Analysis: ECB interest rate rises to try to curb inflation are fuelling fears that Europe could see a recession so what could that mean?
The European Central Bank rose interest rates again recently because they are concerned about rising inflation. While this is an economically sound strategy to reduce inflation, there are fears it will send Europe into a recession. To reduce inflation, you need to decrease the money supply within the economy. However, by doing this, you will most likely cause a recession.
But there are a few uncertainties about this recession. When will it happen? How bad is it going to be? What will it mean for people?
When could it happen?
Nobel prize winning economist, Paul Krugman, once said that no one can predict economic growth exactly. This makes him a complete rarity in academia – a person who isn't afraid to say, 'I don’t know’. Krugman is exactly right.
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From RTÉ Radio 1's News at One, RTÉ Economics Correspondent Robert Short reports on CSO figures that the domestic economy in technical recession at end of 2022
One of the first things that undergraduate economic students are taught is that our ability to predict the exact turning points of short-run economic growth is limited. David McWilliams illustrated this when he went on The Late Late Show and famously predicted the 2008 crash would happen within 18 or 24 months. Something that isn't often brought up enough about this prediction is that McWilliams made it in 1999. This is a good demonstration of the old saying that 'economists have successfully predicted six of the last five recessions’.
This means that anyone who tells you (with exact certainty) when the next recession is coming is a liar. We don’t know. What we do know is that increasing interest rates will end up reducing investment and consumption. When that happens, GDP will go down and there’s your recession.
How bad is it going to be?
Recessions come in different shapes and sizes. The 2008 recession is referred to as the Great Recession and was the worst recession since the Great Depression in the early 20th century. It is very unlikely that the coming recession will be as bad as either of those. The reason for this is that this recession isn’t necessarily resulting from a collapse of a certain industry within the economy.
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From RTÉ Radio 1's Today With Claire Byrne in Aug 2022, UCC economist Seamus Coffey and Age Action Ireland's Celine Clarke dicuss if we're facing another recession
What happened in the lead up to the Great Recession was that loads of people were given loans and mortgages very easily. This drove up prices and incentivised people and firms to take out more loans and invest even more. Then eventually the bubble burst when people couldn’t pay back their loans or make money off their investments.
Essentially, the housing market collapsed because loads of money was being invested into it when there wasn’t that much underlying value in housing. This meant there were major sectors of the economy, like construction and real-estate, with major structural issues. Couple this with the fact that loads of businesses and households had built up major debts, and you got one of the worst recessions in history. That’s not exactly what this recession will look like.
As can be seen above, Ireland's GDP has been on an upward trajectory since 2013. This is when we started the recovery from the 2008 collapse. The ECB had been engaging in monetary easing in order to increase the money supply and incentivise spending.
While this strategy helped the economy, it continued for quite a while. More and more money kept being pumped into the economy and then, suddenly, the Covid pandemic happened. Major restrictions were needed which meant production decreased, but government spending was also required to fight Covid. This meant there was even more money required to help the economy without a lot of production to match it. The result was major increases in inflation.
All of this inflation exacerbated the on-going cost of living crisis, which is why the ECB wanted to increase interest rates. The potential in-coming recession, then, will likely be attributable to the ECB trying to reduce inflation, rather than because there is something structurally wrong with certain industries in the economy. This doesn't mean there won’t be negative consequences like reductions in income or job losses, but it does mean that the recession is likely to be far less severe than the 2008 one.
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From RTÉ Radio 1's The Business in July 2022, how likely is a global recession? With Brown University economist Mark Blyth
What will it mean for us?
When economists use the term 'recession', they are referring to a very specific trend. This is two consecutive quarters of decreasing real GDP. Meaning that a recession is technically just a drop in productivity. This is measured by the total value of consumption, investment, government spending, and net exports within the economy. So, the only thing you can be sure will happen to people during a recession is that they will buy less goods and services than they did previously.
Where it becomes tricky is if this reduction in consumption produces more severe consequences. A key concept of macroeconomics is that your spending is someone else’s income. It’s easy to think about a reduction in consumption as people simply spending less money.
This is the fine balancing game that the ECB and governments around the world are engaged in with their monetary and fiscal strategies
But less money spent on products means less revenue for firms. This can lead to reduced hours for staff which further reduces their income. A reduction in their income leads to a further reduction in their spending and before you know it the recession gets deeper. Eventually unemployment starts to rise amid business closures and GDP falls even more. All because the ECB wanted to reduce inflation.
This is the fine balancing game that the ECB and governments around the world are engaged in with their monetary and fiscal strategies. Too much inflation and you’ve got economic bubbles and cost of living crises. Too great a cut in consumption and you may spiral the economy into a difficult recession which reduces incomes and livelihoods.
The views expressed here are those of the author and do not represent or reflect the views of RTÉ
