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.
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