Time for a macroeconomic reset as the UK economy hurtles towards stagflation
The Bank of England yesterday forecast the longest recession since the Global Financial Crisis of 2008, lasting through the whole of 2023. This will involve unemployment rising from 3.8% to 5.5% and record falls in living standards, accompanied by double digit inflation for most of the period. In other words, stagnation plus rising prices: AKA ‘stagflation’.
The Bank’s response? The biggest increase in interest rates (0.5%) in over a quarter of a century. This will lift the base rate, which sets all other interest rates in the economy, to 1.75% after averaging 0.25% for the last 13 years, a period characterised by anaemic growth despite record low rates.
Make no mistake, this will materially worsen the squeeze on household incomes. UK consumer credit growth in June accelerated at 6.5% — the fastest rate in three years — as households borrowed £1.8 billion to help cope with the cost of living crisis. Nearly 2 million homeowners will also be hit next year as their fixed term mortgage deals come up for renewal, with a quarter of these facing a quadrupling in their monthly payments. And businesses will also be hit with higher borrowing costs just as their costs rise. It is very hard to see how such a policy will not make the predicted recession worse.
As the Bank of England themselves admit, the cause of today’s price rises are not that people or firms are borrowing or spending too much. In the UK case, inflation is driven mainly by record increases in the cost of energy and supply chain issues relating to the Covid-19 pandemic and Brexit. In other words: these are not demand-side but supply-side shocks.
However, the Bank, as with other central banks, remains wedded to a macroeconomic orthodoxy which says price stability should be the overriding objective of monetary policy and that there is only one tool to choke off inflation: raising the general rate of interest. This tool must be used, whatever the cost, even if that means collateral damage of people’s jobs. For once inflation becomes entrenched, it is self-reinforcing. As supply-side costs rise, firms charge more to sell products and workers then demand more income in a self re-enforcing ‘wage-price’ spiral. Raising the price of money punctures the process. Its bluntness is its advantage: it hits everyone hard.
There is very little evidence of a wage-price spiral. Wages have not been rising at anywhere near the level of prices over the past year, indeed real pay has fallen at the fastest rate in the last 20 years. Parallels with the 1970s are misplaced given the very low rates of unionisation in the UK compared to that period. Employers on the other hand in certain sectors do seem to be enjoying considerably higher profits, suggesting a ‘profits-price spiral’ may be a better description of current dynamics.
In the short run, there are clearly limits on what policy can do to limit supply-shocks driven by wars or pandemics. The issue becomes rather how to distribute the pain across the economy. There are three options.
Firstly, lower income groups can take the hit. This is what will happen if interest rates continue to be the main tool for controlling inflation. Raising rates will disproportionately affect lower income groups who are already being hit harder by rising energy and food prices, whilst making little difference to large firms’ profits.
Second, the state can take the pain by using fiscal policy (borrowing) to support lower income households. The government could guarantee a minimum level of energy provision for every household. In the medium-term it could embark on a nationwide home retrofitting program, creating jobs, reducing costs and carbon emission all in one swoop. It could nationalise the energy companies to help achieve both of the above solutions, as the Trade Union Congress has proposed. Such spending would, of course, increase the government’s deficit. But since the interest rate on public borrowing is will always be significantly below that facing households and firms, it makes economic sense, to say nothing of the fact that sovereign states like the UK create money when they spend and cannot ‘run out of money’.
A third option, which may be preferable given inflationary concerns, is for the government to undertake the above fiscal expansion but at least partially offset the new money creation by withdrawing it via increasing taxation. Here the obvious candidates would be windfall taxes on the energy companies and other firms that have ridden the wave of higher prices. More generalised alternatives would be the introduction of wealth and property taxes to capture economic rents. Either way, the target should clearly not be lower-income groups.
In the longer term, the only way to bring down energy prices will be to decarbonise the energy system. Raising interest rates directly mitigates against this process given the cost of capital for renewable energy firms is significantly higher than for fossil fuel companies due the high levels of upfront investment required for the former. The Bank of England could consider a dual-interest rate scheme that encourages green lending to counter this. It could also go further and consider introducing credit guidance policies to green financial flows, as was commonplace in the post-war period.
These are all policies that would help steer the economy towards a greener, fairer and lower cost future. Fiscal, monetary and industrial policy need to coordinate to meet the multiple crises facing the British economy, working in tandem to achieve a just transition. The blunt tool of interest rate hikes will only worsen existing inequalities whilst doing nothing to support the structural change the economy requires.