In her recent Mais lecture, UK shadow chancellor Rachel Reeves criticised Nigel Lawson’s belief that fighting inflation was a matter for macroeconomic policy. ‘In a world that has been repeatedly shaken by supply-side shocks’, she said, ‘it is inadequate to see the fight against inflation as a matter of macroeconomic policy alone. Our resilience in the face of shocks brings microeconomic policy… to the fore in the fight against inflation’.
According to Reeves, not only was Lawson wrong to advocate for policies aimed at supply-side liberalisation as a means to boost growth, but his contention that microeconomic policies have no role in fighting inflation was an error. To her mind, the state should adopt more activist microeconomic policies, like protecting domestic industries and supply chains and promoting domestic energy production, as a means of fighting inflation.
Like many other political officials, Reeves draws the wrong lessons from the post-Covid inflation surge. While supply shocks like international gas price hikes or disruption from pandemics can increase inflation temporarily by reducing the production of goods and services relative to money in circulation, these shocks are seldom large enough and rarely last long enough to account for the inflation we observe throughout history.
What does that mean for policy and ‘the fight against inflation’? It means that microeconomic policies, whether of the activist sort favoured by the current Shadow Chancellor or of the liberal kind favoured by Nigel Lawson, are not effective for taming inflation, irrespective of their broader economic merits. The reason is straightforward: reducing inflation by even one percentage point via altered supply-side policies requires that the policy increases the growth rate of real (i.e., inflation-adjusted) GDP by the same amount.
Increasing real GDP growth by one percentage point may not seem like much. However, to put that number in context, real GDP was only rising by 2% annually in the decade before the pandemic. Thus, reducing inflation by even one percentage point would require boosting real GDP growth by 50%. We can think of few obvious microeconomic policy changes capable of achieving such an effect, let alone a package that would prevent the inflationary forces that saw the consumer price index peak at 11.1% in 2022 (over 9 percentage points above target).
Reeves implies that if the UK had had a different energy mix, a stronger domestic productive capacity and less brittle supply chains, then the specific shocks associated with the pandemic and Ukraine war would have been less inflationary this time around. Perhaps certain policies would have made things marginally less painful this time. Yet the thing about supply-shocks is that they are unpredictable and could just as easily hit domestically as they do overseas. The government cannot foresee all potential impairments to growth nor set aside spare capacity to improve resilience against all potential shocks, at least without severely hurting economic efficiency in normal times. Setting microeconomic policies to reduce inflation in unusual crisis periods is thus a fool’s errand.
If supply-side reforms won’t cure inflation, what will? Sustained inflation, like the sort we have experienced recently, is primarily caused by increased spending, not supply shocks. Typically, the fuel for this increased spending is excessive monetary stimulus – just the sort of macroeconomic policy error Lawson warned about.
Over the first year of the pandemic, one measure of the money supply in the UK (M4x) grew by 15% and then by 5% in the second year. Historically, 3.5 to 4.5% growth in the money supply has been consistent with 2% inflation. This burst of liquidity fueled a surge in total spending, such that nominal GDP grew by nearly 11% in 2021, 8.2% in 2022, and 5% in 2023–way above the pre-pandemic trend growth of 3.7% per year.
The pandemic and gas price shocks undoubtedly contributed to Britain’s inflation peak, but they were simply too small and short-lived to explain the rise in the price level we have seen over the past three years. Moreover, these supply shocks, alone, cannot explain why the price level remains 12.5% higher than its pre-pandemic trend, nor can they account for the above trend growth in total spending. Ultimately, inflation of the sort we have experienced can only be caused by excessively loose monetary policy, and thus can only be fixed by getting monetary policy back on track.
Understanding the history of this inflation matters. Around the world, political officials and central bankers have, at different times, deflected blame for this inflation towards external shocks or ‘greedy’ corporations. While the Bank of England ultimately took steps to tighten the growth in the money supply, helping bring down inflation towards target (indeed, there is growing evidence the Monetary Policy Committee, if anything, has now over-tightened), a lot of commentators and politicians maintain that there were less painful inflation ‘cures’, including beefed up competition policy, government interventions in supply chains, and even price controls.
This is the sort of zeitgeist that Reeves is flirting with. Yet it represents a regression in economic thinking. These sorts of microeconomic policies are a dead end for an anti-inflation agenda, ranging from merely ineffective to highly destructive. While economists often disagree on what microeconomic policies will enhance a country’s economic growth prospects, Nigel Lawson remains correct that keeping inflation at trend is a macroeconomic task.
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