Recessions and inflation are equally devastating to the economy. However, a recession can potentially lead into a depression with the associated deflation in the economy. A protracted recession could have devastating effects on the economy. Inflation on the other hand tends to be self-correcting. As the prices of goods and services continue to climb, they get to a point where people switch to substitutes or learn to do without. The change in consumer behavior then leads to excess supply and hence a reduction in prices or wages.
Recessions lead to significant declines in economic activity that spreads across the entire economy. Recessions are defined by two consecutive quarters of negative economic growth as measured by the gross domestic product (GDP). Recessions are believed to be essential elements of the business cycle. Recessions help to clear out excesses in the economy such as over production of goods with the associated increases in inventory and employment. As the economy contracts, things equilibrate back to a level that can be sustained by the economy.
Recessions are usually caused by imbalances in the market that lead to overindulgence in one sector or the other. In recent history, we have seen two examples of these imbalances in both the stock market (2000) and more recently the real estate market (2005). Investors were overly exuberant and as a consequence, they drove prices of these assets to unreasonable levels. As a consequence, these assets were out of the reach of the typical investor and hence there was a reduction in demand as the prices of these assets peaked. This led to a decline in the assets and as the assets declined, consumer confidence was impacted and panic hit the market leading to massive sell-offs. We can debate the facts as to whether the sub-prime market and low interest rates were responsible for the current problem in the real-estate market and likewise the easy money policy of the fed and the stock market slide in 2000.
Inflation on the other hand results from the government printing too much currency, an increase in the cost of raw materials used in production or the cost of labor or imbalances in the nation’s balance of payments or balance of trade. All of these factors lead to higher prices for the consumer.
Recessions do not always affect every sector of the market; whereas inflation does, this is probably the most significant distinction between inflation and a recession. Prolonged recessions can turn into depressions, which may last a lot longer.
My view is that inflation is the worse of the two problems, especially since once it starts and takes hold, it is a much more difficult thing to manage and control. In some instances, it is possible to end up with a condition called stagflation, which results from both inflation and low economic activity. This is one of the worst scenarios that an economy can face because there are very little options available to the Federal Reserve to remedy this condition.
Recessions by their very nature tend to result from government intervention into the marketplace; on the other hand, inflation can result from causes that are not directly related to government intervention. We are currently witnessing such a conundrum. The rapid growth in India and China and the demand for raw materials is leading to increases in the prices of certain raw materials worldwide. The cost of raw materials such as copper, aluminum, platinum, corn and oil is causing inflationary pressures all over the world and with the attendant weak economic environment vis-vis slowing economic growth worldwide, it is truly a challenging time for central banks all over the world.
The factors that cause inflation in an economy, the consequences of inflation, and the available remedies, make inflation a more deleterious condition than a recession.