How do we deal with inflation?
People’s wages are falling in real terms while the cost of essential goods and services are rising at their highest rate in decades. The causes are global. But there is a great deal the government could do to protect ordinary people from this historic rise in the price of everyday necessities.
Interlocking global causes
Gas prices began rising in Europe as demand increased with the lifting of lockdown restrictions. This was exacerbated dramatically by Russia’s invasion of Ukraine. The conflict, combined with sanctions, led to a sharp fall in the supply of Russian gas to Europe and a hefty spike in fuel prices. The war also disrupted grain supplies - since Ukraine and Russia are both large suppliers - driving up food prices across the world. At the same time, extreme weather events are taking their toll on prices. This summer’s heatwave caused the Rhine in Germany to fall so low that cargo ships could not get through, causing huge problems for transportation of goods in Europe. Experts say extreme weather events like these will only get worse, further disrupting global supply chains.
What can the government do?
During inflationary crises, governments and central banks typically put up interest rates – and this is exactly what they’re doing in the UK right now. High interest rates mean it costs more to borrow money and the purpose is to reduce spending. The logic behind this is that if people are spending less, prices will fall (or at least rise less quickly).
However, when the causes of inflation are global, this strategy does not work. Higher interest rates in the UK will do absolutely nothing to change Russian military tactics, let alone prevent extreme weather events. It will however increase the cost of mortgages and loans for ordinary people already facing massive price increases.
So, if raising interest rates won’t work, what else can policy makers do? In the medium and long term, governments need to be taking action to protect economies from future shocks. These interlocking crises have shown just how vulnerable global energy supply chains are. To prevent future shocks, the government should be investing in cheap, domestic, renewable energy, as well as insulating homes to reduce demand and protect households from higher bills.
In the short term, if prices are going up and wages aren’t, somebody somewhere is making profits. This is most obvious in the widely reported windfall profits generated by oil and gas giants such as BP and Shell. Other industries are also benefiting. Banks are gaining from higher interest rates for example. Companies such as Amazon made immense profits as pandemic restrictions
closed smaller retailers, enabling them to increase their market share considerably. Right now, governments could be taxing these excessive profits and using the revenue to increase public sector wages, as well as benefits and pensions, and by introducing price caps on essential goods such as energy and rent.
But what about the wage price spiral?
Efforts to raise wages and benefits to protect families from the effects of inflation are often accused of ‘just making inflation worse’. It is based on the (largely unsubstantiated) theory that if you increase wages, people will have more money to spend, which in turn enables producers to increase prices, leading to further demands for higher wages and so on: a wage price spiral. A recent report by the International Monetary Fund examined data from thirty eight advanced economies and found that wage price spirals simply do not happen in the vast majority of cases. Why? Firstly, because very few employees have enough bargaining power to demand higher wages and, secondly, because if the causes of inflation are external, raising wages will have little impact.
Anyone can see that the current inflationary crisis in the UK is not caused by higher wages pushing up prices. Instead, ordinary people are facing the largest decline in living standards on record and the biggest fall in real disposable incomes since the 1940s. The global factors causing this crisis will not be affected by people in Britain seeing their wages and benefits rise in line with inflation. Increases in income would simply enable families to cope with the rising costs of essential goods.
The effect on inflation on public services
It is not just households who are suffering from high inflation. Many essential service providers such as schools, care homes, local authorities and the NHS are seeing large real-term cuts to their already stretched budgets. The paltry public sector pay increases being proposed by government are not only causing massive staff shortages as workers leave, they are also creating waves of strikes and industrial action across a large range of crucial sectors such as nursing, public transport, postal services and criminal justice. The lack of funding also means that the quality of these essential services is suffering so that people are not receiving the support they need.
The value of these services cannot be overstated. Their decline is having a real impact in people’s everyday lives. People would not be so squeezed if the cost of getting to work wasn’t so high, or if they weren’t having to pay for private healthcare because their local NHS can’t cope. Or if rents and mortgages had not skyrocketed due to a lack of sufficient social housing or affordable homes. Or if unaffordable childcare was not forcing parents out of the work force.
Today’s inflationary crisis may be largely due to global factors, but the cost-of-living crisis is greatly exacerbated by UK domestic policy. The Government and the Bank of England must step in to protect ordinary people and essential services from the devastating impacts of inflation. Instead of dabbling with discredited economic theories, they should focus on ensuring that everyone’s basic needs are met. That calls for more and better public services, combined with a fair living income for all.