Inflation is bad, unemployment is far worse

What’s worse, higher inflation or higher unemployment? That question is at the core of the debate over how rapidly the Federal Reserve should raise interest rates to cool off the economy and bring inflation down from its 40-year highs. If you think higher inflation is worse, then it makes sense to raise rates hard and fast, even at the cost of causing a recession. If you think higher unemployment is worse, then moving cautiously is a better choice. The answer is actually pretty straightforward: Higher unemployment is worse than higher inflation if you go by the feelings of real people rather than the theories of economists.

A paper by three New Zealanders that’s forthcoming in the Journal of Money, Credit and Banking taps into results from the Gallup World Poll from 2005 to 2019, covering 1.5 million people in 141 nations. The poll includes questions about how people feel about their lives and their current situations. The researchers correlate how people answered those questions with economic conditions at the time in each country.

The findings are remarkable. People are nine to 13 times as likely to report sadness or physical pain in the short term when there’s been a one-percentage-point increase in the unemployment rate as when there’s been a one-percentage-point increase in the inflation rate. Similarly, an increase in unemployment is about six times as potent as an increase in inflation in lowering people’s self-assessments when they were asked a longer-term question about how they feel about their lives on a scale of zero to 10.

The beauty of the study is that it’s unbiased; the people answering the questions about their feelings had no idea that their answers would one day be used to assess the impact of inflation and unemployment on their lives. If they had been asked directly how they felt about inflation and unemployment, their answers might have been affected by what they had heard about those phenomena in the news or learned in school.

“That’s exactly the power of it,” one of the authors, Robert MacCulloch, an economist at University of Auckland Business School, told me. His co-authors are Lina El-Jahel, also of the University of Auckland Business School, and Hamed Shafiee, a senior adviser to the New Zealand Productivity Commission.

Previous research by MacCulloch and others found similar results, although not always as extreme. In a 2003 paper, the economist Justin Wolfers, then of Stanford University, found that a percentage-point increase in the unemployment rate caused roughly five times as much unhappiness as a percentage-point increase in inflation. A 2007 paper by David Blanchflower of Dartmouth College found that across European Union nations, a one-percentage-point increase in the unemployment rate lowered well-being by at least 1.5 times as much as a one-percentage-point increase in the inflation rate.

The survey results make sense. People surely don’t like inflation, but its effect on their lives is not as bad as you might think. It’s not as simple as “Inflation makes everything more expensive!” If wages manage to go up as much as prices go up, wage earners are left unscathed. True, wages don’t always keep up with prices — in fact, they have not kept up lately — but that’s a problem that can occur when inflation is low (and wage growth is lower). People who live off the income from their bond portfolios are harmed by unexpected inflation, but there’s another group that wins from it: debtors, including all those homeowners who took out fixed-rate mortgages at rates that look deliciously low now.

When economists talk about the damage of high inflation, they tend to focus on second-order considerations, such as the harm inflation can do to investment. (High inflation tends to be more volatile than low inflation, making businesses uncertain about their prospects, which can reduce their desire to invest.)

Contrast that with the clear damage wrought by high unemployment. It’s the difference between a paycheck that can’t be stretched as far and a paycheck that stops coming. True, inflation affects every shopper, while unemployment directly affects only the people who lose work. But high unemployment also hurts fresh graduates who can’t get their first jobs, depresses wage gains and frightens workers, who worry they could be the next ones fired. “Unemployment makes people unbelievably unhappy,” Blanchflower told me. “It has amazed me that this is even a discussion,” Claudia Sahm, the founder of Sahm Consulting and a former Federal Reserve economist, told me. “Yes, a recession is worse than inflation.”

She continued: “There is a discourse building, not at the Fed but among some of my peers, that not only should we be risking a recession, we should be causing a recession. It would be reckless. It would be heartless.”

An old joke goes: A recession is when your neighbour is out of work; a depression is when you’re out of work. The idea, of course, is that people are self-centred. In reality, though, we do care when the unemployment rate jumps, even if our own jobs are secure. The first sentence of Adam Smith’s “Theory of Moral Sentiments” says as much: “How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it, except the pleasure of seeing it.”

The counterargument is that the flames of inflation must be extinguished immediately. The Harvard economist Larry Summers, who has been saying that the United States needs an extended period of higher unemployment to get inflation under control, told my colleague Ezra Klein that he takes no pleasure in the prescription. “I went into economics because I believe that by controlling recessions and preventing downturns, you could change livelihoods for millions of families,” Summers said. But, he added, failing to stop inflation now could cause problems down the road: “What we care about is not just the level of employment this year but the level of employment averaged over the next 10 years.”

Summers’s argument, then, is that by fighting inflation, the Fed is ultimately fighting unemployment as well. But economists who highlight the damage of high unemployment don’t buy it. MacCulloch said he agrees with Summers that the government should try to prevent inflation from getting started. “But once inflation has got away, as it has now in the U.S. and New Zealand as well, you’ve got a problem, and the problem is how to bring it down without a lot of damage,” he said.

If the Fed causes a deep recession, he added, “the adverse well-being effects are so severe, it’s probably not justified.” Better to move slowly in hopes of achieving a “soft landing,” he said.