Interest rates

Raising interest rates won’t solve inflation

The Bank of Canada is raise interest rates again. Progressive economists argue that this will not address the root causes of current inflationary pressures and could harm our economy. Governments could do much more to better cope with rising prices and avoid the pain of rising interest rates.

What causes inflation?

In the 1970s, economists believed that inflation was caused by too much money floating around in the economy. They believed that the only way to reduce inflation was to keep the amount of money in the economy relatively constant. This approach is called monetarism. Even though monetarism has largely failed to fight inflation, it has remained as a zombie idea that refuses to die.

Conservative populists continue to say that the Bank of Canada is causing inflation by printing too much money. The truth is that most money is created when private banks lend money to individuals and businesses. Be that as it may, monetary creation is not inflationary in itself. Other real economy factors play a more important role.

More money in the economy is not a problem as long as supply can keep up with demand. For example, if there are enough workers and materials to produce a certain product, it will be simple to increase production by adding another shift in an existing facility. If there is a shortage of workers or the supplies needed to expand production, we could see longer-term shortages that would lead to price increases for that product.

While most inflation analysis focuses on demand, current inflation is fueled by supply shortages and profits. Let’s look at some examples.

Inflation occurs when the demand for goods exceeds the supply of goods. Sometimes it can be caused by unforeseen factors that suddenly reduce the ability of our economy to supply goods. This happened during the pandemic, when lockdowns caused shortages in global supply chains. Similarly, the Russian invasion of Ukraine affected the availability and price of grain, fertilizers and fossil fuels.

Inflation can also be stimulated by a combination of demand growth and supply issues. For example, growing demand and supply chain issues have resulted in a continued shortage of semiconductor chips. This had a ripple effect by reducing the number of new vehicles made. With fewer new vehicles being produced, the price people are willing to pay for a used vehicle has risen dramatically. Unfortunately, the shortage of semiconductors and the inflationary pressures it creates will not be resolved quickly. There are very few semiconductor producers. In fact, only two companies produce 70% of the world’s supply. Setting up new production is expensive, requires highly skilled workers, and takes months or even years.

Today’s inflation is also caused by profit. Canadians for Tax Fairness studied the financial information of publicly traded companies in Canada and found that between 2019 and 2021, their average annual revenue increased by $174.5 million, but their costs did not increase. only increased by $16.9 million. This means that 90% of the revenue increase in 2021 came from higher profit margins. Lack of regulation, competition and low corporate tax rates make profitability attractive to businesses.

Even though the current inflation is caused by supply issues and profits, central banks still try to fight inflation by reducing demand. In other words, central banks want to solve inflation by reducing the amount of money in people’s pockets. Because central banks cannot directly take money from people, they do so by making it more expensive to borrow money. When interest rates rise, there are fewer borrowers. As a result, private banks create less money. The theory is that when less money is circulating, there is less investment in the economy and unemployment increases. Ideally, this reduces people’s purchasing power and slows the rate of price increases.

The problem is that changing prices by changing interest rates is a bit like steering a cruise ship with a canoe paddle. The Bank of Canada expects it to take two years to fully see the impact of its actions on the economy. In the past, the Bank has raised interest rates higher and faster to show that it is determined to lower prices. This is because the only immediate impact of their actions is on people’s expectations. As such, central banks have tended to go overboard and cause a lot of hardship for workers.

How do governments react to inflation?

The current economic consensus assumes that only central banks can fight inflation and that governments should stay away. It is because of this understanding that governments often respond to inflation and interest rate hikes with austerity. Governments are generally reluctant to spend more money when the Bank of Canada raises interest rates because it is counterproductive to add more money to the economy while the Bank of Canada is trying to reduce mass monetary.

At the same time, government revenues often improve significantly during periods of inflation. Their income is a proportion of economic activity. As prices rise, government revenue also rises. Although provincial government revenues have increased in 2021 and will increase further in 2022, many are still underinvesting in public services and capping wage increases at between 1 and 2%.

What can governments do?

Fiscal policy can do a lot in the face of inflation. In the short term, it is important to understand the causes of inflation and to try to understand what can and cannot be corrected. For example, governments should help fix supply chains and transportation networks in the short term, and think about how to make our industrial policy resilient to future long-term challenges.

In times of inflation, governments may consider how to provide public alternatives for high-priced items. For example, if gas prices are going to be high in the long term, governments at all levels should think about how to make it easier and cheaper to get around without the need for fossil fuels. This is a more targeted and fair way to reduce demand for a high-priced good than the central bank model of reducing the money supply.

Governments can also regulate prices. Rent control is a good example. Where possible, policy makers should consider how to maintain the supply of goods whose prices are controlled. In the case of rent control, a strong plan for public investment in non-market and cooperative housing would help ensure an adequate supply of affordable rental housing.

Public services also play an important role in making life more affordable for everyone. Government spending on everything from childcare and health care to public transit and recreation makes life more affordable for people and makes us all less vulnerable to times of inflation or economic downturn. .

These expenses do not necessarily have to be financed by borrowing. If policymakers are concerned that stimulus spending will raise interest rates, they can fund that spending with the revenue increases they inevitably receive during times of high inflation. In addition, governments across Canada have reduced taxes for corporations and the wealthy over the past 30 years. This means that there is significant room to increase these taxes. Spending that is not financed by borrowing will not be considered inflationary by central banks, and therefore will not induce them to raise interest rates further. Higher corporate and wealth tax rates will also neutralize the negative effects of growing concentration of wealth and inequality.