The Government must take on the burden of challenging inflation

The influence of the state on the economy is legitimised through two main aims: increasing the options available to the individual – and hence their liberty – by securing broad-based prosperity, and addressing externalities and frictions that the market cannot address, thereby also increasing prosperity, increasing the options open to individuals, and protecting individuals from unreasonable harm. These obligations create distinct pressures in the short-term and the medium-to-long-term. For the former, it is clear that right now, moves need to be made to address both the real-terms deprivation that households are experiencing and to address the closely related issue of excessive inflation that is rapidly eroding the value of people’s income. For the latter, the only sustainable way of improving broad-based prosperity is to increase productivity per hour worked, allowing incomes to grow or individuals to take increasing amounts of leisure time without sacrificing current living standards.

As an aside, this latter pressure does not mean that union efforts are not vital in increasing wages. They are. And efforts should be made to increase the bargaining power of unions to address unfairly low wages and wage growth. It is, however, the case that the productivity of a worker is necessarily a cap on the income that worker can receive – if a company were to pay every employee more than the value of what they produced, the company would be running a loss. More broadly, it couldn’t be the case for every company to do this, as there simply wouldn’t be enough stuff made to do this. Therefore, while structural changes are needed to improve pay, such structural changes can only result in a one-off uplift in incomes, and hence can’t generate sustainable increases independently of increases to productivity in the sense that they can’t increase incomes indefinitely (though it should be noted that some studies do show changes in organisational structures do influence productivity).

The current crisis of stagflation – that is low or negative economic growth coupled with high inflation – is the root of most of the government’s current issues. Since the Bank of England was granted independence, it has perhaps unfairly been left with assuming the burden of managing inflation, primarily through the tool of controlling interest rates, or more accurately, the one-day interest rate at which the Bank of England will lend to commercial banks, who typically will pass changes in that rate onto their customers for both unbacked loans and mortgages. It is the latter that has taken much attention in recent discourse, and not without good reason.

The core of inflation is the disparity between changes in the supply of currency and changes in the supply of goods and services. This can be driven either by an over-supply of currency, or an under-supply of goods. Making the incredibly bold assumption that consumption is for all goods and services able to be continuously reduced with a correspondingly continuous decrease in utility, we can understand one purpose of interest rate changes rather simply: the act of increasing interest payments (primarily on mortgages) means that currency has been eliminated from circulation, as more of people’s income that they would have spent has gone to interest payments. That assumption needs some clarification, and the reader should be aware that we’re not uncritically accepting it, or indeed accepting it at a household level, as will be explained below.

Informally, the assumption is simply that if one were to reduce their consumption of a good, say, entertainment, by a small amount, then the decrease in the utility or wellbeing resulting from that is also small. Another way of saying this is that there are no cliff-edges. For a lot of goods and services this is reasonable, but it’s not difficult to think of examples where this isn’t the case – food, heat, and water are all goods where there is obviously a point at which reduction in the good results in a massive decrease in utility, corresponding to starvation, freezing, or thirst/unhygienic environments. That economists often use this assumption is not evidence of any sort of apathy to human suffering, but rather because it makes the mathematical analysis of economic models tractable in a way they otherwise wouldn’t be. Some modern economists have started exploring utility functions that don’t imply this assumption (the interested and mathematically advanced reader should consider looking up “generalised CES aggregators”), but much thinking is rooted in the idea that consumers with lower income can just consume a bit less of a wide range of goods and services when in reality this won’t hold, and reduction of consumption in response to other variables isn’t feasible or is extremely undesirable.

There are two main reasons that interest rates – a single value – are not suited for the issue that is currently facing us. Firstly, is the shotgun approach it takes to the population. Simply put, for a lot of people, over-consumption isn’t the problem, and for these people consumption can’t be reined in much more than it already has. This has the additional issue that increases in mortgage interest payment rates don’t have the intended affect. It’s unavoidable that they reduce lifetime consumption – the expenditure of increased interest payments comes from somewhere, and it’s hard to imagine that it has any stimulating effect on a household’s income – but it’s not a foregone conclusion that reduction is achieved in the present. Currently the UK is seeing many homeowners who are reaching the end of their fixed term rates extending the term of their loans so that monthly repayments remain roughly the same. For many, this is likely because consumption can’t be reasonably reduced. For the same reason, many have started dipping into their savings, rather than cutting consumption. This means that the effect of interest rate rises in reducing inflation by reducing consumer demand doesn’t happen in the current period. Given that the intention of raising short-term rates is to affect short-term variables, depressing consumption far in the future of these households (particularly the period in which they had planned to have finished paying off their mortgages and will now still be paying, or when they had originally intended to draw down from their savings) does nothing to help any macroeconomic aim and only depresses the long-term wellbeing of households.

Worse than that, households that own their home outright are the only demographic that aren’t harmed by increases in interest rates increasing the interest rates on mortgages. The ways in which mortgage-holders are affected is obvious, but renters will suffer similarly as their landlords raise their rents to accommodate increased mortgage payments or as landlords who own properties outright increase rents to take advantage of the market conditions. The only demographic spared is the third of households that own their homes outright – households that are wealthier and better placed to withstand reduced disposable income, simply because they have more of it.

Secondly, the function that maps interest rates to everything we care about is under-specified, in that the range of this function is multivalued; we care not only about the rate of inflation, but also about growth, unemployment, homeownership, and living standards. Without exceedingly good luck, this is mathematically doomed to failure. If I have a function, say the square root of x; another function, the square of x; and a target that the first function should be exactly 6, it would be unreasonable for me to then introduce the target that the second function must be below 900, as the first target requires that x be set to 36, and the second target requires that x be below 30.

Fortunately, if we are to understand the effect of interest rates as being the elimination of currency from circulation, then we only have to look to fiscal policy to find a tool that can be applied far less bluntly to achieve the same goal: taxation. This line of thinking borrows much from modern monetary theory, and while we should be cautious of uncritically adopting models that depart from orthodoxy and which can be used to motivate policies we already advocate, the argument is hard to refute. In any case, an analogous (though perhaps clunkier) motivation can come from a more explicitly Keynesian framework. The general idea is that taxation does not pay for government activity in a direct sense by taking existing money. Instead, currency is introduced into the economy by the state through state spending on both capital expenditures and current expenditures such as wages and benefits. The purpose of tax is to then eliminate a correlated amount of currency in order to not introduce more currency into circulation than real value generated by this spending, hence avoiding inflation. Without tax acting in this way, the amount of money would increase more than the amount of stuff that people want, allowing people to bid more money on any given good.

By setting tax appropriately, currency can be eliminated from the economy in a way that doesn’t cause extreme hardship, namely through progressive taxation. Instead of everyone facing a sudden loss of disposable income through increased interest payments, which increase by the same proportion for all, we can protect the disposable income of those earning the lowest, and increase taxes on incomes over a certain value (through whatever tax is preferable, be it income tax, national insurance contributions, or capital gains tax). At its simplest, this would represent increasing the value of higher rates of income taxes or national insurance contributions. That said, the state has complete discretion over how it chooses to delete money in the economy through tax, and so while the current typical adjustments in tax are finite vectors (that is, any change in tax can be described by the rates of each tax band and the thresholds for each tax band), the options open to the state are much wider. For the purpose of taxation being simple to understand – which is important, as individuals should be able to easily predict and understand the way in which the state is going to confiscate their income – tax as a function of income should probably be restricted to piecewise linear functions, which are functions composed of straight lines that change steepness at certain points, but this still leaves plenty of room for the state to address inflationary concerns while protecting living standards. This means that fiscal policy, as opposed to changes in interest rates, can successfully target multiple metrics in a way that interest rates are fundamentally unable to. Such a policy also has the advantage of not being able to be circumvented by measures such as extending the terms of repayment.

It should be noted for full completeness that addressing inflation through progressive taxation is a choice. It’s one that we should take, because it is vital that no one in the UK choose between heating and eating, or face homelessness. But taming inflation through a progressive tax would entail confiscating more of the population’s income than some alternative fiscal policy. This is because the effect of fiscal policy on inflation is affected by people’s propensity to consume – the proportion of their income they spend on consumption, where consumption is understood to be the alternative to saving. Household’s propensity to consume is a decreasing function of their income and wealth. Poorer households spend a higher proportion of their income than richer households. The higher the propensity to consume, the greater the effect of a change in income on inflation as more of that increased or decreased income will be put into or removed from circulation. Indeed, if the only role of the state was redistribution, it would be the case that to maintain an inflation rate of zero, the state would have to run a surplus – where we now understand this to mean that the state removes more money through tax than it adds through spending, or in this case than it gives out through benefits. If it instead ran a balanced budget, the same amount of money would exist, but because it has been shifted from those with a lower propensity to spend to those with a higher propensity to spend that total demand in the economy would increase, thus driving inflation. To be clear, targeting an inflation rate of zero would not be desirable for a variety of reasons that aren’t of interest here, and the state should absolutely not only act to redistribute income and should instead be fiscally active in other ways such as developing public infrastructure, but this illustration is useful in understanding how varying propensities to consume interact with systems of progressive tax. If we chose to address inflation with progressive tax changes, we would be taxing more than we would otherwise have to. I would strongly argue that this is worthwhile and to do otherwise would be unbecoming of us as a society, but there are legitimate ideological disagreements to be had here.

While we’ve so far discussed how interest rates effects consumer demand through mortgages (and the downstream effects on the rental market), it’s worth noting that another way in which higher interest rates are intended to reduce inflation by reducing demand is by also disincentivising businesses from taking on debt to finance investment. Investment entails demand for inputs to expansion such as raw materials and services. More investment means more demand for these inputs, which means more inflation. As opposed to mortgages, this does have an immediate effect.

What’s unfortunate is that the UK is struggling with investment already. Underinvestment has resulted in productivity-growth of virtually zero since the financial crisis – a situation not seen in comparison countries – and we are currently in a crisis of not having enough stuff rather than having too much demand for stuff; hence why many households simply can’t reduce consumption. Were productivity higher inflation would be weaker, as the rate of increase in the amount of stuff people want would be higher and therefore closer to the rate of increase in circulating currency. The issue of productivity is directly related to that of inflation, and vice versa as increased inflation decreases ability to invest.

Addressing the short-term issue of appropriate inflation rates and the medium-to-long-term issue of low productivity growth arising from under-investment is difficult. In all likelihood, the consensus that there is just no combination of policies that lead to a painless recovery is correct. Since there is a lag between investment and increased productivity, any boost to investment will have an inflationary effect due to increased demand before it has a deflationary effect due to increased supply.

That said, we also exist in a context where some investment can’t wait. The industries supplying means to mitigate or adapt to climate change need to massively expand, ideally twenty years ago, but failing that, now. Delay isn’t an option and previous delay is why a focus on adaptation measures is now a priority alongside mitigation measures that reduce GHG emissions while maintaining living standards. The health and social care sector and the education sector need to invest in higher salaries to address the issue of talent being lost to other countries offering better incomes to doctors, nurses, and teachers, or to other groups in the private sector seeking the same skillsets and willing to pay for them. Analogously to the ways in which tax should act to deal out enforced reductions in demand through currency elimination among households in a way that is fair and commensurate with each household’s ability to bear this rather than the broad brush of interest rate rises, the UK must similarly identify industries that can’t wait to grow and craft taxes so that the industries which need to bear the current brunt of restrictions in investment are incentivised to do so. This again is within the power of the state as it determines fiscal policy.

Ultimately, interest rates are too blunt a tool for what we need right now. This isn’t to argue that interest rates aren’t legitimate and that rate changes aren’t necessary. Debt and credit are legitimate items and necessary for smoothing income and consumption over a lifetime, and there needs to be an incentive for people to make loans which is interest. It’s just not clear that monetary policy is a better tool than fiscal policy in addressing the UK’s current malaise. It’s possible it’s the only tool that’s perceived to be politically palatable – tax is often perceived as sticky (that is, difficult or slow to change), and it is useful for a democratically elected government to be able to blame an independent body for households’ hardships. For taxes to be used in this way would require a shift in thinking as well as legislative changes – perhaps specifying in the budget a range over which tax rates can vary as opposed to a fixed value. Until the state acknowledges the role of fiscal policy in maintaining appropriate levels of inflation while still attacking medium-to-long-term goals, there will be more suffering than there needs to be.