Crisis and Inflation: Back to the Future?

Gordon Brown claimed that he had ended the boom and bust cycle. The current economic crisis demonstrates that normal service has been resumed.

It is one of the ironies of our times that the election of ‘New Labour’ in 1997 was meant to have left ‘Old Labour’ and everything connected with it behind. The popular perception (first outside the Labour Party and then inside it) was that Old Labour meant nationalisation, inflation, labour unrest, and a host of other negative experiences that were associated with life in the 1970s. Gordon Brown was the New Labour ‘iron chancellor’ who had left all this behind, created a low inflation environment and abolished boom and bust.

The current economic crisis has demonstrated that normal service has been resumed. Unemployment is on the up (no Labour government has ever left office with unemployment lower than when it was elected), the financial sector is in turmoil, price rises are at their highest level in years, and state sector wage restraint means that the unions are (understandably) grumbling.

One of the interesting things about capitalism is the way in which when the economy is booming an economic consensus of sorts has a tendency to break out. The general support for Keynesian economics that developed during the long boom of the 1950s and 60s was famously labelled ‘Butskellism’ by the Economist after Tory Chancellor Rab Butler and his Labour shadow, Hugh Gaitskell. In recent years there has been a similar consensus of opinion even if the Labour and Tory parties don’t like to admit it explicitly – it is almost as if when the economy goes well they are afraid to do anything too different, lest they upset the magic formula in the process.

Psychological blow

What happens when an unexpected economic crisis breaks out is that politicians, central bankers and pundits all realise that perhaps the magic formula didn’t work after all. The realisation in the 1970s that Keynesian economics didn’t really work was a psychological and philosophical blow that some never recovered from, and its replacement by something loosely called ‘monetarism’ was never entirely accepted even by those on the political right who had been most well-disposed towards it.

After a series of crises in the 1970s was followed by the big recession of the early 1980s, and then the recession of the early 1990s, another long boom occurred and with it the latest economic consensus. There was little if any new thinking to underpin it – it was merely a pragmatic amalgam of vague aspects of ‘monetarist’ practice with some left-over bits of Keynesian theory. For the politicians and economists, these had emerged by default because they were the bits of these two theories that hadn’t been transparently discredited to the satisfaction of all concerned by the preceding crises and recessions. There is no better example of this dubious consensus than current thinking on the (interlinked) issues of inflation and interest rates.

The persistent rises in the price level that have occurred in the UK and most of the developed world since the Second World War have exercised the minds of politicians and economists in the decades since, and various explanations have been put forward to account for it: wage increases above rises in productivity, excessive government spending, high government borrowing, the expansion of credit, and many others besides. In the 1970s and 80s a highly contentious explanation for it was advanced by Professor Milton Friedman and was adopted by the Thatcher government in the UK: the aforementioned ‘monetarism’. Loosely, this was the view that inflation is caused by an overly rapid expansion of the money supply that increases monetary demand for goods and services in the economy and pulls up prices. It was often linked or integrated with other views, such as inflation being caused by government borrowing (with government borrowing and money supply expansion allegedly being correlated).

The problem for the Thatcher government’s monetarist anti-inflation strategy was that the main definitions of the money supply chosen for the purposes of monitoring monetary expansion were erroneously based on bank deposits. And there was no reliable way they knew of to control their expansion and contraction anyway. Ironically for a Party concerned by government borrowing levels, one method they resorted to was ‘overfunding’, described by Thatcher as when ‘the Government sought to reduce private bank deposits . . . by selling greater amounts of public debt than were required merely to finance its own deficit’ (The Downing Street Years, p.695).

When this and other anti-inflationary tactics didn’t work, the eventual method settled upon by Thatcher and her Chancellor Nigel Lawson was to use interest rates as a policy instrument. In her memoirs, Thatcher stated that in her view ‘the only effective way to control inflation is by using interest rates to control the money supply’ (p.690) and this was one of the main reasons Thatcher and Lawson famously disagreed towards the end of her reign, because he began to use interest rates as a means of tracking the Deutschmark in the European Exchange Rate Mechanism (ERM) instead.

Brown follows Thatcher

It is notable that interest rates have been used as the main policy instrument for controlling inflation ever since, by the governments of Major, Blair and now Brown. This is despite the fact that as a policy it not only arose by default, but has little to practically recommend it. The theory is that when interest rates rise, people borrow less and cut their spending. But this only takes into account one aspect of what happens. Interest rates are the price of borrowing and lending money and when interest rates rise, lenders are affected just as positively as borrowers are affected negatively. A movement in interest rates changes the terms of the relationship between borrowers and lenders in an economy and can create a short term economic disturbance, but it does not affect the level of purchasing power as a whole and can have no significant and persistent effect on the price level (for example, while those with mortgages and other loans are disadvantaged by higher interest rates, those with savings, interest-bearing investments, etc gain to a similar overall extent).

That raising interest rates cannot halt inflation – or even slow its rate of growth – has been demonstrated by a close look at economic history. During the time when Thatcher was Prime Minister the Minimum Lending Rate (as it was then called) for the banks rose from 9 per cent in 1988 to 15 per cent in 1989 yet the Retail Price Index (RPI) increased considerably across the entire period, having an average annual rate of 4.1 per cent in 1987 that had become 9.5 per cent by 1990.

If that was considered a ‘fluke’ it has just been repeated, as the UK economy under Gordon Brown has just experienced a similar situation. Base rates reached a recent low of 3.5 per cent in mid 2003 and were progressively raised to 5.75 per cent last year. Yet throughout this time, the RPI has crept up from a recent historic low of well under 2 per cent in 2002 to around 5 per cent now, the highest it has been since Thatcher left office in 1990.

These two examples reflect what really happens when an economy experiences price rises – which is that instead of interest rates influencing price rises it is effectively the other way around. Banks make their profits generally by lending money out at a higher rate than they borrowed it at, being concerned with the ‘real rate of interest’ after inflation is taken into account – and rates tend to rise in order to protect these banking margins (the contrary idea of the ‘credit creationists’ that banks make profits not by doing this but by effectively creating money out of nothing instead, should never have been taken seriously, and is in present circumstances beyond risible). ..continued on next page 11