Jacqueline Best, Professor, School of Political Studies, the University of Ottawa.
With the Bank of Canada announcing an oversized interest rate hike this week, it might appear that central banks are coming to save us once again from inflation. Yet, despite playing an important role in mitigating a COVID-induced recession, central banks lack the power to solve our inflation problem.
There is no doubt that the outlook for inflation today is worrying. With inflation hitting 5.7% in March in Canada we are facing a perfect storm of inflationary pressures from a combination of supply chain bottlenecks, pent up demand and massive increases in energy prices resulting from Russian sanctions .
As politicians start making noise about inflation, we must be careful not to accept the outdated assumption that central banks can control inflation by limiting the money supply.
Conservative Party leadership hopeful Pierre Poilievre recently affirmed that the solution to inflation is “to prevent the central bank from printing money to pay for government spending”. This is not only factually incorrect (the Bank of Canada stopped the purchase of large quantities of government bonds in October last year), but also obsolete.
The legacy of monetarism
In the late 1970s and early 1980s, Ronald Reagan and Margaret Thatcher capitalized on public concern over rising prices by bringing their conservative governments to power on a promise to crack down on inflation using monetarism.
We should therefore not be too surprised to see the legacy of this antiquated economic policy being carried on among members of the Conservative Party of Canada.
Poilievre revived the ancient the theory — call it quack monetarism — that inflation is caused by too much money circulating in the economy and that the solution is to reduce central bank money creation. Inflation has never been just about money; central banks cannot simply wave a magic wand and let it fall.
The limits of monetary policy
While central banks player an important role in controlling inflation by setting interest rates, they don’t have all the tools they need to bring inflation down this time around – especially when some of the dynamics behind the rises prices will not react to changes in interest rates.
As writer Adam Tooze pointed outmonetary policy cannot ameliorate bottlenecks in the supply of microchips – which drive up car prices – or increase the supply of gas.
Even when monetary policy is effective in bringing down inflation, there is always the risk that the central bank will overshoot its targets and push the economy into a recession – as a growing number of policymakers worry can happen today.
So why do conservative politicians like Poilievre want us to believe we can solve this problem by getting the central bank to stop printing money? It’s the kind of “zombie idea” that won’t die, although it is turned out to be wrongbecause its simplicity is so politically appealing.
This statement refers to The famous saying of Milton Friedman that inflation is “always and everywhere a monetary phenomenon”. The monetarist theory championed by Friedman and which became very influential in the 1970s and early 1980s assumed that the solution to inflation was to limit the expansion of the money supply.
What’s wrong with this idea? American banker Henry Wallich is famous responded to Friedman’s statement in replying, “Inflation is a monetary phenomenon in the same way that shooting someone is a ballistic phenomenon.” In other words, excess money can be partly to blame for inflation, but if you really want to fix it, you need to understand the underlying causes of the problem.
As political economist Matthew Watson showedeconomists keep changing their minds about the broader causes of inflation: from pointing the finger at international balance of payments shocks in the 1960s to 1970s oil crisis, “wage-driven” inflation in the 1980sGovernments’ lack of anti-inflationary credibility in the 1990s and finally the problem of unanchored inflation expectations over the past decades.
Even if today’s inflation had similar causes to those of the 1970s, we don’t want to try monetarism again. The central banks of Canada, the United States and the United Kingdom all tried it in the late 1970s. By 1982 they had given up because monetarism just did not work.
Most money is actually created by private banks and so the central bank’s attempts to limit the money supply are doomed to failure. The bank can influence the demand for money by raising or lowering interest rates, but it does not control the money supply itself.
Monetary policy is a blunt instrument
What ultimately brought inflation down in the 1980s was a combination of extremely high interest rates – more than 21% in Canada – and the most painful recession since the Great Depression, with unemployment reaching 12.8% in Canada. It is not an experience that we wish to repeat.
If the economic trauma of the 1970s and 1980s teaches us anything, it is that monetary policy can be a very brutal instrument. To be truly effective, it must often be brutal.
Although there are no simple solutions to our current inflationary challenges, it is clear that we need a holistic approach. US President Biden’s recent statement strategy offers a promising alternative. Its aim is to fight inflation by urging businesses to cut costs, rather than wages, and by making prescription drugs, energy and childcare more affordable.
So the next time a politician tries to sell you a quack monetarist remedy for our current inflationary woes, ask him if he’s prepared to make us pay at all costs for another historic economic blunder.