribution. And it is clear to me, as it is to many fellow economists, that the job of policy should be to help those disproportionately affected. There are ways that governments can address these disparities: there is a battery of fiscal redistribution policies that can ameliorate the pressures faced by many households, or there could be higher taxes for those at the top of the income distribution, which would spread purchasing power more equitably. Of course the danger with this approach is that our fiscal and monetary armoury to deal with the current situation would work against itself, hence the expectation that the Bank of England will announce a relatively “generous” rise in interest rates tomorrow (15 December).

At this difficult juncture, it is worth reminding ourselves that policy choices are always tough. However, on balance, the economic damage that can be caused by a recession far exceeds that caused by high inflation. If I had to choose my poison, I know which one it would be.

[See also: What if inflation falls in the wrong way?

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