Exactly what sort of recession would a Brexit create? The answer matters a lot

Why does it matter? Because different policy medicine will be appropriate depending on what type of recession it is

Ben Chu
Sunday 05 June 2016 11:41
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Priti Patel, Michael Gove and Boris Johnson on the Vote Leave campaign bus in Lancashire yesterday
Priti Patel, Michael Gove and Boris Johnson on the Vote Leave campaign bus in Lancashire yesterday

“A technical recession.” Mark Carney, the Governor of the Bank of England, has warned that’s what we might get if the British people vote for Brexit on 23 June. Christine Lagarde, managing director of the International Monetary Fund, concurs. Chancellor George Osborne has, unsurprisingly, shouted the warning from the rooftops. Many economists are more circumspect about using the “r” word. Yet very few analysts expect zero economic impact in the event of a Leave vote.

So what sort of recession might it be? Does it matter? Aren’t they all painful? Jobs are lost, incomes fall, resources stand idle. They all hurt. But it’s worth asking the question. Olivier Blanchard, the former chief economist at the IMF, is interested in the answer. So is Larry Summers, who narrowly missed out on being appointed chair of the Federal Reserve. The two economists have been looking at various “types” of recession lately.

And they broadly identify three categories. There are “supply shock” recessions, “demand shock” recessions and recessions that are brought on by lowered expectations of growth from a population, what they call “reverse causality” recessions.

First, supply shocks. This is where an economy is hit by something unexpected and out of the blue that impedes its potential to grow at the previous rate, such as sudden spike in global oil prices or a credit crunch brought on by a banking crisis. This shock tips the economy into recession.

Demand shocks are when there is a sudden stop in spending by households or businesses. This hits aggregate demand in the economy and brings on the recession.

Reverse causality recessions are the most controversial and hardest to identify. This is when businesses and households, supposedly, perceive that underlying productivity growth is slowing down and that their future incomes will be lower, even if headline GDP is still growing strongly, and they cut back spending in response, which ultimately brings on the GDP contraction.

Why does it matter? Because different policy medicine will be appropriate depending on what type of recession it is. A supply shock will likely lower output growth relative to the old trend rate of expansion for good. The old rate of growth was not sustainable. Stimulus can help stop the bleeding, but there is not much that can be done in terms of pushing the economy back up to the old trend, at least not without prompting a bout of damaging inflation.

But a demand shock argues for a big dose of stimulus to achieve precisely that. Otherwise resources that could be used, without generating inflation, risk wasting away. A demand shock recession causes unnecessary long-term damage in terms of unemployment, a loss of skills and idle equipment.

Reverse causality recessions, like supply shocks, are also not very amenable to stimulus.

But which type of recession is it? The answer is that, as Summers and Blanchard concede, it can be very hard to tell. Take the 2008-09 recession. This was associated with subdued inflation before the crisis, suggesting a demand shock. But it was also a global financial crisis, commonly associated with a supply shock. Some nations – notably the US and the UK – also witnessed a productivity slowdown in advance of the crisis, arguably pointing to a reverse causality correction.

This is the dilemma of central bankers and governments. It is very hard to unpick reasons for a recession in real time. There can be simultaneous hints of both a supply and demand shock. And a demand shock can, if it persists long enough, end up lowering potential supply, confusing the picture. Different policymakers can advance arguments for and against stimulus depending on how they interpret the data, which is often only still fragmentary when the decisions need to be made.

Is it then an impossible dilemma? It really shouldn’t be. A combination of high inflation and weak growth certainly create a headache for policymakers. But where there are very clear disinflationary pressures – as there have been around the world for the past decade - the greater risk is clearly in underdoing stimulus, whether through monetary policy or fiscal policy.

If there is too much stimulus applied and inflation spikes, that can relatively simply be tackled through a central bank raising interest rates to bring price growth back down to earth. This is not costless, but if one believes in the independence and authority of central banks the cost can certainly be contained.

But if too little stimulus is applied, whether through dithering by central banks or by an excessive zeal by governments to cut budget deficits, irreparable damage can be inflicted. Output that might have been enjoyed, without inflation, if there had been sufficient aggregate demand, can be lost for good. Worse, the economy’s potential growth rate might, Summers and Blanchard suggest, even end up being permanently lowered if skills are wasted.

So what if the UK did go into recession in the wake of a Brexit vote? Would this be a supply shock or a demand shock or even an expectations correction? Should the Bank cut rates into negative territory in an attempt to spur spending? Should the Treasury slow the pace of fiscal consolidation? The Bank of England and the Treasury would obviously have to ask these questions. But the right policy would surely be to stimulate and see.

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