A recession that is sweeping in like a tornado to devastate the developed world

Yesterday, the ECB raised its key interest rate by ¾ of a point, immediately making mortgages more expensive for all Europeans. The ECB’s aim is not to cool down an overheated economy – given that the European economy is not overheated – but to prevent the dollar from continuing to rise in value, since oil is paid for in this currency and the exchange rate has become the main driver of inflation. It is becoming increasingly clear that this crisis bears a growing resemblance to the worst crises of the last century – following the Great Depression of 1929, the oil crisis of the 1970s, which left the developed world in tatters and developing countries facing a crisis that took them more than twenty years to overcome – and from which some have still not recovered.

28 October 2022 Reading time: 4.10 mins

We are in the midst of a crisis which, unfortunately for us, is coming to resemble more and more the so-called oil crisis of the mid-to-late 1970s. A military conflict, a dramatic rise in oil prices and a perfect storm of so-called stagflation.

“There are too many parallels with what may well have been the worst crisis since the Great Depression of ’29 – the oil crisis of the ’70s”

A buzzword that lacks any quantitative definition and is therefore not a technical term. This buzzword was coined as a joke by a Tory minister in the late 1950s to describe – to put it loosely – an economy characterised by high inflation and poor growth. Without getting into the trivial debate over whether or not a recession is necessary for there to be stagflation, what nobody can deny is that many countries have been in a real recession for a long time.

“To be in stagflation, you don’t have to be in a recession; as long as the gap between growth and inflation is huge, we should already consider the principle to be fulfilled”

Economists – or at least some of them – agreed that a recession was defined as an economy experiencing ‘negative growth’ for two consecutive quarters; but, to avoid committing themselves too firmly, they added the adjective ‘technical’ to the term, resulting in ‘technical recession’, which did not necessarily have to correspond to a full-blown recession. And I’m going to explain why.

If an economy has experienced extremely strong growth but then suffers a sharp downturn due to an external event – such as a virus – when it recovers so quickly, it goes through a period of stabilisation that will involve adjustments. It’s like a spring. If we stretch it too far and then release it suddenly, it will overshoot before returning to its original position.

“When an economy grows rapidly from a very low base, it needs a period of stabilisation, which may involve brief periods of decline”

A perfect example can be found in the US. Its economy was severely affected by the lockdowns, but during this period there was a massive build-up of savings – what is known as ‘pocket savings’ – which in this case was staggering. Consequently, when restrictions were lifted, private spending soared and the economy recovered extremely quickly. So much so that it subsequently had to stabilise and experienced two quarters of the ‘negative growth’ I mentioned earlier.

According to the theory, its economy had entered a technical recession, but this was far from being a real recession.

So what should we look at to know whether we are actually in a recession? Well, one factor that everyone will understand: everyday life. Employment and private spending by citizens. Sooner or later, both of these will be reflected in the macroeconomic data.

If people’s spending habits change due to a fall in their disposable income beforehand

or they will eventually affect employment. Higher unemployment leads to lower private spending, and it is this cycle that triggers the real recession. Spain, together with Argentina, were the two OECD countries whose economies were hardest hit by the COVID crisis. Spain is also the only country among the 29 EU member states that has not yet recovered its pre-crisis GDP levels. And we are still quite a long way from achieving that.

“Any recession is a self-perpetuating cycle: lower consumption leads to higher unemployment, which in turn leads to even lower consumption.”

We have just seen that the ECB has raised interest rates by ¾ of a point and, at the same time, its message has hinted at at least two further rises of ½ a point, which will bring the key interest rate to 3 per cent before long.

I have heard many colleagues say that it is a sensible measure to reduce consumption and cool the economy.

Do any of my readers see people in the streets in a spending frenzy? I’m sure not – and that is precisely why we haven’t yet returned to pre-COVID levels.

“In Spain, own-brand products first appeared in the late 1980s, but they really took off during the 2008 financial crisis”

Before the 2008 crisis, Mercadona was a complete unknown to many Spaniards outside the Valencian Community. Its success came about thanks to the shrewdness of an entrepreneur who recognised that what customers needed at a time of reduced disposable income was a product of sufficient quality, but at a significantly lower price. It no longer mattered what marketing messages consumers were receiving; survival was the priority.

Well, you can’t deny that we’re in exactly the same situation, or very much the same one, right now. So why is the ECB raising interest rates? Even though the economy isn’t overheating, even though consumer spending is already slowing down of its own accord, and even though unemployment is rising, particularly in southern European countries? Well, it’s because the main driver of inflation – oil – is paid for in US dollars.

Around 92 per cent of the world’s oil is used in transport – that is, to produce motor fuels – which therefore affects the final price of all products.

The US economy is indeed overheating due to its extremely rapid recovery, fuelled by pent-up savings; this, combined with the rise in oil prices, has led to inflation that can only be tackled by raising interest rates and reducing the money supply in circulation – or, to put it simply, by reducing the amount of money in circulation.

To combat inflation, the Fed uses its tools and raises the key interest rate with the aim of curbing consumption and thereby cooling the economy, thus reducing the inflation that is plaguing it. However, this makes investing in dollars more profitable than investing in other currencies, so as demand for dollars increases, the dollar strengthens.

“The exchange rate against the dollar has become the main driver of inflation in the economy”

But we Europeans pay for oil in dollars, so the stronger the dollar is, the more expensive it will be for us and the more inflation it will cause. At the time of writing this article, the dollar/euro exchange rate is the biggest driver of inflation in Europe, even more so than the rise in the price of a barrel of oil.

So the ECB has no choice but to raise its key interest rates – not to cool the economy, which is already in a slump, but to prevent the dollar from appreciating further and fuelling inflation in the economy.

The trouble is that, as the cause of their inflation is different from ours, they can achieve their objective whilst minimising the damage, whereas we will only achieve ours at the cost of real hardship along the way.

We will only achieve our inflation-reduction target by exacerbating the crisis and causing the recession to reduce consumption even further in its own right.

Does this mean that the ECB is wrong, as the Minister for Social Affairs claims? Far from it. The ECB is doing this to control the exchange rate against the dollar.

“The ECB cannot use its other weapon to tackle inflation unless governments such as the Spanish government drastically cut public spending”

But the ECB has another option, which it cannot use effectively because it requires coordinated action by governments. And that option is to drastically reduce the money supply in circulation. For this to affect inflation but not consumption, the only way forward is for the government to make a drastic cut in public spending.

If the government drastically cuts public spending and this is accompanied by a reduction in the money supply in circulation, the decrease in the amount of money in circulation will not affect consumption, but it will make access to money more difficult and therefore reduce inflation. This will lead to a reduction in inflation. It’s simple maths.

Well then, to conclude, don’t let them fool you. As things stand, the US is not in recession, but Spain and the rest of Europe certainly are, or will be very soon.

The Spanish Government bears a great deal of the blame for what is happening because it is taking exactly the opposite measures to those we need to get out of a hole that is getting deeper and deeper. It does nothing but increase public spending when what it should be doing is cutting it; just look at the consequences – things are getting worse every day.

And to round off, the renowned professor – known as the prophet of the ‘subprime crisis’ – Professor Roubini of New York University has predicted that we are heading for a crisis just as bad as that of the 1970s. I don’t know whether he’ll be 100 per cent right or not, but I have a feeling that for some countries the situation is going to be very similar.