Inflation Spiral or Recession: Which Is Worse? : Economy: The Gulf crisis could cause a recession, but in the long run, economists fear inflation more. They haven’t forgotten the bad old days.

The crisis that has brought American troops within miles of the bristling encampments of the Iraqi army has also left the U.S. economy in a dangerous face-off with its frequent adversaries, inflation and recession.

The reason is a spike in oil prices, and it has presented the Federal Reserve Board with a choice of easing credit and risking a price spiral, or restraining it and possibly setting off an economic slump. These tough choices are usually before the Fed, but the crisis has increased the stakes, and given new urgency to the question: Which of these demons can hurt us most?

With a weakened banking system and debt-heavy economy, a recession now could be unusually painful. Yet many economists say that over the long term, the graver danger is still inflation, the disorder that brings economic chaos as it accelerates.

“It’s like a cancer,” said John O. Wilson, chief economist with Bank of America. “It makes it difficult to make the right economic choices. It eats away at investment. It hurts business efficiency. And ultimately, it does enormous damage.”

Such strong convictions on the dangers of inflation are shared widely, for the country is still living with the legacy of the 1979-1982 price spiral, which lifted the consumer price index 50% and carried the prime lending rate to a peak of 21.5%. Today’s Fed is dominated by “inflation hawks” who have made price stability their first priority, and talk about reducing the inflation rate to zero.

They aren’t the only people with strong convictions on the dangers of inflation.

The financial markets show their lingering anxieties about inflation in the interest rates for long-term bonds that remain, year after year, well above historic levels, economists note. Inflation is a particular enemy of bondholders because it erodes the value of their returns.

Even some more liberal politicians formerly unfazed by inflation have got religion.

“A lot of Democrats who used to enjoy the political benefits of easy money now take a different view,” said Michael Barker, an economist in Washington who has been an adviser to top Democrats. “You have to get way to the left of the Democratic spectrum to find people who like it. This is still the age of the inflation hawk.”

It isn’t difficult to see what they find so disturbing.

As some prices rise, producers and workers demand to be paid more to offset the increases in their costs. If those demands stick, an accelerating cycle of wage and price hikes begins.

As prices spiral, the buying power of the dollar falls, eroding the value of savings. It becomes difficult for businesses to plan spending, and for investors to determine how much interest to require for their money.

Bond buyers, for example, aren’t sure how much to ask in interest rates for long-term bonds, because they can’t guess how much inflation will eat away at the value of their payoff. So they tend to demand higher interest to protect themselves.

But many investors ultimately pull back from long-term investments and keep their money in shorter-term instruments, such as Treasury bills, or inflation-resistant hard assets such as gold or real estate. It isn’t long before such a withdrawal by investors slows economic growth, and tends to lead to recession.

Some businesses find a limited amount of inflation comforting, because it allows them to raise their prices without much resistance from customers.

But such easy price-hiking allows businesses to get by without keeping a close eye on their own costs. As it makes them wasteful and inefficient, inflation lowers their productivity and eventually slows their growth.

The losers in inflation are all those who can’t pass on higher prices. That’s often the poor, and the younger workers who don’t have bargaining leverage to get higher pay. The assets of these groups tend to be in savings--rather than, say, homes--and they get badly hurt through erosion of the dollar.

Inflation also falls hard on retired people who don’t have adequate cost-of-living increases in their pensions to fully offset rising prices.

While inflation is the traditional scourge of bondholders and doesn’t much help stocks, it’s good news for those who have huge debts to repay at fixed interest. A burst of inflation now would helped beleaguered New York entrepreneur Donald J. Trump, and “would probably also be welcome news to his bankers at Citicorp,” said Edward Bernstein, an economist at Brookings Institution.

Inflation has long been good news for middle-class homeowners with traditional 30-year fixed-rate mortgages, because it lifted the price of their houses while allowing them to repay their debts with devalued dollars. But now these benefits are disappearing, as lenders have increasingly turned to mortgages with rates that rise and fall with other interest rates, says Jeffrey K. Thredgold, chief economist at KeyCorp, a banking firm in Albany, N.Y.

While more than two-thirds of all mortgages are still fixed-rate, the share of adjustable-rate mortgages has been rising over the past decade. Three-quarters of California mortgages are adjustable, industry officials estimate.

And inflation is no longer such a boon for borrowers who take out personal loans or car loans, for an increasing share of these also are adjustable to float with prevailing rates.

The casualties in a recession are also numerous, and their distress is often more visible than the suffering of inflation’s victims.

They include the working poor and young people without much seniority who are the first to be laid off. Also at particular risk are those in marginally profitable industries, and industries that make the kinds of durable goods customers believe they don’t have to buy right away, such as autos, housing, and furniture.

Companies with heavy debts are also heavily at risk as an economic slowdown makes it harder to raise the money to pay back borrowings.

Winners in a recession include owners of long-term bonds, which rise in price when interest rates tumble, and individuals or companies that are cash-rich and can snatch up assets at recession-reduced prices. But there tend to be few such winners, and most people are hurt as a slowdown in production cuts demand and profits.

In the 1981-1982 recession, the worst since the 1930s, an average of 10.7 million were out of work. The slump hit the housing and auto industries with terrible force, and was one of the reasons for the near-bankruptcy of Chrysler Corp.

The severity of such shocks shows that “over a period of six months, a recession can do more damage than inflation,” said William Melton, economist with IDS Financial, a financial services company in Minneapolis. “But when you extend the period to a year or more, then inflation is the more dangerous, because it accelerates with time, until it becomes intolerable. That’s the story of the Eighties.”

Indeed, some economists relate the history of the last three decades as a means of describing the persistent dangers of inflation.

For most of the 1950s and 1960s, inflation averaged about 1.5%. When it rose to 4% in 1972, the Nixon Adminstration slapped on wage and price controls for 18 months.

But when controls were lifted, inflation edged back up. After the Arab oil embargo quadrupled oil prices in 1973, the Fed didn’t tighten credit sufficiently, and prices spurted.

In the view of many economists today, such Fed chairmen of the 1960s and 1970s as Arthur Burns and G. William Miller seemed remarkably unwilling to risk a recession to control inflation. For some, the more relaxed attitude of the 1970s is best symbolized by President Gerald Ford’s campaign for voluntary anti-inflation measures, which he tried to promote by passing out “Whip Inflation Now” buttons.

But the second Arab oil shock, which followed the fall of the Shah of Iran in 1979, brought inflation to levels that were politically intolerable. In 1981, with the consumer price index rising at 9%, Fed Chairman Paul A. Volcker, with the tacit assent of President Ronald Reagan, tightened credit to bring on a recession that would break the inflationary cycle.

Inflation hit a low of 3.8% in 1985, but amid the long economic expansion, inflation began to again creep up. In the view of some economists, the Fed eased credit too much after the stock market crash of October, 1987, allowing consumer prices to rise 4.4% in 1988.

(The consumer price index rose 4.6% last year, and, even more worrisome, grew at a 5.8% rate in the first six months of this year.)

Frederick S. Breimyer, president of the New England Economic Project, in Boston, says that seen one way, the recent U.S. recessions are caused by inflation, because recession is the only sufficient antidote to accelerating prices.

Economic downturns can halt inflation by putting downward pressure on prices. Recessions can also clear the way for economic growth by eliminating some of the inefficiencies that are tolerated during inflationary periods.

According to Breimyer, inflation forced recessions in 1966-1967, when government spending for the Vietnam War drove up prices; in 1974-1975, after the first Arab oil shock; in the brief 1980 slowdown; and again in the deep 1981-1982 slump.

As inflation rises, “people can’t make decisions, they have a sense of losing control, and it becomes clear recession is the only way out,” says Breimyer.

In his view, inflation can also be blamed for the crisis that has engulfed so many American savings and loans. Many thrifts turned to risky, high-yield lending practices because inflation drove up their cost of funds when they were being paid less than 10% interest on older, fixed-rate mortgages.

While over the long term inflation may be the greater danger, many economists believe it is less of a threat now than a recession. A downturn could push many marginal banks and savings and loans into insolvency, driving up the tab for the thrift crisis, and thus the federal budget deficit. It would drive down inflated real estate values, particularly in California and the Northeast, wiping out much of the wealth of many homeowners.

In a recession, some of those same Americans might also be on the unemployment lines.

A recession also would fall hard on the businesses that have loaded up on debt in the 1980s, including those that went through high-priced leveraged buyouts assuming economic growth--and debt-easing inflation--would continue. The retail, auto and airline industries would likely be hard hit, economists say.

“In my 35 years at this, I’ve never seen a time when we’re more vulnerable,” said Joel Popkin, an economic consultant in Washington.