Economics and politics - comment and analysis
7. October 2022 I Heiner Flassbeck I Economic Policy, Economic Theory, Europe, Forecasts

Recession ante portas – Why repeat the old mistakes?

Fifty years ago, there was a very special situation in the global economy: There was a major supply shock, oil prices rose, but oil continued to be consumed in almost unchanged quantities, oil producers made enormous profits, measured inflation rates in Western countries went up and central banks raised interest rates to fight inflation. The result was a deep recession, huge global income losses and the first wave of mass unemployment, the consequences of which have not really been overcome to this day.

Sounds familiar? Indeed, the similarities with today’s situation are striking and actually obvious. Well, you will probably say, then at least one can assume that those responsible and the experts have learned how to deal with such a constellation. But you are completely wrong here. The economic policy of the Western world is about to make exactly the same mistakes as back then. Today’s politicians know as little as they did 50 years ago, and the professionals who are supposed to advise policy are completely resistant to learning.

Why is what is happening so dangerous? Isn’t it that the world’s income is just being redistributed by the supply shock? The suppliers of energy gain, the consumers lose, nothing much changes for the world as a whole at first. If you add to this the fact that energy prices are rising and energy saving is the order of the day anyway because of the climate, there is really no need to get particularly upset.

Redistribution on a global scale

The problem today, as it was then, is that those who benefit from the high prices, who are already very rich, already hardly know what to do with their wealth. The emirate of Qatar is the classic example. Consequently, those whose incomes are rising sharply will spend far less of that extra income again than would have been spent by those whose incomes are now falling. Which means that saving in the world will increase significantly, or demand for goods and services will decrease significantly.

Does that have to be a bad thing? Doesn’t more saving automatically mean more investing? Unfortunately, it’s not that simple. The only mechanism that the prevailing neoclassical doctrine of economists has come up with that turns more saving into more investing has to do with interest rates. If saving ratios go up, the hope is, interest rates will fall and entrepreneurs will borrow more and consequently fill the demand gap that saving has torn.

Stupidly, most of the world’s central banks, foremost among them the U.S. and the ECB, are currently raising interest rates because they classify the current price surge as general inflation and feel pressured by public opinion to fight it with the means of raising interest rates – regardless of side effects. Consequently, the only mechanism that neoliberal market economists could have relied on to ensure that increased saving would not be followed by recession has not only been eliminated, but even turned into its opposite. The world’s central banks are greatly exacerbating the danger of a major recession.

Severe recession likely

But the experts’ forecasts, you will object, are not so bad after all. The German economic research institutes have just predicted a very slight drop in GDP for Germany next year, but not a deep slump if the energy situation does not deteriorate again significantly. They do not see any negative consequences for unemployment at all.

True, but you have to look closely at how the clever experts “got it right.” After all, they had to “find demand” with which they could justify that the slump would not be so bad. They “found” this demand, believe it or not, among those who have been hardest hit by the supply shock, namely consumers in Germany. The institutes’ “forecast” predicts that private households, whose incomes are falling significantly in real terms, will reduce their savings. The private savings rate will fall from 15 percent in 2021 to less than nine percent next year.

You have to imagine that: Despite extreme uncertainty due to falling real incomes, despite rising interest rates (which, for the institutes’ economists, should clearly lead to increased saving), despite recently published indicators showing that consumer sentiment has reached an all-time low, the institutes’ joint diagnosis shows vigorous consumption. This is the only way to set up a scenario in which the government can even reduce its deficit without suffering a severe recession. The gas price cap was not yet included in the institutes’ forecast.

Even more awesome: In the great demand emergency, workers are “given” high nominal wage increases (5.7 percent in 2023 and 5.9 percent in 2024), because otherwise the consumption slump on the consumption side would have had to be counterfinanced even more by a declining savings rate. The institutes find such nominal wage increases unproblematic. They write: “Despite weakening labor productivity in the wake of the recession, real unit labor costs are likely to continue to decline strongly in the current year, as wage increases do not exhaust the employment-neutral distribution margin. This should support labor demand and thus employment growth over the forecast period.” (S. 52)

This is nonsense. Nominal wage increases that would correspond to the current price push plus productivity development are by no means employment-neutral. If they fall short of this, no employment is supported. The price increases to which the current surge in the price level is mainly attributable do not benefit German employers. The deterioration in the terms of trade, which is reflected in high import prices, must of course be taken into account in the calculation of the “employment-neutral increase” in the same way as a deterioration in productivity. One wonders why these very institutes are so beloved by German employers, even though they let them walk straight into the knife.

You just build the world the way you like it. But it won’t happen that way, and one has to pity any government that has to rely on such advice. Everything points to a massive slump in consumption next year at the latest, because the savings rate will probably even rise again. Private investment will follow this slump because, with interest rates rising and demand falling, there is nothing to persuade companies to even maintain their current level of investment spending. Since monetary policy will only gradually come down from its counterproductive path, the only thing left to do across Europe to prevent the worst from happening is another massive expansion of government debt.

Every government needs serious macroeconomic advice

The political problem of economic policy advice is easy to understand. The institutions, all together, are largely financially dependent on the state. Moreover, the political orientation is currently very homogeneous (there is no dissenting opinion on the confused diagnosis), because there is no institute that is explicitly allowed to have a different theoretical position (as was once the case with the DIW). It is therefore almost impossible to predict a recession without getting into enormous political trouble. Consequently, one gives free rein to one’s prejudices, because they at least meet with the approval of one or the other government minister.

After all, the government’s decision to cap gas prices has settled the debt issue. Public debt will increase far beyond the planned level in order to provide relief for private households and companies that consume gas. Whether this will be enough to prevent a deep slump in the economy is a completely open question, because no one knows how high the state’s payments will eventually be, since no one knows next year’s gas price. Nor can it be ruled out that other types of energy will also have to be subsidized, because the unilateral relief of gas consumers meets with political resistance and the suppliers of other energy sources also have an interest in rising prices for their product, as OPEC+ is currently demonstrating.

Be that as it may, a German government that wants to live up to its responsibility – for Germany and for Europe – must immediately break away from the Swabian housewife mentality and the debt brake. It needs strategic thinking and action with outstanding consideration of the global macroeconomic context. Since neither the ministers nor the existing staffs can obviously do this, a task force should be set up immediately at the European level, staffed by personalities who are truly independent, have sufficient practical experience and represent the relevant theoretical orientations of macroeconomics.