Recession or Inflation? Governments around the world must pick their poison
If you're running a country right now you are looking down the road at a pretty bleak choice.
A bleak choice has a lot to do with why Liz Truss's term as Prime Minister had such a short shelf life.
The choice: Inflation vs. Recession. Are you going to try and bring down inflation or are you going to try and stave off or soften a coming recession? Doing both at once is probably not possible because what puts one fire out adds fuel to the other.
Where is the poison?
The situation brings to mind a scene from one of my all-time favorite movies: The Princess Bride. It's a battle of wits between the dashing man in black (Cary Elwes) and a Sicilian kidnapper (played by the wonderful Wallace Shawn).
The game? Try and guess which goblet of wine has been poisoned.
"Where is the poison?" asks the man in black, placing a goblet of wine in front of himself and another in front of the Sicilian. "The battle of wits has begun. It ends when you decide and we both drink, and find out who is right... and who is dead."
The Sicilian launches into a dizzying logical breakdown of the situation: The man in black is strong and might have poisoned his own cup, thinking he could survive it, "so I can clearly not choose the wine in front of you!" Then he counters that his adversary is also smart and would never poison his own cup, "so I can clearly not choose the wine in front of me!"
The Sicilian finally picks a cup, they both drink and the man in black tells him he chose wrong. The Sicilian triumphantly announces that he secretly switched the goblets and has avoided the poison! In the middle of the laughing fit, he dies. As it turns out, both cups were poisoned.
Policymakers, pick your poison
If you're running a government right now, you may feel a bit like our poor, doomed Sicilian: Are you going to focus your efforts on defeating inflation, even if it means a recession that shutters businesses and throws millions of people out of work? Or will you try to avoid a recession at all costs even it means living standards devastated by the soaring costs of inflation and a wrecked currency? There is no choice that does not involve serious economic pain.
UK Prime Minister Liz Truss went hard in the direction of staving off a recession. She came into office promising economic growth by means of tax cuts, and also relief for consumers by means of help with rising fuel prices.
Truss made some major missteps early on. "She went even further than what she'd promised on the campaign," said Soumaya Keynes, Britain economics editor at The Economist magazine. In addition to the planned tax cuts, Truss rolled out a tax cut for some of the wealthiest Brits and it didn't end there. "Then there were briefings saying that the government might go even further and announce even more tax cuts," said Keynes. "They were really going for it."
Investors, economists and market analysts began to voice criticism of the plan, pointing out that there didn't seem to be a plan to pay for the tax cuts, not to mention the increase in government spending that would be required to offset rising fuel costs, as Truss had pledged.
What's more, Truss failed to submit her economic plan to the UK's independent budget office, which usually weighs in on government economic policies and delivers a forecast. "That sort of added to the bad vibes," said Keynes.
There were bad vibes a-plenty. President Joe Biden even slammed the plan on Twitter, calling it "trickle-down economics" a pejorative term often used to describe the idea of cutting taxes to grow an economy.
I am sick and tired of trickle-down economics. It has never worked.— President Biden (@POTUS) September 20, 2022
We're building an economy from the bottom up and middle out.
When I asked economist William Gale, director of the Tax Policy Center at Brookings, about the Truss' plan for the UK's economy, he actually lost words for a minute.
"It's just... It's... I just. It was just such a bad idea in their circumstances," he said. "Tax cuts are expensive." Not only was there no plan to pay for those tax cuts (Truss simply asserted that they would eventually pay for themselves, though tax cuts have a mixed history of doing that), but also the UK is struggling with serious inflation right now. Prices are rising in the UK at a rate of more than 13%. Tax cuts and government aid seemed likely to make inflation worse because they both pump money into the economy. When people and businesses have more money, they tend to spend it, and that increased demand tends to push prices up. That is not what you want to happen when you're fighting inflation.
Things started to go really weird
Soumaya Keynes worried about the financial fundamentals of the plan. But she also thought it might not be so bad since the UK is one of the strongest and wealthiest economies on the planet. Surely global investors and institutions would continue to invest in the UK and lend it money, even if the plan wasn't rock solid. "My immediate reaction was that this was bad, not ruinous," recalled Keynes. "Then things started to go really weird. Something was wrong."
International investors cast their own kind of no confidence vote on Truss' plan and started yanking money out of the UK. The country's borrowing costs went through the roof, as if investors didn't have much faith the country would be able to cover its debts. The Bank of England had to jump in and take emergency measures.
This was really shocking. What was happening was something that usually only happens in countries that are in terrible economic crisis and in danger of total collapse. "There was this real sense of almost panic," said Keynes. "There was a definite financial crisis-style event happening and that really added to this sense that something was really broken."
Keynes' theory is that Truss plan to spend with abandon to grow the economy and avoid a recession might have gotten a pass from international investors in another situation. But right now there is a low tolerance for bold moves--investors want things to add up. "It's just a much more hostile environment and a much more dangerous one in which to take this kind of economic gamble," said Keynes. "Investors are not feeling great about where the world is headed."
Inflation vs. Recession
Economist William Gale said we should all take note of what happened in the UK. He said although Truss' plan had clear flaws, the global economic situation also played a big part in recent events.
"They have high inflation and they're worried about their fiscal sustainability and their monetary authority and they're trying to grapple with inflation versus recession," said Gale. "And if that sounds a lot like the us, that's not surprising."
Gale pointed out that right now governments are in a particularly tricky situation. Are they going to go hard after inflation or are they going to try and help people and businesses now and hopefully stave off a bad recession? Which poison will they pick?
An inconceivable choice
Here's the problem: Bringing inflation down (a.k.a. lowering prices across the economy) usually means raising interest rates, which basically binds an economy and prevents it from growing quickly. When interest rates go up, it gets more expensive to borrow money, so people and businesses tend to borrow less money and spend less money. They buy less stuff. Because they buy less stuff, demand for stuff goes down and that eventually brings down prices. Voila, inflation solved!
But people not buying stuff also means companies are selling less stuff, making less money and are less inclined to grow, invest and hire new people. They may even start laying people off scaling back plans to grow. Raising interest rates holds down economic growth and it is a painful solution. When Fed Chair Paul Volcker tackled inflation back in the 1970s and 80s, it plunged the country into a deep recession and millions of people lost their jobs. Millions of jobs lost, businesses shuttered, lives damaged? Surely a government cannot choose that cup.
You should see the other cup
Except that the other cup risks something pretty terrible, too. Avoiding or softening a recession usually means pumping money into the economy. In that way a government keeps money flowing through the system to people and businesses. This encourages people, businesses and banks to keep spending, investing, hiring and growing. But all of that can make inflation worse.
If an inflationary spiral takes hold, it can totally destroy a currency and an economy. It also decimates lives: Imagine your savings all goes up in smoke? Imagine you're paying $20 for a cup of coffee? Imagine you work all day and barely make enough to pay for lunch? This destructive inflationary spiral has happened in countries like Brazil, where it caused decades of terrible pain, from which the country's economy still hasn't fully recovered. Surely a government can't choose that cup.
Right now in the U.S., the government's doing a bit of both: Federal Reserve Chair Jerome Powell is raising interest rates and the White House is also doing what it can to keep fuel prices low, cancel student debt, and get aid out to people in various ways. Right now, inflation in the U.S. isn't spiraling and the economy is looking fairly solid. But if that changes, which it could very quickly, we could find ourselves picking our poison and feeling the consequences of it for decades to come.
There is still the great hope of the so-called soft landing: The idea that raising interest rates now might calm inflation enough that the choice isn't necessary and our government can avoid having to make such an inconceivable economic decision.
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