Mick Collins is a barrister and Treasurer of Islington Conservative Association.
One can be forgiven for thinking that in the aftermath of the financial crisis, to quote Richard Nixon, “we are all Keynesians now”.
After all, the response to the financial crisis was a concerted global stimulus of unprecedented size. It was a brutal, textbook Keynesian response to a recession: spend, spend, spend. It resulted in the UK alone borrowing and spending almost £100 billion more than it collected in taxes since 2007.
If the stimulus saved the global economy from another Great Depression, what it did not do was spark a return to pre-crisis levels of growth.
The response of the West to the lack of a recovery has been more stimulus. The rhetoric in the UK has been austerity but even ten years after the crisis, the UK still has a deficit of more than £58 billion despite near record low unemployment, and the Government will not balance the budget until 2025 at the earliest.
In the Eurozone quantitative easing, although reduced, is still running at €30 billion a month, whilst in the US the Trump administration has plans for huge cuts in tax to stimulate recovery.
It is against this background that the Bank of England’s decision to increase interest rates, albeit by only 0.25 per cent seems surprising. One of the first rules of Keynesian economics is that with growth rates at barely more than 1.5 per cent, what you definitely do not do is increase interest rates.
It is often easy to forget that the purpose of increasing interest rates is to reduce demand in the economy. Less demand means lower growth and higher unemployment. So the decision of the Monetary Policy Committee (MPC) to follow a policy designed to increase unemployment requires some compelling justification.
The justification in the press is that interest rates must be increased to reduce inflation, which at nearly three per cent is above the Government’s two per cent target. But no one serious in the economics profession shares the view that our current rate of inflation is caused by too much demand in the economy. The reason for our current inflation is the 15 per cent decline in the exchange rate since the Brexit referendum, which has increased the cost of imported goods.
While exchange-rate induced inflation is painful for consumers, for economists it is less of a concern. The inflation figures measure year-on-year increases in prices. One off increases in inflation like that which we have experienced as a result of the decline in the exchange rate are temporary and disappear from the figures after a year.
A rise in interest rates to combat an increase in inflation that will disappear after a year thus makes no sense. Nor does an increase in interest rates to appreciate the currency. The benefit to consumers from the reduction in the price of imports will be countered by the increase in borrowing costs and slow down in growth as a result of the rise.
Is there any other evidence of year-on-year inflation of the sort we should be concerned about? The answer is no.
According to the latest assessments by the Office of National Statistics household spending growth is at its lowest level since 2014. Nominal wages and salaries increased by a modest 2.2 per cent in the last year andd the growth in GDP in 2017 looks likely to be 1.4 per cent – the second lowest yearly rate of growth since 2009.
So if the economy is not in danger of overheating, why is the MPC adopting a policy designed to increase unemployment at a time when growth rates are far below the pre-crisis average?
An insight to the reason is given by the Bank of England’s report on the “natural (or equilibrium) rate of unemployment” which was published in April in response to a request from the Treasury Committee. The natural rate of unemployment, so the Report explains, is the rate of unemployment below which unemployment cannot fall without generating accelerating inflation.
Officials in the Bank of England while away the hours debating just what the natural rate might be, almost as medieval forebears debated the number of angels that could dance on the head of a pin. These debates culminated in the MPC’s announcement in its February 2017 Inflation Report that the natural rate of unemployment had fallen from five per cent to 4.5 per cent.
With unemployment currently at 4.3 per cent, below even the recently revised natural rate, the theory says interest rates must rise and unemployment be increased lest we see accelerating wage inflation.
It seems that the belief in the natural rate has persuaded the MPC to increase interest rates despite the absence of any actual evidence of wage inflation. Nominal wage and salary growth is at 2.2 per cent, only slightly above the Government’s two per cent inflation target and much lower than the pre-crisis average of four per cent.
This is particularly worrying for a Government whose outstanding achievement has been the low level of unemployment. The problem is that without a return to pre-crisis growth rates of three per cent, those in work are not feeling more prosperous and the Government’s successful stewardship of the economy is not translating to support at the ballot box.
Michael Gove captured the spirit of the referendum debate when he said that the people have had enough of experts, and we must remember that the decision to make the Bank of England independent was made by a Labour government. Tory governments, by contrast, saw the value of a system whereby experts were charged with persuading politicians that interest rates needed to be changed.
The decision on independence, once taken, can never be reversed. But perhaps the time has come when more business people, rather than economists, should be appointed to the MPC. They may keep a firmer view on the growth rates and rises in wages when making decisions on interest rates, and prove less easily be persuaded of the dire consequences of unemployment falling below the natural rate.