Analysis by Keith Rankin.
The present cost-of-living crisis, and the present inflation, are global issues. It is just silly to discuss these, to address these, in predominantly nationalist terms. The next key point to note is that rises in the cost-of-living and inflation are not the same thing, yet public discussion largely treats them as if they are the same. Rising costs are real, and must be borne. Inflation is ‘nominal’; a fall in the purchasing value of money, if you like.
Real-cost Crises
Rises in the cost of living are events of real cost increases. These cost-events may be events which we can reasonably expect to come to an end (such as a pandemic), and most wars. Or they may be events which will not end in the foreseeable future, such as the climate crisis, the crisis of antibiotic resistance, the infrastructure deficit, or the housing crisis. (Three simultaneous real-cost events are commonly called a ‘perfect storm’, a frequent and hackneyed expression these days.)
When there is a cost-of-living crisis, the reasonable expectation is that prices will fallwhen that crisis resolves, when the real-cost event ends. In the case of cost events that cannot be foreseen to end, then the rate of crisis-associated price increases will eventually fall as populations adapt to higher costs. Real-costs are not a monetary issue. Reserve Banks should not become involved. Adaptation should be a process of market-led rationing, with governments attending to any arising market failures.
Real-cost crises represent a burden on the population, meaning that, at least for a while, standards of living become lower than they would have been in the absence of the crisis. There’s no escaping this.
The central role of government policy in this kind of situation is to manage the burden, protecting those with the least ability to ‘tighten their belts’, and ensuring that there is not a new group of incomeless people taking on a disproportionate share of the burden. Policies which seek to increase unemployment, or are otherwise known to cost people their livelihoods, are both unethical and ineffective.
Because these cost-of-living crises are typically global, the temptation of governments is to try to export their country’s share of the burden. An example of such ‘beggar-thy-neighbour’ policies is to pay subsidies on, for example, petrol. If petrol is more costly to supply than before, because there is a reduction in global supply, the economy needs to adjust by reducing the amount of petrol consumed. If a government acts to make it look to consumers that petrol has not become more expensive, then people in that country will consume as much petrol as before; that would mean consumers in other countries would be forced to bear the burden of reduced petrol supply.
We should also note that in our experience environmental costs are typically ‘externalised’, meaning the environment is suffering exploitation; that the total costs of exploitative practices are not reflected in the prices of the resulting goods, and therefore a portion of the costs are borne in the form of environmental harm (some of which may be exported to other countries). It is correct that governments should set taxes to ‘internalise’ these costs, meaning that the prices we pay reflect our just share of the burden. Such taxes do not in any sense constitute a cost problem; they are a cost solution. There will be a domestic cost crisis, though, if other countries export their real-costs to us.
An interesting case is when exploited workers find the power to resist that exploitation. Labour exploitation is like environmental exploitation. If workers remove their shackles, as happened to some extent in the covid pandemic, they may appear to be contributing to a cost-crisis; in fact, it means that the costs of exploitation come to be borne by consumers, as they should be, rather than by workers. Ending exploitation is a solution, not a problem; though such a solution may appear to be part of a wider ‘cost-of-living’ problem. Labour, like the environment, should be properly priced; ‘internalised’ as economists say.
The most important ways that governments can facilitate market-led rationing is to have in place a system of universal benefits and flat production taxes. (Properly understood, income taxes are production taxes.) Then when the rising costs occur – and I mean real costs such as those discussed so far – societies as a whole can bear those costs fairly, by raising both the tax rate and the level of benefit. This is a simple non-bureaucratic way through which the vulnerable can be insulated (not necessarily 100%) and those who can afford to bear more of the rising costs are required to do so.
It is commonly believed that a ‘universal basic income’ is a policy for times of high unemployment. While it is true that universal benefits and flat production taxes help in times of labour surplus, it is equally true that such a tax-benefit mechanism helps to keep the economy going – seamlessly – when costs including labour costs are high. A universal-benefit flat-tax mechanism ensures that labour supply is ‘elastic’.
Inflation Crises
Inflation occurs only when the price level increases for reasons other than rising real costs. And it only really matters when it becomes (or threatens to become) a process– sometimes characterised as a spiral process – that get out of control, like a runaway train.
The first thing to note here is that annual inflation of two-percent – that is, a small general level of price increases unrelated to costs of production, or (if you prefer) a small regular monetary debasement – works well to keep market economies lubricated. So, if a country has an annual increase in prices of seven percent during a cost-of-living crisis – as New Zealand does at present – then it should be taken as most likely there is a five-percent real-cost component and a two-percent inflation component.
However, it is possible that a cost-of-living crisis can trigger an inflation crisis; indeed that’s probably what’s happening in the world today. (Before continuing, it is necessary to note that this is not the only way an inflation crisis can begin; and we must remind ourselves that a real-cost crisis, which is not the same thing as an inflation crisis, can occur with inflation present; the two problems can get horribly confused with each other. In some cases inflation, as a form of market adjustment, may even be a part of the solution to a real-cost crisis.)
(It is also important to note that inflation can get going through a process that looks like a cost crisis but is not. This is when monopolies and cartels – and, in history, these monopolies may have been labour unions – raise their prices simply because they can; ie because of their market power, not because they are passing on real costs. This kind of process was part of the story of the early 1970s.)
Inflation generally happens when people try – and continue to try – to buy more goods and services than the world is currently offering to sell. This is a demand process, whereby a real-cost crisis is a supply event. And the process really only qualifies to be called inflation if this excess demand persists into some kind of ‘spiral’. In other words, an inflation process can get started if we experience a real-cost crisis in a state of denial, as is happening today. Too many consumers around the world today seem to think that governments rather than businesses supply goods, and set prices by edict; and that rising prices are misdeeds of governments failing to conjure up affordable goods and services, a problem that popular opinion believes can only be addressed by ‘dealing-to’ those wicked governments at the next election.
(There are two key exceptions to the generalisation of the above paragraph. First, prices may rise in a decelerating spiral as economies, coming out of a crisis, adjust to a new normal. This is good inflation, not bad inflation; it is not an out-of-control process. Second, individual countries may face spiralling inflation if they are undergoing a domestic currency crisis, as Türkiye is today; more dramatic was the German currency crisis that took place in 1923, giving Germany hyperinflation at a time when the world as a whole was not experiencing inflation.)
Before returning to the present crisis, we should note that the world was facing a looming inflation crisis before the Covid19 pandemic distracted us. It was a looming inflationary spiral that might not have become apparent until around 2025. This potential inflation was not a consequence of the successful low-interest-rate monetary policies that saved the world economy in the period between the 2008 global financial crisis and the 2020/22 covid crisis. Those policies did not trigger inflation, despite the claims of the monetary hawks that they would do so.
The inflationary time-bomb, brewing before the covid pandemic, was and still is the world’s private pension funds. As a substantially high proportion of the world’s people with retirement savings shift from accumulation mode to consumption mode, ever larger demands will be placed on an increasingly threadbare global supply chain; a chain for which the most crucial component will be personal services. It is the ‘funded’ retirement income schemes that are already starting to unleash their contribution to global inflation, not the pay-as-you-go public pensions which have been vilified by our class-elites. In Aotearoa New Zealand we see it in the substantially increased advertising for upper-middle-class retirement villages, while traditional residential care and nursing homes are being forced to close due to their inability to secure staff.
Going back to the present crisis, part of the problem – as I have already suggested – lies in the fact that governments, in order to give themselves a chance of re-election, are trying to export the present cost-of-living crisis. That’s a recipe for global ‘stagflation’, whereby an inflationary spiral coexists with a real-cost crisis.
Interest Rates
The second, aggravating and particularly worrying problem, is that the monetary authorities (the Reserve Banks) are reverting to shaman-like dogma. They are aggressively raising interest rates, substantially adding to the present cost-of-living crisis. They are trying to create a monetary deflation – by creating unemployment despite labour shortages – to offset rising prices associated with the increases in real costs. This way, they are protecting the ‘purchasing value of the dollar’ for our elites – including the elites with lots of ‘retirement savings’ stashed away in pension funds and other financial assets – ensuring that the burdens of the cost-crisis and the subsequent monetary deflation will fall directly upon the expanding poor and vulnerable classes.
The people who staff the Reserve Banks are not evil. They believe that they are doing the right thing. They have simply experienced an education that has been substantially biased in the service of the elites; an education that, in the context that the university system, is in practice the gateway to an elite lifestyle. In preserving their elite careers, they have no choice but to continue with their shamanistic (and unscientific) practices around money; practices which have been around, in one form or another, for centuries.
For economics, history is the only real laboratory. We have the events of the 1920s, the 1970s, the 1980s, and the late 2000s to testify the moral and academic bankruptcy of high interest rate policies; policies which create unemployment, and create servile small business and working classes.
In the 1980s’ revival of this policy programme – as the bankruptcy of crude monetarism was becoming more obvious – the academic leaders came to emphasise the role of ‘inflation expectations’ as the central driver of inflation. They started talking about ‘credible’ and ‘independent’ central banks which would have the power to torture the small business and working classes, and to do this independent of democratically elected governments. High interest rates were the whip. Once small businesses and workers had been beaten into submission, then ‘inflation expectations’ would have been seen to have been overcome.
(Re the return of that torturous policy, the following, from RNZ Checkpoint on 2 November 2022, were an interesting listen. Low unemployment figures get pessimistic response from economists; Housing downturn grim, but not another financial crisis – economist. Lisa Owen [3’40” in, second recording]: “So to be grim, Jarrod, do we need people to lose their jobs to even out the economy?” Jarrod Kerr: “That’s a very blunt way of putting what the Reserve Bank is trying to do, yes.” Although I cannot believe that Lisa Owen has only just come to realise that the intent of our monetary policy settings is to create unemployment, to undermine the livelihoods of a group of people.)
The financial elites were always uncomfortable with the low-interest-rate environments from 2008 to 2021. They claimed throughout that period that inflation was about to erupt; but it didn’t. In that period, it was deflation – negative inflation – that was always the more likely problem. In that period, asset inflation – quite distinct from consumer inflation – did take hold, as those elites bought and sold assets while governments fiddled and twiddled; while too many governments refused to invest in sustainable infrastructure and sustainable income accounting, letting the speculators play with the money instead.
Global Race to the Bottom
High interest rate policies have the perverse effect of drawing money from countries which don’t follow that monetary policy to countries which do follow the prescription. So reluctant countries become obliged to follow the leader countries, to defend their currencies. While undervalued currencies are seen as advantageous in a mercantilist world in which countries seek to run trade surpluses – or at least avoid trade deficits – the problem with falling currencies is that they generate inflation spirals in the concerned countries; this is especially true for small countries which are substantially inter-connected in the global economy.
Thus we see the terrible culpability in 2022 of the United States Federal Reserve Bank. Interestingly, Japan, the world’s third largest national economy, has a degree of self-sufficiency (and a track record since the 1990s) that enables it to resist this race-to-the bottom. Today Japan has a central-bank interest rate of minus 0.10%, and an inflation rate of just 3.0%, despite a falling currency. The United States, despite its purported anti-inflation policy (of aggressive interest rate ‘hikes’) and its rising currency, has a central bank interest rate of 4.0% and an annual inflation rate of 8.2%.
A race-to-the-bottom is initiated in a situation where an action is globally adverse, but is seen to be domestically favourable. In other words, it occurs where leaders in one country see a gain to their country by imposing a greater cost on the rest of the world. It means that the leaders in other countries become obliged to pursue the same policies, thereby further exporting the problem. When all countries pursue the ‘race-to-the-bottom’ policy, also known as ‘beggar-thy-neighbour’, then all countries become losers. It’s worse than that though, because those which pursue the policy most vigorously become the losers with the least losses; which in a perverse way makes them the ‘winners’. (Just as megadeath in the trenches of World War One came to be seen as ‘victory’ if the other side’s megadeath was even greater.)
Real interest rates
Real interest rates, a measure of the probable true costs of borrowing money (and the true yields from lending money), are defined as the current annual interest rate minus the expected rate of price increases for the coming year. (Because future prices are unknown, this ‘expected rate’ is an average of the probabilities; where those probabilities are assessed from current information, historical knowledge of similar situations, and generalised ‘knowledge’ derived from theory.)
Example: if the current interest rate is 6% and prices are expected to fall 2% because normality is expected to return over the next year, then the real interest rate is 8%.
In a cost-of-living crisis, real interest rates rise, because the expected rate of price increases falls; ie the significant price increases are understood to have already happened. This acts as a dampener on business borrowing, because loans will need to be serviced when the prices businesses receive are lower than are present prices. The appropriate monetary policy response to a rise in the real rate of interest, if any response is undertaken, is for the Reserve Banks to reduce their ‘official cash rates’ (or whatever they are called in other countries).
It is also important to note that, during a period of inflation – when expected inflation rates are positive, maybe substantially positive – that interest rate increases should follow inflationary price increases. The problem with monetary policy as we experience today is that the authorities seek to control what should be a market price, and they seek to use rising interest rates as a weapon against inflation rather than have them as a passive consequence of inflation.
What we saw in the 1980s was a ruthless attempt to turn a 1970s’ situation of negative real interest rates into a situation of positive real interest rates. Looking back, we clearly see this as having been a political coup on the part of the financial elite; the richest ‘ten percent’ and the financial industry which services them. When real interest rates are positive, incomes – entitlements to consume – flow from the poor to the rich; substantial positive real interest rates were the main drivers of growing inequality in the 1980s and the 1990s.
Conclusion
We are now seeing another political coup, as the richest decile – the ‘ten percenters’ – seek to escape from the clutches of an existential real-cost crisis of their own making. Popular denial of a real-cost crisis – for example, by calling it ‘inflation’ – just plays into the hands of the elite. Denial cannot resolve a crisis. In the end, if the ‘ship’ is sinking, all on board can expect to drown. There may be no life-boats. And, if there are life-boats, it might not be money that buys a person a ticket.
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Keith Rankin (keith at rankin dot nz), trained as an economic historian, is a retired lecturer in Economics and Statistics. He lives in Auckland, New Zealand.
