Making the banks richer and the people poorer

The government has a policy for reducing inflation. It wants to make everybody poorer, except of course the banks. That is what its economic brain tells it to do. It is a version of John Major’s refrain in 1989: “If it isn’t hurting, it isn’t working”. But its political brain cries out for something more congenial. So it assembles a package of measures designed to ease the pain caused by high interest rates, especially that felt by home owners with large mortgages. Meanwhile, again zigzagging from one extreme to the other, it talks about bearing down on public-sector pay rises in order to interrupt the growth of an inflationary wages-prices spiral. In fact public sector services are almost always free at the point of delivery, so there are no prices involved. The public could be excused for finding this confusing and contradictory.

But beneath the confusion there is a discernible economic theory. Inflation, it says, is caused by a misalignment between supply and demand, in essence too much money (called aggregate demand) chasing too few goods and services (aggregate supply). So in response to market forces, prices go up, people spend less, and eventually demand and supply return to equilibrium. Reducing demand is done by taking money out of circulation, which is another way of saying making people poorer. One method is to increase the cost of borrowing, as some of the excess money in circulation is in the form of loans such as mortgages.

The Bank of England has just hoisted its base rate, which governs the cost of borrowing across the economy, to five per cent. Banks and building societies have happily followed. Is this theory sound? It seems to have worked before. However, the Government’s own account emphasises that current inflation is an international phenomenon, arising, among other things, from the war in Ukraine and the consequent disruption in the international energy market. Squeezing the finances of suburban families hardly seems relevant. But it could be significant psychologically, as one of the reasons why inflation is such a hard enemy to beat is the expectation, in the minds of the public, that it will continue and even become worse. This is when inflation becomes “built in”, to use the jargon. So though international energy prices may drop, prices of goods in the shops go on rising. Where is social justice in all this? Two principles that apply are that the most vulnerable must be protected, and that burdens must be shared fairly.

Banks are making huge profits, as they seem intent on maximising shareholder value at the expense of hard-pressed households. They have scarcely adjusted the paltry interest rates they pay borrowers, though that would be an anti-inflationary thing to do. So once again the banking sector may be acting against the public interest. This is the way the financial system is set up. But where is the magical “invisible hand”, which according to Adam Smith is supposed to ensure that in a free-market system, everyone shares in the benefits? Perhaps a government hand is needed instead. Indeed, perhaps the whole theory is flawed, and making people.