THE MESS WE'RE IN

 

Inflation stalks the land like an economic plague that is eroding the value of earnings and savings and raising the cost of doing business. When people from our sector ask me “Well, what’s the answer?” I always reply, “That depends on what you think the question is.” Before we can cure the malady of inflation, we need to understand its causes and it is my contention that the Bank of England does not understand the root cause of inflation, which is their own mismanagement of monetary demand. Instead, they blame cost-push price rises from abroad which provide handy excuses for their own failures and those of their political masters.

 The cost of dealing with Covid, which included but was by no means limited to the cost of lockdowns, couldn’t be financed from Treasury tax receipts so the Bank of England financed the government’s spending by quantitative easing (QE). QE is a form of money printing that involves the BoE creating money digitally out of nothing and using it to buy back second-hand government debt so they can inject more money into the system – and government fired this money into the bank accounts of people and businesses like pubs and bars to keep them going during lockdowns and restricted periods of trading.

In normal times the quantity of money expands by about 2-4% a year. In 2020-21 it expanded by 15%. 18 months down the line this has manifested as inflation. The only economists who predicted this from the outset were the monetarists. The Keynesians, sitting in their comfortable swivel chairs in the BoE, consistently underestimated both the scale of the inflation problem and its likely duration. They lacked, or rejected the intellectual tools needed to get it right.

My plea to politicians and central bankers is when you get to grips with inflation, please concentrate on the quantity of money rather than the price of it. And be honest about the trade-offs – there are no pain-free solutions to inflation. Recognise that BoE mismanagement of the growth of money – necessary though it was to get us through a short-term crisis – is the core of the problem. Re-examine the Quantity Theory of Money and let this be a guide to your economic policy decisions. Below is a simple guide, which even Liz Truss should be able to follow:

NODDY’S GUIDE TO THE QUANTITY THEORY OF MONEY, or…

INFLATION FOR DUMMIES – in 4 easy steps

So, monetarist economists believe that the root cause of inflation is excessive monetary growth – ‘broad money’ growing faster than growth in the output capacity of the economy, or more money chasing fewer goods. That’s the only thing that can cause an increase in average prices, apart from an increase in the speed money moves around in exchange (velocity of exchange), which tends to be stable long term. In the absence of excessive monetary growth, supply shocks – like a rise in the cost of oil and gas – can only increase relative prices. Here’s how that theory works: 

1.    Suppose we have an economy in which energy is 25% of total things bought. And other costs are 75%. And suppose this economy has 100 gold coins and each gold coin is permitted to be used once a day (so, now we know the quantity of money, and the speed it moves around in exchange). 

2.      Then the price of energy is 25 gold coins, the price of everything else is 75, and the total price level is 100. 

3.      Then suppose the price of energy doubles so instead of it being 25% of all costs it becomes 40% (50/125 x 100/1 = 40). Will there be inflation – an increase in the average price level? No! What happens is that 40 gold coins are used to pay for the energy and 60 to pay for everything else. 

4.     Hang on! 60 to pay for everything else? So, the price of everything else goes down because the energy price went up? Yes – all that a sectoral cost increase does is redistribute a percentage of the existing stock of money from one set of expenditures to others - the quantity of money hasn’t changed, so the price of other things must fall.

DEFLATION FOR DUMMIES – in 3 easy steps 

1.      Suppose someone said: “We think there should be deflation. So, let’s halve the number of gold coins to 50.” A smartass responds: “Ah, but energy price rises didn’t happen because of inflation, so cutting the number of gold coins can’t make prices fall!” Is he right? 

2.      Answer: No. If the number of gold coins falls to 50, then 20 will be used to pay for the energy and 30 will be used to pay for everything else. The fact energy costs rose doesn’t tell us anything about whether cutting the money stock would affect the price level. 

3.      The same is true for inflation in the UK today. The fact energy prices have risen does not mean that tightening monetary policy (eg by raising interest rates) will not affect inflation. Energy price rises are relative cost rises. The inflation rate measures the movement in average prices.

So, when you hear the Governor of the Bank of England blaming Russia’s invasion of Ukraine and the external shock of increased energy costs for inflation - but forgetting to mention that he facilitated the UK Government’s over-spending on Covid with over £400 billion of QE money printing - then you know you’re listening to utter bunkum.