Understanding recession and inflation

 Recession is the word that is often associated with economic downturn, and everyone thinks they know recession, but do they? Sure, there are certain historical recession that we can all agree on like to the 1920s great depression, the 1970s/1980s great inflation, the 2000s dot com bubble, the 2008 global financial crisis… and more recently the 2020s COVID-19 supply chain breakdown. Wait, was that a recession? You see, how can it be black and white, if each country defines recession differently?

 

The US defines recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales”. In Australia, UK, and many other parts of the world, recession is when there is a negative GDP growth for two consecutive quarters. In China, an annual GDP growth of less than 8% can be considered as a recession.

 

Call it what you like, the greater question is what is social impact of a recession, and why do governments want to avoid it? The most prominent aspect of a recession is excessive unemployment. When unemployment rate is high, households struggle to make ends meet, thus they cut back on spending. When household cut back on spending, low-margin businesses struggle to stay open. Once businesses start to close, it further exacerbates unemployment rate, and economy falls into a vicious cycle.

At the same time, we must acknowledge that “recessions” are not limited to contractionary economies. Inflationary economies can also lead to recession. A growing economy should be inflationary, however if inflation become too overheated, money loses value. If prices of good and services significantly increase, consumers and businesses will see a fall in real income. As living standards drop, consumers demand drops. Businesses struggle, investments are cut back, jobs are reduced, and the economy rolls down the path of a contractionary market. 

 

This is why it is important for governments to intervene with monetary and/or fiscal stimuluses. Monetary stimuluses are exercised by the central bank with an aim to boost spending power. These measures often involve adjusting the interest rate and controlling the money supply in the economy. For instance, in a recessionary economy, the reserve bank might reduce interest rate and hand out cash, so consumers have more money to spend. In an inflationary economy, the reserve bank can restrict spending and incentivise savings.

              Fiscal stimuluses are government spendings and policies that strives to boost spending. For example, infrastructure spendings and tax cuts, so consumers have jobs and in turn money to spend. Tax cuts work similarly as it allows consumers to have more money to spend, but this is money already in the economy, not newly printed money. Fiscal stimuluses are generally funded by government bonds. If economy is experiencing high inflation, government can slow down spending and increase taxes.

 

 

 So here in April 2022, where is Australia heading? To answer where are we heading, we must answer where are we now. Currently, we are facing high inflationary times due to supply shortages and high employment rates, if managed well recession can be avoided.

 

Let’s apply what we know:

Tightening of monetary policies:

-          Increase interest rate

Tightening of fiscal policies:

-          Slow down fiscal spending

-          Increase tax

-          Other policies – increase jobs, immigration

Now, let’s examine if they will work?

-          Increase interest rate

Ø  Increasing interest too much will send economy into recession as proven by history and logic is self-explanatory.

Ø  Reasonable increase should minimise disposable spending, but what if people are already struggling to pay for the essentials, like petrol, shelter, and food?

o   How can we help lower-income households without impacting too much on inflation?

-          Slow down fiscal spending

Ø  Infrastructure and amenities spending on regional areas to help housing affordability.

o   This could boost inflation further in regional areas. Will this manage inflation in the cities?

Ø  Increase social housing to help low incomers

-          Increase tax

Ø  Tax cuts for small businesses has already been announced. This is help businesses survive after the COVID impact and keep up with the increasing wages. The policy is placed to avoid recession.

o   Will this increase inflation? Or does the befit outweighs the consequence.

Ø  Individual income tax for low and middle income earners have also been given up to $1,500 tax offset. This will only come a maximum of approximately $500 once off payment from tax return.

o   The counter-inflationary effectivity is to be questioned.

Ø  A reduction of 22 cents/L on petrol for 6 months to help living cost.

-          Increase jobs

Ø  Both labour and Liberal parties are promising to increase jobs, it hard to imagine the benefit if unemployment rate is already below the government ideal. What people was is an increase in real wages.

o   Increasing employment can increase wages, though the result is either higher inflation or small businesses closing.

-          Immigration

Ø  As much as immigration is dependent on Australian policies, it is also dependent on the state of the world. Both labour and liberal are favourable toward skilled labours for immigrants, though visa numbers remain at pre-COVID levels.

 

So, it seems that if we want to resolve inflation, only interest rate and immigration are helping, everything else will not be.

 

What would I do differently? Increase interest reasonably, increase immigration, stop creating new jobs, limit tax cuts to low-income earners and small businesses, create minimum infrastructure additions in regions.

 

It is worth noting that all these monetary and fiscal tools are targeted at consumers or the demand-side. We have no tools for the supply-push inflation.