Churchill commented, “It is a joke in Britain to say that the War Office is always preparing for the last war. But this is probably true of other departments and of other countries, and it was certainly true of the French Army.”
It is certainly true of the Treasury and the Bank of England in their war against inflation today.
The Last War
In terms of inflation, the Great War was the 1970s. Two oil price hikes ignited high inflation, which was perpetuated by a wage spiral – during the 1970s, despite what was then seen as an economic crisis, real wages rose. Although very few people are aware today of the data, most people became better off during the 1970s, unlike the last 13 years.
The 1970s war on inflation was fought by raising interest rates, which reduced people’s disposable income and eventually inflation fell back. Whether this was the best possible policy is certainly open to debate, but it did work, and it did not result in mass impoverishment. Policy makers developed then – and have not moved beyond now – a mental model of the problem of inflation and its solution.
The mental model sketched out below is still guiding today’s decisions: policy-makers still see the problem as a wage spiral which can only be tamed by reducing consumers’ ability to spend, through higher interest rates. The thick lines are the ones policy-makers see as important.
So we have the Bank of England raising interest rates in the middle of a cost-of-living crisis because, as the Financial Times explained, “The latest annual regular wage growth of 7.2% was far above the level that the BoE thinks consistent with meeting its 2% inflation target.” This is despite the same article pointing out that while wages had risen by 7.2% inflation was running at 8.7% – ie real (inflation-adjusted) wages had fallen by 1.5%.
Inflation is, of course, calculated as an average of prices. Prices which have been rising faster than inflation push the average up; those which rise more slowly are helping to keep it down. Wages have not been driving inflation.
This war is completely different from the war of the 1970s. There is no wage price spiral. Wages have not kept pace with – let alone been the drivers of – inflation since 2007.
Previous UK governments aimed to give the UK population a real pay rise each year – most years, most people would get slightly better-off than the year before. This government calls that “inflation-busting pay rises” and has successfully prevented it since taking office.
Our inflation is – quite obviously – not driven by wage growth. It has been driven by supply shocks. Some of them externally-driven, like the energy price impact of the Ukraine war. And some of it by UK decisions which have impacted supply, notably Brexit.
So the government and the Bank of England are together waging war on British wage earners, using a model which no longer reflects the real world, in their battle against inflation. They are also waging war on UK businesses.
In the real world, supply problems – eg energy prices – have increased UK costs and prices, which have in some cases been passed-on to consumers who have not been able to protect themselves through pay rises. Some businesses have passed on these costs, fuelling inflation. Businesses which have not been able to pass on their costs have seen profit fall and an increasing number have been forced into bankruptcy.
The result of the Bank of England’s interest rate rise will be to increase the costs on businesses further. A business which had an interest cover (the multiple of profit to interest charge) of four times – generally regarded as comfortable – in January 2022 would now be struggling to cover its interest charge. It would be on the verge of being unprofitable.
The real-world impact of the Bank’s policy will be to plunge more consumers into financial distress and more businesses into loss. This may well cause a recession – indeed some of the Chancellor’s advisers are calling for one – and it will almost certainly do more long-term damage than the inflation itself.
What should they do?
All this was quite foreseeable. We wrote last year that the UK was set to mishandle inflation, because we would mis-diagnose the problem:
“Policy-making on inflation is poor: we treat it as a single, simple issue; we mistake inflation for a measure of ability to buy; we assume that low inflation is a sign of a strong economy; we panic about it when we see it; and we use the wrong tools to contain it.”
Our conclusion was that instead of using interest rates as the policy ‘solution,’ the Governor of the Bank of England should have the courage to write to the Chancellor and the Prime Minister explaining that this is not the kind of inflation the Bank can tackle with interest rate rises and suggesting government policies which could help. These would include:
- Protecting the most vulnerable by imposing price caps on energy and windfall taxes on energy companies, by reforming the energy regulator Ofgem so that it properly protects consumers’ interests, and by temporarily reducing taxes on energy;
- Progressive taxation to fund a rise in benefits without fuelling inflation – raising the rates of tax on dividends and capital gains so that unearned income is taxed at the same rate as earnings would be a start;
- Investment in capacity building in green energy generation, energy storage and energy efficiency measures to help reduce the supply constraints. Although in the very short term, this could fuel inflation, in the long-run, building capacity is what prevents supply shocks and will prevent inflation taking hold. And, of course, we face a climate emergency, which makes these things even more urgent.
It is not that there is nothing constructive that we could be doing to ease the cost-of-living crisis; it is simply that our government and central bank are not planning to do it.
If you would like to see a move to rational policy-making in the UK, take a look at the 99% Organisation and join us.