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Recession: medicine that's worse than the disease
Some experts say we need a recession to bring high inflation down. That's incorrect. Their model of the economy and views on what's causing inflation risk making a bad situation much worse.
Macroeconomists often make blunt statements that are hard to unpack and inform major policy debates. For example, here’s my back and forth with Olivier Blanchard:
Hint it’s not about sleep. My translation:
Him: Phillips Curve is the right model, and inflation is primarily demand.
Me: No, it’s the wrong model, and inflation is primarily supply.
Today’s post unpacks that disagreement.1 I explain why some macroeconomists say we need a recession, maybe even a severe one. And why others like me disagree.
Before I dive in, no macroeconomist wants a recession. We know high unemployment is terrible. We also know high inflation is a real hardship. The policy question is how to get the high inflation now down. That’s where the models, the data, and the judgment come in; that’s when it gets contentious.
A recession is worse than inflation
Full stop. The costs of a recession are wide-ranging and long-lasting. The pain goes way beyond the unemployed. Raises, promotions, and moving to better jobs are rare. Over-time is cut, and part-time is more common. Those who finish school have trouble finding a job.
And that’s just the labor market. Small businesses, startups, the arts, local governments, and on and on take a hit in a recession. Letting this strong recovery go would be tragic.
Inflation is indeed a hardship. The price of necessities like food, gasoline, and housing has jumped since the pandemic began. It hit the families with the least the hardest since more of their spending, even before Covid, is on necessities.
Keeping up with the high inflation on these necessities takes real money. Low-income families must spend over $300 a month extra on these three items. Higher-income people need to spend even more but have considerably more income and room to cut back on discretionary purchases.
As bad as inflation is now, a recession would be worse. A lost paycheck would be a much bigger problem than covering the extra costs of inflation now. And it’s the workers at the bottom who are the most likely to lose their jobs. In “Who Suffers During Recessions,” Hilary Hoynes, Douglas Miller, and Jessamyn Schaller find:
that the impacts of the Great Recession (December 2007 to June 2009) have been greater for men, for black and Hispanic workers, for young workers, and for less educated workers than for others in the labor market. While the recent recession was deeper than several other recent downturns, the pattern of unemployment and job opportunity cycles across demographic groups has been remarkably stable in recessions since at least the late 1970s.
Trading hardship for disaster is not the way to do policy.
So, why does anyone say we “need” a recession?
A model and an opinion about inflation today.
Let’s meet the model: the Phillips Curve. It says that inflation goes down when unemployment goes up and vice versa. Here’s a chart from Greg Mankiw’s textbook.
The intuition is straightforward: when unemployment falls, people have more income and spend more. Demand increases faster than supply, and we get higher inflation. See this piece by Kristie Engemann for a clear explanation of the model.
There’s intuition, and then there’s reality. The Phillips Curve was born in the 1950s and matched up fine with the data then. Not so much, not at all, since the 1970s.
There are fancier versions that may not look as bad, like the New Keynesian Phillips Curve, in which inflation expectations play a huge role. If they become unanchored, all hell breaks loose. An even scarier one is the accelerationist Phillips Curve, which takes off upward once inflation starts rising. Regardless of the flavor, you can see why believers of the Phillips Curve and demand-driven inflation caused by the Rescue Plan and low-interest rates say, “we need a recession.”
One clear thing in the real world is that if the Phillips Curve exists, it’s much flatter than in the past. See the cloud above. This means the relationship is weak, so you would need a lot more unemployment to bring inflation down a bit. Inflation needs to come down more than a bit. So, that’s how we get. “We need a severe recession. We need 10% unemployment.”
What’s my opinion? The Phillips Curve is the wrong model. It’s not stable enough for high-stakes policy advice. It is not even clear it exists. And it is especially the wrong model now. The logic of the Phillips Curve is about demand-driven inflation. Supply disruptions have caused a lot of today’s high inflation. There is no increase in the unemployment rate that would unload the containers, re-open China, defeat Putin, open child care centers, produce chips, drill oil, grow wheat, build apartments, etc. A recession could make some of these problems worse. Inflation would likely come down in the recession, but the underlying problem would remain.
What we need is action and not from the Fed alone
Another problem with using the Phillips Curve for policy now is that it leads to pressuring the Fed alone to get inflation down. The Fed cools demand and the labor market by raising interest rates. The experts who see demand as the main problem are blasting the Fed for not raising rates sooner, calling on them to raise them faster, and warning them not to stop even if it causes a recession.
But again, the Fed cannot fix supply-driven inflation. That’s why it waited last year. Then Covid came back, and then Putin. It is raising rates now, which makes sense; some of the inflation is from demand and is spreading. Even so, Fed officials have said repeatedly that they are not trying to cause a recession, and we don’t need one. That’s not just a nice talking point. It’s their model and view on inflation.
I am not worried (too much) about the Fed. I am very worried about Congress. They need good policy advice, and macroeconomists' current debates are a mess. If, as a member of Congress, all you hear is that inflation is high, government spending caused it, and the Fed will clean it up, you might decide it’s best to do nothing.
That seems to be where Senator Joe Manchin is.
It’s frustrating. Every part of the legislation Manchin put on ice would reduce inflation:
Lower prescription drug prices.
Avoid a spike in ACA health insurance premiums.
Support domestic energy production—renewables and fossil fuels.
Raise taxes on the rich.
Only Congress can do these programs, not the Fed. And that legislation only scratches the surface of how Congress could invest in our people and our planet. We don’t need a recession. We need Congress to step up.
Being right for the wrong reason can be a big problem. If you misdiagnose the disease, you will likely prescribe the wrong medicine. You won’t cure it, and you could make it much worse.
The experts who say “we need a recession” or big payroll numbers might be a “nightmare” are those who warned that the Rescue Plan would spark high inflation. Inflation did pick up a lot. They were right about the direction. But, while the Rescue Plan played some role, it is not the reason for the inflation. Covid and the war in Ukraine caused massive, ongoing disruptions once you accept that it’s time to back away from the Phillips Curve.
We need many things today, but a recession ain’t one of them.
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This post is my take on the disagreement among macroeconomists. It is a simplified version. I have not asked Olivier Blanchard or anyone else to weigh in. So the errors are my own. I welcome anyone who wants to correct me.