Prices are rising. Money is worth less than it did a month ago, and a lot less than it did a year ago. Central banks, who have the ability to reverse inflation by raising interest rates, have been slow to react. They worry that higher interest rates can trigger a recession. But the effects of inflation are a lot more destructive than those of a recession, argues Eammon Butler.

Our financial authorities seem to think that inflation is nothing to worry about, and is far better than falling economic growth and recession. They are wrong. Inflation is the most universally destructive force known to economics.

SUGGESTED READING Recession is the threat, not inflation By David Blanchflower Since the financial crisis, the Bank of England has seemed desperate to prevent even a short economic contraction. It slashed interest rates, holding them at ‘emergency’ levels for over a decade. With prices rising, real interest rates became negative, and still are. At the same time it flooded us with ‘quantitative easing’ Monopoly money. The hope was that the ultra-cheap borrowing would induce entrepreneurs to start and grow businesses, while ultra-abundant cash would induce customers to buy their stuff. Up to a point, that worked: over the last few years, the UK’s economic growth has still exceeded its European neighbours (despite Brexit, as they say). But it is fantasyland growth.

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We all want to forget lockdown and spend, spend, spend and the Bank has semi-wittingly given us the cash to do it.

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All central bankers love to dole out money and credit, and bask in the economic boost it brings. But they are always late in reining in — dashing away the punchbowl before the party gets out of control, as one central banker put it. And, true, it can be hard to spot when the party has turned. For instance, the Bank did not expect consumer demand to bounce back so strongly after the pandemic. We all want to forget lockdown and spend, spend, spend and the Bank has semi-wittingly given us the cash to do it. That’s driving up prices — further compounded by the fuel and food shortages caused by Covid-fractured supply chains and the Ukraine War. And through-the-roof food and fuel prices affect every part of the economy. The Bank has had to double its inflation forecast, though still hopes that the inflation will top 11% and will be only temporary.

Yet if the Bank continues to deny reality, inflation will be high and prolonged. In the US, the Federal Reserve Bank realised it had to cool things and upped interest rates by 0.75pc. A day later the Bank of England bottled out, with a rise of only 0.25%. It’s a sign that they are not going to fix the problem, and it undermines trust in the UK economy. That is why smart money has moved to the US, boosting the dollar and depressing the pound — incidentally making our imports of food, fuel and all the rest even costlier.

Everybody knows the misery of recession, but why should we fear inflation even more?

For a start, fantasy money produces fantasy finance. In the early 1970s, I paid 17% (!) interest on my student overdraft. My response was to borrow as much as I could (!) since inflation was running at 23%. The bank was paying me to take its money! That is because, when prices rise rapidly and unpredictably, businesses just can’t keep up. Inevitably they make bad business decisions, and bad investment decisions too, that waste money, effort and time, leaving us all worse off.

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Six years of 10% inflation and your savings have halved in value. That is particularly bad for young people saving to buy a house: their dream will slip ever further away.

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We need investment in the right places, but inflation undermines that in a second way. The more you have of something, the less you value it. When businesses enjoy ultra-low interest rates, they are less careful about investing, and put more money into low-value ventures. Customers, meanwhile, with wallets full of Monopoly cash, spend it incautiously. It’s a double-quick march into a lower-value economy.

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Inflation fuels itself. Knowing that prices will be higher next month, people buy feverishly now, putting further upward pressure on prices.

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Third, inflation is great for spendthrifts — like the government — because they can borrow now and repay their debts in devalued money. It’s equally bad for savers, who see their savings eroded year after year after year. Six years of 10% inflation and your savings have halved in value. That is particularly bad for young people saving to buy a house: their dream will slip ever further away. But it’s bad for growth too: we need to encouraging savers because they provide the funds for investment in new and expanding businesses.

Fourth, inflation makes it hard even for a rational investor to know where to commit resources, leading to further waste. When prices in general are going up by an average of 11%, it is hard to see which ones are really rising and which are really falling — where demand is outstripping supply and vice versa. The ‘noise’ of the inflation drowns out the ‘signal’ of individual prices. That leads people to invest in businesses and products that are relatively unprofitable — and maybe unsustainable in normal times. The whole economy is affected by bad investment choices, and though everything might seem to be OK, or even booming, when reality reasserts itself, those poor investments have to be written off.

Fifth, inflation is hard to stop. It’s like a drug. People get habituated to the cheap credit and easy money. So it takes bigger and bigger doses to give them the same economic hit. That’s why Europe had hyperinflation in the 1930s and the UK had 25% inflation in the 1970s. (Nobody predicted that, either.) But the longer the authorities keep fuelling the inflation, the bigger the hangover when they stop.

Sixth, inflation fuels itself. Knowing that prices will be higher next month, people buy feverishly now, putting further upward pressure on prices. Workers put in pay claims that reflect not just what they have lost in the last year, but what they expect to lose in the next. That is why, in the 1970s, the National Union of Mineworkers demanded a 43% pay rise, and why we are seeing strikes and pay demands now. Those demands will get larger and the disruption more widespread, especially in the large nationalised industries — like rail, once more — industries that can disrupt the entire economy.

Inflation must be stopped dead, even at the cost of recession. Only with the economy on an even keel can it move forward.