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.
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).
The current rise in the RPI in the UK coupled with the economic crisis has led some economists to argue that capitalism is about to be gripped by the kind of ‘stagflation’ that existed in the 1970s, so called because economic stagnation coincided with rising prices. With the credit crunch biting and the financial apparatus of capitalism in turmoil, unemployment is now on the rise and growth has come to a standstill, at best.
In the nineteenth century, when the study of economics developed seriously and Karl Marx developed his critique of it, persistent inflation (and therefore the possibility of stagflation) hadn’t occurred at all after the Napoleonic War ended. Instead, prices generally tended to rise during booms and then fall away during slumps when demand was lower, and price charts from this period show the cyclical ebbs and flows quite clearly, both in Britain and abroad. By the start of the First World War in 1914, for instance, the overall price level was almost identical to what it had been in 1850.
This general tendency for prices to rise during times of economic prosperity and then fall back when there is economic contraction is still evident today. However, it is disguised by something that only existed episodically before the Second World War, after which it has been a permanent feature – currency inflation.
Since the beginning of the war, the price level has risen every single year and is well over 30 times its 1938 level. The cause of this persistent rise in the price level has been an excess issue of currency (specifically currency that is no longer convertible into an underlying commodity like gold). This is because while interest rates and movements in wages and profits, etc change the distribution of purchasing power in the economy, they do not – of themselves – increase the total amount. An excess issue of notes and coins in circulation does precisely this if it is over and above the amount needed to carry on production and trade.
An over-issue of currency injects purchasing power into the economy which is not reflective of real wealth generation; put simply, it is too much money circulating given the level of production of goods and services (and the trade associated with buying and selling them). Before this truth was lost in a fog of now discredited economic theories, inflation was routinely called ‘currency inflation’, to reflect this. And on the occasions it occurred governments could – and did – put a stop to it, like when they withdrew the then significant sum of £66 million in notes and coins from circulation in 1920, which led to a fall in the general price level of around 30 per cent, before the return to the gold standard in 1925.
In 1938 there was £442 million in notes and coins outside of the Bank of England circulating in the UK economy. Economic growth since then has averaged around two and a half per cent a year (typically going up more than this in booms and down in slumps) yet the amount of notes and coins in circulation has persistently increased far beyond what has been needed for the purposes of production and trade. Today, according to the Bank of England, notes and coins in circulation stand at £50,370 million, up from £47,800 million a year earlier, as the inflationary process that started in the late 1930s has continued apace. This is why, unlike in the nineteenth century when slumps led to overall price declines, prices have risen every single year since the war whether the economy has been in boom or slump (because while slumps have put downward pressure on prices this has always been outweighed by the effects of the ongoing currency inflation).
It is true that for some years prices rises in the UK and other countries – while still positive and persistent – haven’t been at quite the levels seen in the 1970s, 80s and early 90s. The main reason for this appears to have been the entry into the world market of vast amounts of low cost goods produced by the massive emerging market economies of the Far East, including China. As rising productivity lowers the amount of labour time necessary to produce goods, this phenomenon is to be expected, and its scale in recent years has been colossal with massive price falls in clothing and leisure goods like electricals according to the Office for National Statistics (prices of many goods have fallen by between a quarter and a half in the last 10 years). Without this effect, overall rises in the basket of goods that comprise the RPI measurement would have been higher still, as has been evidenced by the continuing big price increases of goods not directly affected by this phenomenon, such as fares, catering and leisure services.
What’s happened over the last couple of years is that this low-cost goods effect has started to lessen because of the world economic boom that built up, especially in commodities like oil, metals, wheat, and so on. The persistent, ongoing currency inflation plus the effects of this well-documented commodities ‘bull market’ have meant large price rises are once more a major policy concern (in the 1970s, when price rises took off and peaked at nearly 27 per cent in 1976, this again was a combination of the background effect of currency inflation with a massive bull market in commodities like oil).
One club golfers
Here lies a big current problem for Gordon Brown and other world leaders, and in some cases the central bankers to whom they have devolved responsibility. Unaware of the real cause of inflation, which has been lost in the mists of time, they have reached a stage – more by default than design in some respects – whereby they have only one policy instrument to deal with inflationary pressures (raising interest rates) and one main policy instrument to deal with a declining economy drowning in debt (lowering interest rates). When asked to deal with the two problems simultaneously, they have only confusion, as the two solutions they would have proposed are mutually exclusive of one another.
In reality, such have been the problems on the money markets and the declines in the stock markets in recent weeks – and such is the evidence that the credit crunch is now having a significant effect on the real economy – they have belatedly decided to lower central bank base rates as the lesser of the two evils.
What is germane to this is that in the nineteenth century, Marx wrote that while the market economy’s periodic crises and convulsions cannot be eradicated through government policy, there are occasions when it can make matters worse (he cited, in particular, the 1844 Bank Act which kept interest rates abnormally high). This is in some respects the history of recent times too, as after the credit crunch began last summer base rates have been higher than they might have been because of the view of governments and central bankers that high rates were needed to stave off inflationary pressures.
During any slump, interest rates tend to fall away from their peak reached at the end of the boom as the demand for money capital eases, this being one of the many conditions for an eventual improvement in production and trade, but on this occasion it has been slow happening (especially given the severity of the housing bust and the associated financial crisis). The irony now is that such is the magnitude of this crisis, with a major bank filing for bankruptcy or being rescued almost literally every week (Bear Stearns, Lehman Brothers, Wachovia, Fortis, Bradford and Bingley, HBOS, the entire Icelandic banking system, etc) that wherever central banks decide to pitch base rates, these are being effectively ignored by the banking system as a whole, where the key London Inter-Bank Offered Rate (‘Libor’) is still nearly two per cent above base rates with the credit markets locked into a state of fear-driven paralysis.
The severity of the current crisis, with big falls in demand in the economy and increasing unemployment, may well lead to pressure on retail prices easing somewhat despite the government’s continuing recourse to the printing presses. But whether this happens or not, there is a sense of real danger and panic in the market economy at the moment as the lubrication that keeps the capitalist machine running – the money markets – are dysfunctional.
So, with inflation concerns (and no clue how to handle them), the effects of a recent oil price spike, stock market crashes, soaring unemployment, the most significant financial crisis in most people’s lifetimes, and the return of nationalisation as a means of propping-up failing businesses, it is certainly a case of ‘back to the future’ for Britain’s Labour government.
Most market commentators don’t know whether the most appropriate comparison is with the 1930s slump after the Wall Street Crash or the 1973-4 UK secondary banking crisis and bear market which followed the ‘Barber Boom’ and housing bubble. While capitalism never repeats its history precisely, it may be an especially severe dose of the latter rather than the former . . . nevertheless, given the general panic and helplessness of recent weeks, you wouldn’t want to bet your Collateralised Debt Obligations on it.