Economics Analysis

Finding the tools to end the cost of living crisis

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(Cartoon by Paul Dorin / @DorinToons)

Finding an end to the cost of living crisis will depend on modern economic theories rather than the outdated monetary models currently in effect, writes Dr Steven Hail.

WHEN YOU SPEAK privately to central bankers, some will admit they don’t have much faith in their model of inflation. They might agree that the cash rate is at very best a blunt tool – even if it is their only tool – for hitting inflation targets. They may even go so far as to say they are not necessarily the best institution to have the primary responsibility for dealing with inflation.

This is not without reason. Most of the public statements and many of the policy decisions taken recently by the world’s leading central banks, the Reserve Bank of Australia (RBA) included, have been based on an outdated model of how the economy works. It is as though they are always fighting the last war, if not the one before that.

In this model, often called New Keynesian, but with roots in the Monetarism of the 1970s and '80s, if inflation rises above the central bank’s target, it is a sign that there is too much spending in the economy. This is supposed to be because the unemployment rate has been driven below what they call its NAIRU (non-accelerating inflation rate of unemployment), giving workers the power to bargain successfully for pay rises not justified by prior increases in the cost of living or productivity gains. Employers react by increasing prices more quickly, to allow for accelerating labour costs and inflation accelerates.

The model recommends raising the cash rate enough to slow down spending so that unemployment rises far enough above NAIRU to weaken workers’ bargaining power and bring inflation back under control. That is the story — an increase in unemployment is (unfortunately) the price for reducing inflation.

The trouble with the story is that it is irrelevant to what has happened since 2020. The period leading up to 2020 should have undermined our confidence in it already. Central banks like the RBA continually cut interest rates to try to create inflation, but in most rich countries it stayed stubbornly below target from 2014 to 2020, whatever they did. This is despite the unemployment rate falling below what they had previously believed to be its NAIRU.

All very confusing, if you are a New Keynesian or a Monetarist: not so confusing if you are a modern monetary theorist, like the economists featured in the new documentary Finding the Money, or a member of the other schools of thought that have been challenging the New Keynesian mainstream in the 15 years since the Global Financial Crisis.

Modern monetary theorists make the following points: firstly, that the “cost of living crisis”, as it is often described, originated in supply chain disruptions relating to COVID-19, in a European war and in a variety of climate events. It was not principally (and perhaps hardly at all) the result of excessive spending.

Secondly, in modern monetary systems, the links between interest rates, spending and inflation are various and complex and therefore hard to predict.

And thirdly, that the New Keynesian model is almost childishly oversimplistic.

Space does not allow me to explore all these issues, so we will concentrate on the last of them. Economists like professors Isabella Weber of the University of Massachusetts, and Stephanie Kelton of Stony Brook University (and my own Torrens University Australia), backed up by research in institutions like the Austrian central bank, have used a well-established analytical tool called input-output analysis and an evidence-based approach to pricing decisions to explore the drivers of inflation in depth.

The simple demand-supply model is misleading in its simplicity. To the extent that it has value when discussing price pressures, this is mainly in the primary sector of the economy – when discussing energy, food, and other resources. Of course, it was here that the recent acceleration in the cost of living began — with power and food prices rising. In the secondary sector (manufacturing) and tertiary sector (services), it is more accurate to describe prices as being set with reference to costs plus a mark-up, where the mark-up reflects monopoly power.

Weber and others have discussed how inflation can be propagated, with primary sector price increases feeding through to the secondary sector and eventually the tertiary sector, since rising primary sector prices become higher secondary sector costs and rising prices in the other two sectors become tertiary sector costs. If the economy avoids a major downturn, as ours did due to the fiscal support provided by the Government during the pandemic, then businesses across the economy will be able to maintain their profit margins by raising their selling prices.

This will allow the inflation to persist for some time, following an initial shock. Big business in the primary sector will see profits surge, if the ability to sell is not affected by the initial shock. Big businesses in the other sectors may be able to exploit uncertainty in the community about their costs through an implicit agreement to use the crisis to build profit margins. The potential for inflation to persist is enhanced by wage rises demanded by workers, not to raise real wages but in defence against the fall in real wages brought on by the initial shock and its consequences.

This is a very different story of inflation from the old-fashioned one which continues to dominate our media and is supported by policymakers, at least when they are talking in public, if not in private. It needs to be questioned. It means interest rates may be higher than they need to be, which is highly regressive, placing heavily indebted households and small businesses under unexpected financial distress. It might lead politicians to defer investments in renewable energy and ecological sustainability, or other public goods, because they wrongly believe those investments might add to an inflation driven by excessive spending.

Instead, we should be anticipating further supply-side shocks and using a realistic model of the economy to consider our options. If there is an issue with excessive spending, fiscal restraint can play a role, but so can credit controls on our banks. We don’t need to rely on the blunt tool which is the interest-rate mechanism. If it appears the drivers of inflation come from elsewhere, we should address them.

In a crisis-prone world, we need to consider the security of our supply chains. To reduce our vulnerability to fossil fuel prices, we should accelerate our investments in renewables. If monopoly power is driving inflation, we should take more action to promote competition, or where this is impossible, consider windfall taxes on monopolies or even strategic price controls.

And don’t tell me price controls are never an option. What is the RBA’s target cash rate, except a price control?

You can follow Dr Steven Hail on Twitter @StevenHailAus, as well as on Facebook at Green Modern Monetary Theory and Practice. 

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