Raising interest rates won't solve inflation

Against the new consensus in economics

Raising interest rates wont solve inflation

Interest rates are up, austerity is back, and we are told this is the only way to manage the current inflation crisis. Wrong. These approaches rely on a no longer fit-for-purpose economics orthodoxy. Instead of trying to solve a supply crisis with demand management, we should fundamentally reorganise our economies to face the supply constraints that will become the norm in our era of climate change, argues Jo Michell.


Following the recent brief but chaotic experiment with Tory fiscal profligacy, some commentators claim that the UK has no choice but to accept a sustained period of austerity. The market reaction to Truss's tax giveaways, they argue, demonstrates that the UK has no choice but to accept interest hikes, spending cuts and further dismantling of state provision.

This is a misleading account of the choices available to the government. It is true that an incoming Labour government will inherit an economy in dire straits following a decade of mismanagement. But a return to Treasury orthodoxy will only deepen the malaise; the forces that led to the stagnationary tendencies of the last decade – unequal income distribution, lack of investment and government retrenchment – have not gone away.

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However, these forces now co-exist with inflationary pressures driven by supply constraints: recurrent supply shocks will be a persistent feature of a heating planet. The simplistic critique of Keynesian policy currently pushed by "sound money" advocates serves to obscure these bigger issues. In order to debate the future of economic policy in a world of supply constraints, we need first to debunk these narratives.

"Keynesianism" is sometimes used, inaccurately, as a shorthand for policy which involves substantial borrowing and spending. A more accurate definition is that Keynesian policy refers to the use of macroeconomic tools to keep total spending in alignment with productive capacity: when demand is weak relative to the capacity of the economy to produce goods and services, stimulus should be used and vice versa.

Demand stimulus involves looser monetary policy (the reduction of interest rates), looser fiscal policy (tax cuts and/or higher government spending), or both. Conversely, when demand exceeds the capacity of the economy, inflationary pressure is the result, and tighter policy is the appropriate response.

Almost all economists recognise the need to manage demand in this way. In this sense, to use the words of Milton Friedman, "we are all Keynesians now". Indeed, the current orthodox approach to macroeconomic policy, which regards an independent inflation-targeting central bank as the appropriate institution to take the primary role in demand management, is sometimes referred to as the "New Consensus".

Why, then, given the prevailing consensus, is there so much disagreement on what the appropriate economic policy is? These disagreements partly reflect differences in emphasis among those who accept the current consensus -- appropriate policy depends on what we expect growth and interest rates to do over the coming years, and such predictions are highly uncertain. Disagreements also reflect differences on issues such as the extent to which higher public debt poses economic risks.


Claims that there is no alternative to current spending cuts and rate hikes thus reflect ideological positions as much as any dispassionate reading of the economic data and forecasts


Treating all differences in opinion as technocratic disagreements within a shared policy paradigm is misleading, however. Hawkishness on policy tends to align with political preferences: for those ideologically opposed to state activity and provision, concerns over government debt can be used as a fig leaf for policy aimed at reducing the size of the state; interest rate hikes can be presented as the unfortunate but unavoidable response to inflation – the fact that the resulting unemployment constrains wage claims and protects profit margins is seen as simply a fortunate side-effect.

Claims that there is no alternative to current spending cuts and rate hikes thus reflect ideological positions as much as any dispassionate reading of the economic data and forecasts. The position facing any incoming Labour government is undoubtedly difficult, but choices do exist. Public debt can be stabilised over a longer period, and stabilisation can be achieved without spending cuts – there is substantial scope for taxation of those on higher incomes. Furthermore, it is far from clear that the reaction to the Truss budget demonstrates that the markets will not tolerate further borrowing: there is little evidence that the size of the deficit was the primary driver of bond market turmoil. Inflation and interest rates are likely to have receded from their current peaks before the next election.

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Increasingly, however, it is becoming clear that the current economics orthodoxy is at fault. This orthodoxy holds that monetary policy (the policy interest rate set by the Bank of England) should take responsibility for adjusting demand so as to keep inflation stable, while fiscal policy (taxation and spending levels set by the Chancellor) should be set to ensure that government debt is sustainable.

This orthodoxy failed during the austerity years of 2010 onwards – tight fiscal policy led to weak economic activity, low productivity and stagnating wages. The Bank's attempts to counter these tendencies with near-zero interest rates and quantitative easing were ineffective but generated substantial increases in house prices.

In the current situation of global supply-driven inflation, the Bank's tools are likewise inappropriate: in order to generate domestic disinflation sufficient to counter global inflation, the Bank would have to raise rates enough to generate a major recession. The collapse in house prices that would accompany such a strategy would pose a serious risk of financial instability.


Tasking Central Banks with the primary responsibility for managing demand was a mistake


The current consensus is based on a set of ideas which is misleadingly called “New Keynesian” economics. Despite the name, the approach has more in common with the monetarism of the 1980s than the Keynesian ideas that monetarism opposed. The central monetarist claim – that the economy can and should be managed by requiring the central bank to make appropriate adjustments to the supply of money – was rapidly discredited and discarded once tested. But the idea that demand management can be achieved using monetary policy alone persisted, albeit with the money supply replaced by the rate of interest as the primary policy tool.

Tasking Central Banks with the primary responsibility for managing demand was a mistake. The Bank has limited capacity to determine overall demand – the main role of the Bank should be in managing the liquidity of financial markets. Government spending and taxation have a more direct influence on economic activity. Yet it would be a mistake to conclude that all that is required is to adjust the balance of responsibilities between monetary and fiscal policy, and to use fiscal policy more aggressively to maintain growth and employment.

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As described above, demand management policy aims to adjust economic activity to match the capacity of the economy – akin to adjusting the pressure on the accelerator pedal to keep to the speed limit. The challenge we currently face, however, is not only one of demand management, but also one of structural change. Our economies need to be fundamentally reorganised in response to the climate crisis. Rather than adjusting the pressure on the accelerator, the car needs to be replaced with zero-carbon public transport.


Reducing policy debates to “austerity” versus “expansion” stifles much-needed debates on how to tackle more fundamental problems. These narratives need to be exposed as economically incoherent and ideologically loaded


The required process of structural change requires both large-scale public investment and substantial redistribution. It is likely that public debt levels will have to rise further. The situation bears similarities to that at the end of World War II. Debt levels are high, supply is constrained, and substantial rebuilding is needed. As the experience then shows, the scope for progressive policy is constrained as much by the imagination of politicians as by the economics: the 50s and 60s were a period of substantial shifts towards state activism and provision, and income redistribution.

The current attempt to reassert a regressive Treasury orthodoxy serves to obscure these challenges. Reducing policy debates to “austerity” versus “expansion” stifles much-needed debates on how to tackle more fundamental problems. These narratives need to be exposed as economically incoherent and ideologically loaded. Only then can we face the real task of rebuilding our economies to cope with the crisis of climate change.

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