, October 05, 2022

Recession is unavoidable, then what?


  •   6 min reads
Recession is unavoidable, then what?

A recession is unavoidable, at least in the UK, but how bad will it be and then what?

It really is very simple; prices are going up, wages aren't, not so fast anyway. It is not just energy costs; it is not just that we know food prices will rise later this year; we are seeing secondary effects. Rents are rising, there is hard evidence to back this claim, but set aside the data, instead, look at rents on Rightmove. Believe me; they are rising. The evidence is plain to see.

Of course, there is also evidence of a US recession from the yield curve, which has inverted — meaning long term bond yields have fallen below the yield on short term bonds. (Historically, an inversion of the yield curve is a reliable predictor of recession.) Although, as this FT piece points out; there is nuance here and not all versions of the yield curve point to recession

I repeat my comments from above. The evidence is plain to see. You don't need a PhD in economics to understand this. Neither do you need a Masters's from the School of Life; you just need a degree of common sense.

For people on low incomes, barely able to survive at the moment, these higher costs will be crippling.

In the UK, at the time of writing, the chancellor is preparing his mini-budget and talk is he will cut fuel duty. It is a no brainier, I read. But actually, it is a no brainer. A rise in fuel duty will disproportionately affect the rich. The Daily Express, keen to appease it's demographic, calls on the chancellor to increase the state pension. But if the chancellor really wants to help, he should increase personal allowances, increase universal credit or reduce the taper on universal credit.

It is obvious; prices are going up, and so are interest rates. Interest rates are rising because of inflation, but higher rates will dip even further into people's disposable income. As a result, less money will circulate in the economy.

If we don't have a recession, then I am a monkey's uncle.

A bit of theory

According to the economic school of thought called monetarism, "inflation is always and everywhere a monetary phenomenon."

A lot of people are not getting this point. Higher prices are not the same thing as inflation. Instead, we get inflation if we see sustained higher prices. And that sustained rise, suggests monetary theory, is caused by a rise in the money supply.

Meanwhile, central banks have been busy trying to increase the money supply these last few years. Post-2008, we were told quantitative easing would create inflation, and it didn't. Post-Covid, we hear the same arguments, and this time inflation is indeed occurring

Or is it? Those who draw parallels with the 1970s may not be comparing apples with apples. Back then, we saw a wage-price spiral. Prices rose, and wages increases followed. Higher wages led to higher demand, and prices rose some more. Then, in time, unions anticipated inflation, and wages rose in expectation of inflation. What ended the upwards spiral? Was it the union reforms of that era? Was it austerity? Or was it monetary policy? It was when Gordon Brown became chancellor in the UK in 1997 that he made the Bank of England independent. Before then, UK rates were set by the chancellor, in contrast to Germany, where the central bank was always independent. Central bankers claim it was their independence that stopped inflation.

Controlling the money supply isn't so easy. Bank lending causes growth in the money supply, so interest rates as a tool to influence lending became the mechanism to control the money supply.

But sometimes, the money supply can contract; this happened in the 1930s, thanks in part to banks collapsing. Post-2008 many economists feared a 1930s style depression. That is why banks were bailed out, and central banks cut interest rates.

It sort of worked — a Great Depression was avoided (by the technical definition), but a side-effect was a surge in asset prices to possibly unsustainable levels and an increase in wealth inequality.

The cure to the 2008 crisis may have sowed the seeds to the next crisis.

Some people, such as economics professor, John Hearn, argue that central banks messed up, which will/is cause/causing inflation.

Is it that bad? There are some reasons for optimism.

Market prices

Markets have begun to reverse recent falls. As the extremely knowledgeable John Authers (who, while at the FT, called the 2008 crisis pretty well) tweeted, "Markets rallied again, and analysts think they know why: Stocks are an inflation hedge." It's logical. If prices are rising, what do you do with the money? Cash is a guaranteed way to lose money. Bonds are not so good because higher yields mean lower bond prices. Therefore, goes the narrative, investors will put their money in equities because there is nowhere else to put it.

Bitcoin is down on the year and still languishing roughly a third below the 2021 peak — which is odd because Bitcoin was meant to be a hedge against inflation!

Bitcoin passes a test, but does it matter?
While stock markets saw sharp falls, Bitcoin and other cryptocurrencies surged on the Russian invasion of Ukraine. Bitcoin has passed a test, but does that test matter?

Gold is up significantly this year, although its price has fallen recently while stock prices increased.

The gas price has fallen significantly in the last few days, halving in less than a week — although it is still more than double the five-year average.  It's an encouraging trend, all the same.

Brent Crude oil hit its highest level since 2013 a few days ago; it has fallen a little since then.

Look beyond the here and now

Many of the price rises we are seeing are temporary. So, will oil and gas will fall back eventually? Of course, they will, they always do, and such is the opportunity created by renewables that energy costs are likely to be much lower in a few years.

Food prices will rise in 2022 but fall in 2023. Ukraine and Russia are significant grain exporters but account for hardly any soybeans or rice. Other grain-producing countries will adapt, it will take time, but in a year to 18 months, food prices will be downwards.

Between them, Russia and Ukraine account for 7.3 per cent of global wheat output and 2.6 per cent of global corn production. These percentages represent big numbers, but not excessively so. Rice and soybeans output in the two counties is tiny. As Aaron Smith says: "A reduction in wheat exports from Russia and Ukraine may lead farmers in other countries to plant more wheat and less corn, and it may cause consumers to eat more rice and less wheat."
Consequences of the Ukrainian crisis part one
What are the consequences of the Ukrainian crisis? This will become clearer over the next few weeks, but here is the Techopian’s first take:

As for the rent and house prices, the big shock is yet to materialise. As companies adjust to the permanent shift to remote working, office space will become vacant. In time, this space will be converted into residential. We will see a surge in residential supply. House prices will fall. So will rental costs. This effect will take three to five years to roll out.

Falling house prices could cause another recession, as falling house prices hit the net wealth of property owners.

The effect of falling house prices will be deflationary.

Technology will come into play. Later this decade, we will see the emergence of autonomous cars and robo-taxis. This shift will lead to a sharp fall in demand for cars.

The fall in car demand will also be deflationary.

Central banks will respond to deflationary pressures by cutting interest rates.

During the second half of this decade, interest rates will be back to zero.

But as a consequence of falling house prices, wealth inequality will fall. In addition, for a variety of reasons, including lower energy costs, cheaper transport and lower rent, disposable income will rise.

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