Political choice isn't the same as economic necessity

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One of the most widely-understood concepts in economics is the law of supply and demand, where the price of an item ends up being set at a level where the demand exactly equals the supply. It’s not only the best understood, it’s also an incredibly useful concept, underpinning the way in which markets work. It also gives rise to the idea that price increases happen when demand exceeds supply, and if supply cannot be increased in line with demand, then inflation results. It follows that one way of controlling inflation is to reduce demand – which is usually interpreted in practical terms as reducing people’s ability to spend. One way of doing that – and this is virtually the only tool available to the Bank of England – is to increase interest rates. People who have to spend more on borrowing money have less available to spend on other things, and are forced to concentrate more on the essentials of life.

The theory, though, is much cleaner and simpler than the practice. Not all inflation is caused by such a simple theoretical mechanism. Much of the inflation we are seeing today is a direct result of a perceived reduction in the supply of oil, caused, primarily, by Trump’s reckless bombing campaign in Iran. There isn’t an actual shortage (as yet), and if a real shortage does emerge, it will be more to do with the difficulty in getting the oil to market than with any underlying shortage. The perception of a threat of a shortage has, though, allowed speculators to push the price up, and the oil companies to increase their profits at no additional cost to themselves. Inflation caused by rising demand is not the same thing as inflation caused by a reduction in supply – especially when it’s not even a real reduction. The increase in the price of oil is real enough, however, and works its way through not just to the price of fuel at the pump, but to the price of everything which needs to be transported from one place to another – which is most of the things we buy.

The Bank of England seems poised to respond to ‘inflation’ in the only way it knows how, by increasing interest rates. It’s an example of someone with only a single tool in the box, a hammer, seeing every problem as a nail; but it’s a circumstance in which an interest rate rise does nothing to address the underlying problem. Far from prices rising because people have too much money, this type of inflation is already leading people to cut back on their spending; deliberately reducing their spending power still further just adds to the cost of living crisis. The government and its wholly-owned and controlled central bank cannot seriously claim to be addressing the cost of living crisis whilst simultaneously adding to it.

Then we have the Tories’ latest wizard wheeze of cutting welfare benefits to control inflation. There is no doubt that cutting benefits would reduce the amount of spending power in the economy, which is the stated objective. However, it would do so by reducing the spending power of some of the least well-off, almost all of whose income is already going on essentials rather than discretionary purchases. Reducing the spending power of those already struggling to pay for the basics is applying abstract economic theory without looking at the real impact on real people.

Whether the increase in energy costs is a temporary phenomenon or a longer term change remains to be seen, but either way, it will work its way through the economy in a way that a general  excess of demand over supply would not. Whether it therefore needs action at all is a judgement call, but it seems that judgement is being replaced by a blind commitment to a wholly arbitrary inflation target of 2%. And, as is ever the case in an economy run for the benefit of the few, it is those least able to cope who will bear the biggest burden. It’s a political choice, not an economic law, which underpins that.

Wielding the hammer. Again.

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For those who have been battered by the rise in the cost of living recently, the report that inflation is slowing down is good news of a sort. It’s usually better to get poorer slowly rather than quickly, even if that isn’t quite the way in which the government has presented it. Given the unshakeable belief of the Bank of England, and the government, that this fall in inflation is all down to interest rate increases, it means that we should be able to look forward to some interest rate cuts later this year. That will, of course, help the main target group which the government hopes can thus be bribed into supporting it, namely those with mortgages. It won’t necessarily help the poorest of all, but then they tend not to vote Tory anyway.

Economic theory tells us that high interest rates deter people from spending and therefore remove upward pressure on prices, rather ignoring the fact that they also further impoverish those who have little room for discretionary spending in the first place. The problem with the theory is the implicit assumption that inflation is always caused by too much money chasing too few goods and services, but that really wasn’t the cause of the most recent bout of inflation, which had rather more to do with the war in Ukraine and profiteering by energy companies who never let a good crisis go to waste. Still, when the only tool you have is a hammer, every problem looks like a nail, and the Bank of England has bashed away with great enthusiasm at that nail. It now seems to seriously believe that inflation with external causes which would have gone away eventually anyway has actually been vanquished by their demented hammer-wielding rather than by the passage of time.

And that brings us to the sting in the tail. Alongside the half-promise of interest rate relief at some unspecified later date came the warning that inflation might not have gone away yet because the hostile acts of the Houthis in Yemen against shipping in the Red Sea may yet cause a further bout of price rises, as goods either become scarcer, or the cost of shipping them increases. In terms of the threat of inflation, it’s a reasonable fear – but it doesn’t follow that the answer is to continue using that hammer. The mechanism by which high interest rates impact inflation caused by hostile acts at sea is, being charitable, less than entirely clear. It’s not as if the Houthi leadership is looking to buy houses in the UK, and will be deterred from launching rockets by continued high mortgage costs. High interest rates aren’t going to affect the scarcity of goods or the price of shipping them either, merely help to ration them on price. It doesn’t take a genius to work out who loses most from rationing by price.

Slowing the rate of decline

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There is a scene in ‘the Scottish play’ where a somewhat drunken porter explains the effects of drink to Macduff and Lennox. One of the things which he says is impacted by drink is lechery. As he puts it: “Lechery, sir, it provokes, and unprovokes; it provokes the desire, but it takes away the performance”. Leaving aside any question about the extent to which this may be literally familiar to some politicians, the political parallel which actually brought this to mind is the impact of an increasing cost of living on wage rises. It provokes the desire for wage rises, but takes away the value of any that are actually achieved.

Yesterday, the PM stood up at PM’s Questions and claimed that the government was “…delivering… the fastest wage growth in years”. In absolute terms, it’s probably true, or at least as close to being true as any words that emerge from the mouths of ministers these days. But given the efforts which the government has been making to control pay rises, it’s a strange thing to claim as a ‘success’. And whilst it may be true in absolute terms, in relative terms wages are still lagging behind prices. He could, with an equal level of veracity, have announced that the government is “…delivering the fastest decline in real wages in years”. Some might argue that that would also be a ‘success’ for a government hell-bent on reducing the standard of living of the many as a way of opening the door to tax cuts for the few.

It isn’t the only ‘creative’ presentation of economic statistics. Other ministers have been saying things like ‘a fall in inflation is the best type of tax cut’, and ‘when inflation is halved and people see prices starting to fall, they will feel better off’. It’s possible that their level of mathematical understanding is so low that they believe this stuff, and that they really don’t understand what inflation is. Occam’s Razor tells us that the simplest explanation (‘they’re just stupid’) is probably more likely than the more complex one (‘they know that they’re talking rubbish, but think they can fool us’). Those of us who live in the real world understand that, whilst falling inflation is, on the whole, a good thing (even if zero inflation is not necessarily so good) a world in which wage growth lags behind price increases simply means that we become poorer more slowly, not that we become better off.

Ultimately, that is the very best economic proposition on offer from the current government – 'we’ll slow down the rate at which you get poorer'. Trying to spin abject failure as success is all they have left – the desperate last throw of the dice.

Getting poorer more slowly

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The reluctance of trade unions to accept some sort of one-off payment in recognition of the high level of inflation this year is understandable. One year’s 10% inflation doesn’t disappear if inflation halves in the next year, it merely becomes part of the next year’s base level of prices. So, if inflation is 10% one year and 5% the next, when we take into account the wonder which is compounding, it needs a total increase in pay of 15.5% over the two years just to keep pace with the cost of living. And that’s without even considering the extent to which pay fell behind prices in the years before that. Suspicion of a non-consolidated payment for one of those years is entirely justified.

The government are making a great play of the idea that they are getting the cost of living under control by reducing the rate of inflation, but a reduction in the rate of inflation when wages continue to lag behind prices doesn’t ‘solve’ anything. It merely slows the rate at which people fall behind. “We will slow the rate at which you get poorer” isn’t the catchiest of election slogans, yet that is the best that the current government is effectively offering. Far from regretting that people do not have a proper command of mathematics, government policy on pay depends on the assumption that people don’t understand that reducing inflation in itself is not enough. They may find that people’s understanding of basic mathematics as it directly affects them is rather better than they might wish. Voting to be impoverished more slowly is not the most attractive proposition.

Still dividing, still ruling

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Divide and rule is probably the oldest trick in the book for the ruling elite, yet still they get away with it. It is such an obvious trick that one might think people would start to see through it, but enough people seem to fall for it every time to allow the elite to maintain their grip on society. Control of the media is clearly a part of the trick, but the gullibility of large numbers is probably more important. And social media – which theoretically provide an opportunity for alternative views to those expressed in the main stream media – are filled with the views of the gullible, acting as willing shills in their own oppression. The rail dispute is more complex than much of the more simplistic reporting suggests; arguments over the replacement of people with technology and new working methods are in the mix as well as the pay dispute as such. But at the heart of the dispute is an argument over whether holding down pay – and thus imposing a real cut in living standards – on working people is the only or even the best way to prevent a wage-price inflation spiral.

The first problem with even presenting it in that way is that current inflation is not the result of a wage-price spiral at all. It’s understandable that those who remember the inflation of the late 1970s would be keen not to return there, although it’s just possible that a government whose whole approach depends on expecting people to forget what they’ve done in the last 12 years might be pinning rather a lot of its hopes on people remembering what happened almost half a century ago and being suitably afraid as a result. The point, though, is that the causes of inflation now are rather different; even if the solution was the right one in the 1980s (itself highly debateable), it doesn’t follow that it’s the right one today.

The government are largely getting away with framing the terms of the argument, and Labour’s absolute terror of being seen to be supporting working people defending their standard of living is a complete gift to the Tories. Not only does it reinforce the Tory framing of the dispute, it also assists Tory stereotypes about the evil trades unions and alienates Labour from many of its own members and supporters. Dominic Raab has told us today that the government (which claims not to be a party to the dispute or to have any role in its resolution) “can’t allow … the unions … to win this argument”, as though ‘the unions’ are somehow an entity completely different from and divorced from the working people they represent. The Tory line is accompanied by misleadingly selected figures about how much the employees in dispute currently earn, in an attempt to suggest that they don’t ‘need’ an increase at all – a dishonest way of stating that they must accept a cut in living standards. The figures have, of course, been seized upon and repeated ad nauseum by people complaining that they (or nurses or some other ‘deserving’ group) earn less and aren’t getting a pay rise at all. They’ve been conned into a silly and ultimately self-defeating argument which focuses their ire on a different group of working people rather than on those who are orchestrating the attack on living standards.

It's true, of course, that some people earn less than some rail workers. It’s true, equally, that some of those lower paid people will get a wage rise lower than that asked for by the rail workers. It’s true that there may be some unfairness in both of those things. But extrapolating those facts to an argument that rail salaries must not be allowed to keep pace with inflation is an argument which justifies and supports the attack on their own living standards. Their ire would be better directed at those who are doing very well out of the misnamed ‘cost-of-living crisis’; the bankers gaining as a result of interest rate rises which generate extra profits for no extra work, or the oil giants benefiting from a wholly speculative price increase when their costs of extraction have changed not one iota. And, of course, the speculators and gamblers who so heavily fund the Tory Party. Just what does it take for the working people criticising the rail strike to realise that their own interests align more closely with those of the rail workers than those feeding them the lies?

Pinning the blame where it belongs

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Being extremely rich should not, in itself, be a bar to serving as a government minister. What should act as much more of a bar, however, is an inability to even begin to understand the pressures on people for whom even a small drop in their income or a small increase in the costs of things they buy makes a huge difference. Unfortunately for the population at large, the two things do have a strong tendency to occur in tandem. It doesn’t even take vast wealth on the scale of that of the Chancellor’s household to make someone tone deaf to the needs of ordinary people; even the comparatively modest income of the PM, which puts him in the 99th percentile (i.e. he is paid more than 99% of the UK’s population), is enough to leave him floundering when it comes to the impact of his policies and statements on people.

Yesterday, he told us, in effect, that we must not expect our incomes to rise in line with inflation; a statement which amounts to telling us that we must accept a real-terms fall in our standard of living. Belt-tightening will inevitably look more than a little easier to bear for someone whose household maintains a stock of multiple types of bread than for one which is struggling to buy a single loaf. Most of us fall between those two extremes, but those closest to the highest end of the range seem to find it impossible to understand the pressures on those lower down the scale.

(As an aside, I’ve long believed that there is a good argument for setting MPs salaries at the average for the population as a whole (about £26,000 in today’s terms, although there would need to be additional travel and accommodation expenses to cover their costs of doing the job). It would incentivise them to do two things – firstly to try and lift the average salary of the population at large, and secondly to minimise the differences between the top and the bottom. We could give it an imaginative name – something like ‘levelling up’, maybe. The argument against has always been that we need to pay higher salaries to get the best people, but there are several answers to that. The first is simply ‘Boris Johnson’, disproof, if ever it were needed, that paying a high salary attracts the best people to the job; the second is that the process of selecting MPs (i.e. voting for the one with the right colour rosette on his or her lapel) in no way resembles a process of selecting for ability; and the third is that people attracted to the job because of the high salary may not always start out in the right frame of mind to see themselves as servants of the people.)

It's worth asking the question that Johnson obviously has no intention of answering directly – why exactly are we in a position where he is demanding that people accept a cut in living standards? When multiple factors are at play, it’s always difficult to sort out the relative impact of each, but we know at least some of them: the war in Ukraine; the aftermath of Covid; and Brexit. Some elements of this are outside the control of the UK government, but not all. And in every case, government actions have made things worse than they could otherwise have been. Energy price rises, for instance, have been more modest in some countries because their governments have chosen to make it so, and the Brexit decision to leave the single market and customs union and the associated impact on the supply chain is a deliberate and pre-meditated own goal. To an extent, it is not unreasonable for the government to say that they cannot control all of the events impacting on the cost of living, but they could do more to mitigate that impact, particularly for the most vulnerable. Saying ‘we’ll do more’ without being able to answer the obvious questions about ‘what’ and ‘when’ is no answer at all. It is, however, wholly unreasonable to expect the population at large to take a hit for government incompetence and ideology-driven policy making, which is what Johnson is, in effect, demanding.

Hammers and nails

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They say that when the only tool you have is a hammer, every problem looks like a nail. The Bank of England is demonstrating the consequences of that. It’s easy enough for the UK Government to repeat ad infinitum that the BoE has sole responsibility for controlling inflation, but the only tool that they’ve allowed the Bank to have is the very blunt instrument of interest rate rises, a tool which the Bank is using with abandon despite the fact that the problem with which they are dealing bears little more than a passing resemblance to a nail.

The theory behind interest rate rises is simple enough: if the cost of money increases, people will borrow less and spend less, and if less money is chasing goods and services, the price of the latter will stabilise. Like most theories in economics, however, it’s only as valid as the assumptions underpinning it, and in this case, the assumption is that inflation is caused by too much money chasing too small a supply of goods and services, the classic cause of inflation. If that assumption were true, making money more expensive might well work, albeit at a cost. However, in this case, the problem isn’t an excess of money in the UK economy, it is a price shock caused by events – some of them, such as Brexit, caused directly by inept government actions, and others, such as war and the pandemic, completely outside the control of the government, let alone the Bank. The Bank’s governor has himself admitted to feeling “helpless” in this situation, although that hasn’t stopped him wielding the hammer with gusto against the imaginary nail.

In response to an external price shock, interest rate increases don’t stop the poorest needing to buy essentials, they simply pile more financial pressure onto people. Continuing to hit the non-nail with the hammer can only make things worse, potentially leading a government which claims to be promoting growth to preside over a recession instead. In response to the level of price shock that we are experiencing, only government can take action; blaming the Bank, as some Tories have done, is simply abrogating responsibility. And even the government, with all the resources at its command, cannot prevent the sort of price shocks we are seeing; but what it can do (and is refusing to do) is to mitigate the effect on the most vulnerable in our society. If there’s one clear lesson from the pandemic, it is that the government is not, in practice, constrained by a lack of money, a point which they are demonstrating yet again with the huge costs of supporting Ukraine in its defence against the Russian attack. They could equally deploy sufficient resources to help people through the current crisis, but have taken a conscious decision not to do so. They are, instead, fiddling around the edges of the problem, leaving those who can’t cope to their own devices. They’ve probably assumed (and its not an assumption which I’d challenge) that the people bearing the brunt of the crisis aren’t, and never will be, Tory voters. It’s just another demonstration of a complete lack of care for any citizen who isn’t one of them.

Right hands and right hands

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Insofar as the UK government can be said to have an economic strategy at all, it is one which depends on achieving a level of growth in the UK economy. But that growth is expected to somehow just appear, as if by magic, with no meaningful government action to bring it about. In the meantime, according to one former Bank of England official, the ‘independent’ Bank of England is obliged to force the UK economy into recession in order to hit its 2% inflation target. And who, exactly, sets the BoE’s target and demands that it meet said target? Well, that would be the same government whose forecasts on tax revenue and deficits assume that the economy will grow rather than shrink. They could, of course, change the BoE’s targets at any time. That would rather expose the fact that the idea that the BoE is in any meaningful sense ‘independent’ is more myth than reality, but leaving aside that entirely self-generated political problem there is nothing to stop the government relaxing the inflation target (whether in the long term or only temporarily) and replacing it with a target of achieving full employment. That would offend the Tory ideologues, of course, but it would benefit those citizens in difficulty in the here and now.

Worse, amongst the factors claimed to be driving inflation (other explanations are available) are a shortage of labour in some sectors (a more-or-less direct result of the ending of Freedom of Movement with EU countries), a privatised energy sector which has prioritised short term profit over longer term energy storage and security, the impact of Brexit and Covid on trade, and the war in Ukraine. Only two of those (Covid and the war) are not the direct result of ideology-based government policies, and both of those are exacerbated by a government declining to take mitigating action. In short, if we accept the theory of inflation being promulgated by one of those who has been very close to decision-making in the past, and whose views appear to be in line with Treasury thinking, we have a government which is deliberately following policies which lead to higher inflation, instructing the BoE to force the country into recession, if necessary, to control that inflation, and then basing its fiscal policies on the assumption not only that there will be no recession but that the economy will grow, all-the-while wringing its hands about the utterly but conveniently misnamed ‘cost of living crisis’. It’s not in fact a ‘cost-of-living’ crisis at all; it’s a full-blown economic crisis directly caused by government policy. It’s not so much that the left hand doesn’t know what the right hand is doing, as that having two right hands inevitably leads to some form of circular anatine aquatic motion (as the late Rhodri Morgan might almost have put it). At best.

All models are wrong - and some aren't even useful

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On Monday, the Tory group leader in the Assembly demanded that the First Minister dissociate himself from Corbyn’s policies, claiming that they would result in around £4,000 of extra debt for each person in Wales, and that the UK would end up paying around £5.8 billion a year in additional interest payments if Labour’s plans were implemented.  It’s the stuff of good political knock-about, but without a lot more information on how they’ve done their sums (and the Tories don’t exactly have a brilliant record when it comes to financial arithmetic), it’s difficult to know what, if any, relationship exists between his figures and ‘truth’, in the mathematical sense of the word.

But, for the sake of argument, let’s suppose his figures are accurate ones.  Is it really the economic disaster as which he paints it?  Of course, £5.8 billion sounds like a very large sum of money to be paying in extra interest every year, but that’s in absolute terms.  And it makes a number of unstated but implicit assumptions.

The first comparison that has to be made is not, as the Tories effectively claimed, with the status quo, but with what the outcome would be over the same period with a Tory Government.  The implicit assumption in what Davies said is that Tory spending plans would not lead to a similar outcome, but given the way in which out-turn has varied from predictions over the last few years, and the way in which much of the (uncosted) Tory manifesto has been ditched, that looks to me like an invalid assumption.  If there is a gap between the likely outcome under a Corbyn government and the likely outcome under a Tory government (and even that is a significant ‘if’) then it is probable that the gap would be much smaller than Davies is suggesting.  All the signs are that the Tories will also increase borrowing to pay for their programme; the honest question is not how much Labour would need to borrow, but what is the difference in borrowing levels between the two.

The second question is about what proportion of GDP the debt would represent, and what proportion of expenditure any extra interest payments would represent.  Both of those are dependent on a range of assumptions and guesses about the likely level of inflation, economic growth, and interest rates.  Given the propensity of all involved to get such estimates wrong, it would be a very brave person who would claim to know the correct value of any of those variables over a five-year parliament.  But in principle, simple mathematics shows that a debt which increases in absolute value by a smaller percentage than the rate of economic growth will end up reducing the ratio of debt to GDP, which is why the absolute value being used by Davies is irrelevant.  The same mathematics also demonstrates that when interest rates are lower than the rate of inflation, paying more interest in absolute terms can still result in a reduction in the percentage of government income committed to paying interest.

What we do know is that, as things stand today (and I accept that’s a very important caveat), the UK Government is effectively borrowing money interest-free.  It’s costing us, in real terms, absolutely nothing, and given the demand from people who want to lend money to the government, there is no immediate problem in borrowing more.  Indeed, some would even argue that increasing government spending actually generates more tax income than the amount spent: the calculation all depends on the value assigned to the infamous ‘multiplier’.

Now of course it is true that different economists will give different answers to questions such as these, but that merely serves to underline that economists base their predictions on models rather than on absolute truths, and there are a number of different models available.  As the famous statistician, George Box, said, “All models are wrong, but some are useful”.  It’s a point worth bearing in mind that when politicians state categorically what the outcome of a particular policy will be for the economy they are depending on a model of some sort, whether they admit it - or even realise it - or not.

As I said at the beginning, this sort of guff from Davies is all good knock-about politics, but it’s really froth; he has no more clue than do I about the accuracy of what he says.  The real question is why one particular model – the idea that the government is like a giant household, which is used by the Tories when they come out with this stuff – is taken as gospel truth by a media which regularly demands that politicians from other parties explain themselves in the terms mandated by that model.  It would be more useful to political debate – let alone to economic policy – if the idea which underlies much of what they say was challenged more forensically rather than being simply accepted.  And it’s a shame that more opposition politicians don’t appear to have the understanding or the confidence to do that.