You might be astonished by the true source of this inflation
At the time of writing, the Reserve Bank of New Zealand (RBNZ) has just announced a 0.50% increase in the Official Cash Rate (OCR) bringing it up to 3.00% from just 0.25% one year ago. We all know why the RBNZ is doing this as inflation, measured by the Consumer Price Index (CPI), is raging at 7.3% per annum in the year to 30 June 2022. Higher interest rates make borrowing money more expensive so people both have less disposable income from higher debt-servicing costs as well as less propensity to borrow (therefore spend and invest). That is, the RBNZ trying to reduce demand across the economy. As with that of most policy makers at present, this is the Government’s and the RBNZ’s only answer to our galloping CPI. They view our inflation as a demand-side issue (ie too much) and are therefore seeking to dampen demand.
This “demand” management was promoted by one of the world’s most well regarded and renowned economists, John Maynard Keynes, back in the 1930s during the Great Depression “The General Theory of Employment, Interest and Money” is a staple in all Macroeconomics 101 courses. In his book, Keynes argued among other points that economies could and should not be left alone in their natural cycles, particularly down cycles, and that government intervention was required during downturns in order to stabilise / boost the economy. He advocated for increased government spending and lower taxes during an economic downturn in order to stimulate demand which would not recover in its own right. His work and views have been moulded and adapted over the years but remain central to Western governments’ fiscal policy in particular.
It is important to remember and understand Keynesian theory given where we are today: we saw massive fiscal stimulus through Government borrowing and spending in 2020 and 2021 as the Government aimed to counter an anticipated downturn in demand brought about by its policies in response to Covid. We also saw the RBNZ take interest rates close to zero effectively collapsing the cost of money and therefore borrowing. Now it’s mid-2022 and in spite of, maybe perhaps because of, these fiscal and monetary stimuli we surprisingly see sluggish economic activity but unsurprisingly high and perhaps accelerating inflation. Yet our Government continues with its expansionary fiscal approach while the RBNZ cranks up interest-rates as noted earlier. Why are we spending more at the government level, seeing muted economic response, inflation high and increasing interest rates?
I firmly believe that our current economic climate and the key drivers of inflation are the result of various factors on the supply side of our economy rather than demand side. Therefore, “demand management “or a traditional Keynesian policy response is not appropriate in such circumstances. In 2020 our Government shut our borders, prohibited immigration and tourism and, apart from in certain “essential” instances, shuttered industry by ordering people not to go to work, school or university – indeed to stay at home. This severe disruption was always going to have a massive negative or contractionary effect on production of goods and services, or the supply-side of the economy and we’re seeing and paying for the effects now.
Knowing such contraction would be a likely outcome of these policies, the Government looked to implement a great Keynesian compensatory offset by way of fiscal and monetary stimulus: borrowing and spending combined low, low interest rates. With restricted supply and incredible fiscal and monetary stimulus is anyone surprised we now have high inflation? Not really, but we might be surprised by the true source of this inflation: it is supply-side rather than demand side. Our inflation is primarily caused by reduced supply of most products caused by Covid-related production limitations and industry shutdowns, notwithstanding the genuine spike in prices from recent rise in of oil and gas prices. Inflation is not, as in typical economic upswings, caused by a surge in demand ahead of supply. So why are we trying to address this with demand-side response of higher interest rates? And is there truth to the view that unless Ministers and RBNZ Governors dampen down demand we will see the high CPI driving higher wage demands in-turn driving higher CPI and so on and so on?
I think not, we need to tackle this from the supply-side. Government-driven shutdowns should not be treated like a normal recession which typically needs Government stimulus to counter. Rather than acting to stifle demand from the economy by increasing interest rates, which perversely need to work all the harder given ongoing fiscal expansion, we need to get supply back on track in order to meet current levels of demand. This requires freeing up the labour force in the economy from domestic interruptions. Shops, restaurants and cafes for example should not be shut or only opening with restricted hours because of staff shortages. Horticulture products should not fall to the ground because there are no pickers to pick the fruit. Courier companies should not be delaying deliveries because they can’t get drivers. Gib manufacturers… So, ending home and household isolation requirements so people can actually work is a priority. We need to address all unemployment-related welfare arrangements like Jobseeker to ensure help only for those most in-need. And we must redeploy people into productive employment. I have recently heard of a mobile covid-vaccination caravan south of Auckland with a team of seven nurses / caregivers administering an average of two covid vaccinations per day. We also need to look externally to replace the outflow of New Zealanders to overseas work – Kiwibank economists are forecasting net outward migration of 20,000 this year, my guess is this will be sadly higher. Renewed immigration is necessary to help labour supply.
Traditional Keynesian methods of boosting Government spending are not needed in this instance nor are increasing interest rates required to dampen demand – this will only make matters worse. It’s the supply of goods and services that is the problem.