Dennis Leech says treating the cost-of-living crisis like past inflation would be a disaster

The free market economist Milton Friedman said that “inflation is always and everywhere a monetary phenomenon”. To him and his monetarist followers, this was an iron law: a general increase in prices is caused by the money supply growing faster than the supply of goods available. It was never true; yet the Thatcher government made it the cornerstone of their economic policies in the late 1970s and ’80s with disastrous results.

Monetarism was eventually abandoned. Yet many commentators are framing the cost-of-living crisis the same way. They cannot fail to follow the herd and ignore the evidence of their own eyes.

Today’s price increases are due to supply-side factors: bottlenecks due to Covid; Brexit, that has caused labour shortages and bureaucratic obstacles to the movement of goods between the UK and EU; and increases in energy prices due to the Ukraine war.

But energy price increases are not driven solely by shortages due to Russian sanctions. They are amplified in the UK by another factor: the privatised gas and electricity markets that prioritise profit. Other countries, such as France, which have not embraced free markets so enthusiastically and have retained public ownership of energy, are experiencing more moderate price rises.

The stock response to rising prices is for the Bank of England to raise interest rates. This has been the rule ever since Gordon Brown set up an independent monetary policy in 1997. The Monetary Policy Committee had to keep inflation within a narrow range around CPI of 2%. That policy has proved unsuccessful for much of the time since the 2008 crash – and with inflation below target and record low interest rates.

Now we are told that the Bank of England must act. The Governor, Andrew Bailey, has pleaded that it is not to blame and warned that further rate increases will cause a slowdown. Nevertheless, having already raised rates five times so far, from 0.1% to 1.25%, he promises just that. Other central banks, notably the US Fed and the European Central Bank, are following the same irrational stampede.

Rising household bills are actually recessionary, because consumers have to cut spending in order to pay them and increased saving reduces aggregate demand. Increasing the cost of borrowing adds to this deflation while increasing inflation still further. It is exactly the opposite of what is required.

Monetarism was shown to be nothing more than an ideological chimera that does not work in practice in the 1980s, when it was the driving force of Thatcherism. It was a failure that led to deindustrialisation and widespread unemployment, and was eventually abandoned.

The problem is that the anti-inflationary policy regime set up by Gordon Brown in 1997 implicitly assumes that inflation is a sign of overheating caused by too much spending. The answer is to rein in spending by raising interest rates to increase the cost of money. But to apply that rule as if it is a universal remedy is to commit a monumental policy error.

This cost-of-living crisis is not an inflationary process, a technical matter of rising prices, but a matter of income distribution: households are having to pay a larger part of their incomes to boost company profits. These windfall profits serve no economic purpose beyond income for the already wealthy – they are not needed, for example, to incentivise investment – and should be taxed or limited by price caps to support households.

The danger is that the cost-of-living increase will become a wage-price spiral as workers seek higher wages, as happened in the 1970s. An inflationary spiral is a manifestation of class struggle as trade unions try to regain the wealth taken from workers by capitalists, and will inevitably result in further inflation unless sensible policies are followed.

There is a lot of confused economic thinking. Many point to the sheer scale of quantitative easing, that has meant all of Government’s additional spending since the financial crisis of 2008 and due to the pandemic has been effectively funded by new money creation. Therefore, they argue, this must be inflationary by definition (according to the law of monetarism). So there needs to be a recession created by higher interest rates, government spending cuts and austerity for the many. This view seems to be held in high places and should be opposed since it is ideological nonsense, refuted by the experience of the last decade.

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