There is much talk about recession these days and even those who may not yet have directly experienced financial loss feel bewildered and confused by a difficult-to-fathom adversary as if it has appeared out of some Kafa novel hounding at their door. I was asked a couple of weeks ago by some financial analysts to explain the problem of recession that is now a matter of widespread concern, if only because no one knows what recession holds in store. I was asked to comment particularly on various options for reforming the international financial system. However, this specific question cannot be addressed unless we understand the nature of the problem that faces us. The problem has to be placed in its political context. This article does not answer the particular question about reforming the financial architecture, but it puts the discussion about inflation in a wider political context, explaining the reason why a diplomatic war of words has broken out between Germany and Britain about how Europe should respond to the threat of recession.

Splashed across newspapers on Wednesday the 26th of November was a gloomy forecast from the Organisation for Economic Cooperation and Development (OECD), a think tank funded by industrialised nations, that the UK economy will be amongst those that are likely to be most severely affected by the credit crunch. Output might decline by as much as 1.1 per cent. A complacent view is that a decline of around 1 per cent in output of an economy that is amongst the top half a dozen richest nations in the world in terms of per capita income is a manageable shock. A more realistic view is that even a 1 per cent decline in output might set off distributive quarrels in society that could destabilise even the strongest of political institutions. Among the measures suggested to counter the impact of the impending recession and arrest the decline in output are a succession of policies that the Treasury has announced in a short space of time, that would double the ratio of government debt to GDP in the UK. These are desperate measures but even more desperate measures, like the wholesale nationalisation of the banking system in the western world, might be needed. The stake is paradoxically not a dramatic collapse in output but a fear of the potential for implosion of political and economic institutions if output declines by even a small amount.

Thus the impending recession in the western industrialised economies has to be understood in the historical context that many civilisations have been destroyed from within through the inability of existing institutions to maintain a stable equilibrium of conflicting demands within society. Whilst the story of the entry of marauding armies from abroad destroying indigenous culture and overthrowing benign kings to impose despotic rule from abroad makes for good copy in Bollywood and Hollywwod, the reality is different. In recent times, Germany destroyed its own democratic institutions by giving rise to Nazism because there was no consensus about how to respond to economic hardship following the first world war in the 20th century. Conflicting demands in society are kept in balance, even in the best of times, by a thin veneer of consent in society. A recession —it need not be characterised by more than 1 per cent decline in per capita income — could tip the balance leading to a disintegration of economic and political institutions. That is the underlying fear, and it is this fear that is now propelling governments, for example in the United States and in the United Kingdom, to contemplate policies that would have been considered cranky only some months ago.

A difficulty with recessions is that decline in output does not impact evenly on all sections of the community. It is not a straightforward case of the income of the rich being protected and that of the poor being hammered or vice versa. The axe falls more randomly. Consider the experience of Argentina during the Latin American financial crisis at the turn of the century. For example, between the years 2001-2003, decline in per capita income for the second quintile from the bottom, those who are not the poorest but the second most poor, was only 0.7 per cent, but income declined by 10.3 per cent for the poorest quintile of the population. The top two quintile, the richest 40 per cent, also did not fare well and experienced reduction in income, but the average income in the third quintile group went up slightly. If the different groups of losers also have other forms of visible identities, characterised by religious, regional, linguistic or ethnic loyalty, civil war could break out.

To illustrate the argument in the context of Western industrialised economies, consider what happened in Britain following the sudden quadrupling of oil prices in 1973. Prior to that shock, the British economy registered an average growth rate of 2.8 per cent per annum in per capita income for two decades, the only such period of sustained growth since the Victorian times, only for the growth rate to come to a halt and then resume at a slower pace. The rise in the price of oil in 1973 suddenly pushed up the trade deficit to 2.45 per cent of the GDP in 1974, rising sharply again to slightly over 5 per cent in the following year, but to be brought into balance within less than three years. The structural adjustment to the economy, reducing dependence on oil intensive activities and placing emphasis on improving the export performance, entailed changes in income distribution between sectors of industry at a rate that had to be faster than it would be politically manageable. An annual rate of growth that suddenly fell below 1 per cent would unleash political instability. This sudden slowdown in economic growth brought to the fore internal conflicts and resentment about the distribution of income and wealth. Industrial unrest followed. Some commentators forecast that these distributive tensions would spell the end of elections and the imposition of authoritarian rule. As Peter Wright, a former Deputy Director of Intelligence (MI5), wrote in his memoirs in the 1980s, there would be no shortage of rogue elements, including himself, in the intelligence community to participate in the overthrow of an elected government. Even mature democracies encounter occasional problems in retaining oversight over their secret service agents. In the event, the government ameliorated the political tensions and saved democratic institutions by tolerating wage rises that were in many sectors well in excess of productivity. Thus there was inflation in the immediate aftermath of the rise in oil prices while the economy changed gear. The adjustment period of 1974-1978 was characterised by a period of double digit inflation as the price to be paid for ameliorating conflict and protecting the institutions of democracy.

Whilst a burst of inflation over a period of 3-4 years appeared to have worked in Britain in saving civil society from tearing itself apart, the experience of Latin America was different. Once double digit levels inflation began, it became impossible to control its inexorable rise. Closer to home, the experience of Germany during the 1930s in trying to cope with inflation was harrowing. Inflation in Germany was not just a temporary phenomenon reflecting the need for time to adjust to sudden changes in the conflicting demands within the economy for resources, but it became a source of exacerbating those conflicts and thus giving rise to authoritarian ideas, which in this particular case were also virulently racist in outlook, for maintaining order in society. A fascination with these ideas by a population frightened of chaos destroyed democratic institutions which had evolved over decades and were designed for compromise. German politicians are more aware of the destructive forces of inflation because of their focus on the history of their country, and British politicians are more sanguine about their ability to manage any potential threat to democracy by inflation going out of hand because of their own historical experience of being able to contain internal conflict.

Differences in perceptions of the lessons for the future that history holds for us is at the heart of the current diplomatic tussle between German and British governments about policies that are appropriate for managing the period of slow growth or no growth that is on the horizon. Another difference is the degree of dependence of these two economies on the more speculative end of the practices in the financial sector.

Similar problems face both governments. One is that banks must lend to each other if the liquidity needed for trade within and between countries is not to dry up. Liquidity is the jargon for the flow of lending and borrowing entailed in transactions for goods and services. It appears that notwithstanding exhortations from government, banks here will not lend to each other. Banks no longer trust their own accounting data, let alone placing trust in each other’s accounts, after the fiasco of the collapse of the market in financial derivatives. Some of these were instruments at generating capital and liquidity by trading in noise, with products backed up by no substance, and bank managers have suddenly discovered the lack of substance behind what they had come to record as assets in their accounts. Many of these instruments were pyramid selling schemes but packaged to get through the porous regulatory system that has developed over the last twenty years.

Governments in some of the EU nations have stepped into the breach by taking stakes in the banking industry, setting aside fiscal discipline, socialising private sector debt, and groping at whatever straw that they can find to keep lending from freezing up and taking down output in the wake. If these policies to introduce liquidity are adopted by any one government, that will be not be sufficient to stem the severity of recession in that country. For these policies to succeed, trading partners will also have to respond in kind to keep up demand. Prosperous nations trade mostly with other prosperous nations. British trade with a handful of major economies in the EU is likely to be more than 2/3rd of that with the rest of the world. Throw in North America and Japan and we are perhaps talking about 80 per cent of British trade. These ratios are not dissimilar to corresponding figures to be found in the rest of Europe. Thus the British government has taken a leading role in persuading her EU counterparts that it is in their mutual interest to set aside qualms about government debt and fiscal profligacy and ensure that growth resumes without delay. There is no immediate prospect of inflation rearing its head, the argument goes, because of the looming prospect of unemployment that is bound to follow even if output remains stagnant or recovery is slow.

The German government does not disagree with this argument, but they are less sanguine, given the way they perceive lessons from history, about the ability of governments to contain inflation in the long run if the lid on money creation and government deficit is taken off in haste. In their interpretation of the historical evidence, the long term inflationary pressures built up by the fire fighting operations now being urged on Germany by Britain, in conjunction with France and the US, will pose a greater threat to political stability and the survival of democratic institutions than a slight decline in output. This is the background to the current diplomatic spat between the governments of the two large economies in the EU.