Recession Vs. Inflation: What Should the Treasury Focus On?

 by Miranda Worley and Kimberley Leighton-Smith

It’s mid 2022 and 2 major threats to the stability of the UK economy are getting a lot of media attention: a looming recession and rapidly rising inflation.  Traditional economic policies to combat these problems conflict - so which should the UK treasury focus on? 

MJW and KLS argue for different priorities in the coming months.

MJW - We must avoid recession

Gross Domestic Product is the sum of output of the economy - it is the key measure of our economic activity.  Our economic activity pays for everything else - the more GDP grows the better we are able to afford the goods and services that make our lives better, such as food, healthcare, education and holidays. A recession is 2 successive quarters (6 months) of negative GDP growth.  GDP fell by 0.1% in March 2022, after 0% growth in February. This could be an indication that we are already approaching the valleys of the next recession, but that we won’t know it for another 6 months or so. 

Brexit, Covid-19, labour shortages, conflict in Ukraine; all contributing factors to the current economic uncertainty that is certainly choking off UK GDP growth, as firms delay and cancel investment and expansion, household budgets don’t expand sufficiently to cover costs. The media focus understandably on the standard of living crisis hitting many families unable to heat or eat, which will only get worse for more and more families if we enter a recession. 

The Keynesian solution is for the government to stimulate the economy, which will in turn provide more income for the average Brit. How could the government do this now?  Fiscal policy requires tax cuts or increased government spending, particularly aimed at increasing the incomes of those with lower household incomes because they tend to spend more of their income, which will in turn stimulate the economy.  A cut in VAT (a regressive tax) would work, as would an increase in benefit levels for the poorest, such as pensioners or recipients of Universal Credit, or even an increase in NLW for the lowest paid adults.  This would inevitably raise inflation, but the current levels, although high by 21st century norms, are still relatively low compared to the rates in the 1970s, when I can remember it peaking at 24.21%.

Poverty is entirely preventable - and brings with it such a waste of human potential that surely avoiding recession should always be the primary focus of government policy. We must raise household incomes in the short-run to stimulate growth: lower taxes, higher benefits and higher wages will save the day!

KLS - we must reduce inflation

Annual inflation rate in the UK jumped to 9% in April, the highest level since 1982, prompted by rising prices for electricity, gas and other fuels, motor fuels and second-hand cars, in another sign consumers' living standards continue to squeeze. It compares with a rate of 7% in March and forecasts of 9.1%.

Reviewing every recession that the UK has had, there is one common denominator: uncertainty, and a lack of confidence. And by confidence, I am not talking about hair flicks after a cut at the salon. For individuals, this is confidence that they will be able to pay their essential bills and mortgage/rent, confidence that they will be able to hold onto their job and not be made redundant. For businesses, confidence is linked to future profit predictions: confidence that they will continue to make sales, confidence that revenue will be higher than costs, confidence to grow and expand. For both the individual and the business, the result of a lack of confidence is the same: they stop spending.

GDP as referenced above by Mrs Worley can be calculated by looking at total spending, or aggregate demand. This comprises individual spending (consumption) spending by firms on capital to expand production capabilities (investment) spending by the government (known, unsurprisingly, as government spending) and spending from foreign customers buying UK goods, minus spending by UK citizens on goods produced abroad. If people do not have confidence, they will not spend. Whether you have a PHD in Economics, or think Boris Johnson is a slightly shady tennis star from the 80s, almost everyone will know, even if they do not fully understand why, that high inflation is bad. Inflation means prices are going upwards, for almost everything. Imagine your boss telling you that, actually, they have decided to cut back and as of tomorrow, you will be paid half your usual salary, and that this may well go down to a quarter next month. This is an extreme example, but this is what inflation does: the money you have is worth less than before in terms of the products and services you can buy. So unless wages rise at the same rate as inflation (which is rare anyway, and basically unheard of at the rates needed to maintain spending power) I will illustrate this with an example:

The humble chomp bar. I used to have these as a treat at my dance lessons when I was 11 (a huge ten years ago now……..or maybe more) They were 10p. Now, they are 49p. Have salaries on average increased by 490% No. And this is against a backdrop of decades of low, predictable, ‘safe’ inflation. Given current rates of inflation, what might you be paying for a chomp bar in 28 years time (those of you good at maths can work out my age now) 

Now whilst the thought of a chomp bar becoming unaffordable is unlikely to fill you with fear, if you are a person already struggling to make ends meet, further impending fuel and food price rises will. People are starting to lose confidence. These little flames of doubt will be being stoked into an inferno by the media: an entity which is far more powerful than it was around our last time of high inflation. As we can see from the recent pandemic, the media loves to sensationalise, and it is inescapable: news stories, notifications and pop ups, facebook posts, instagram posts, the list goes on. The scaremongers are out again in full force and any attempt of the Bank of England to reassure us inflation is temporary, nothing to worry about, that it will correct itself, is the equivalent of a mumble behind a fist competing with the entire Year 13 cohort with megaphones - it has not reassured, they cannot compete or override the panic.

So what will happen? People will start saving - what used to be a rainy day fund that you might add to if there happened to be anything left at the end of the month now becomes serious ‘survival funds.’ If people are saving, they are not spending (consumption falls) Firms start to scale back investment plans, they are not going to commit to big projects when they have no idea what they will cost from one day to the next. (investment falls) As inflation climbs, UK goods become more expensive to foreign buyers. Particularly if their own inflation rates are lower than ours. The result? People stop buying from the UK (exports fall)

If all of the above happens, GDP will fall. Which causes a recession.

Are recessions bad? Yes, and of course, we want to avoid one. But this is impossible without getting inflation under control. Therefore, inflation needs to be the priority. How to solve that will not be easy, and is a topic for another article, but it should definitely be the priority if we are going to prevent a recession, and so, to answer the question of what the treasury should focus on, the answer is inflation.