Imagine you wake up one morning to find that your house is on fire. You grab the phone and dial 9-1-1. Send help, you say. A few minutes later, to your great relief, two emergency vehicles pull up.
One of them is a big red fire truck, loaded with firefighters and powerful water hoses. The second vehicle’s crew also claim to be firefighters, but they’re carrying jugs of lighter fluid and cords of kindling. Both groups rush to your burning home. One starts pouring water onto the flames. The other starts pouring gasoline.
The fire is inflation. The first group of firefighters are central bankers, trying to lower inflation by cooling the economy with higher interest rates. The second group are governments – in this case, governments running deficits that, through spending that is too high or taxes that are too low, are heating up an overheated economy, and feeding inflation.
This tug of war, between central banks trying to extinguish a fire and governments inadvertently but unmistakably pumping it up, is happening to some degree across the world, including in Canada. But in the United Kingdom, it’s taking place on an extreme, and extremely self-destructive, scale.
Last Friday, new British Chancellor of the Exchequer Kwasi Kwarteng surprised markets by announcing a giant shot of economic stimulus, via big tax cuts. The deficit this fiscal year is expected to double to around 8 per cent of GDP.
Financial markets freaked out – as one does, when one sees an 18-wheeler filled with kerosene being driven at top speed towards a house fire.
Before Mr. Kwarteng spoke, His Majesty’s Government could borrow for five years at an interest rate of 3.5 per cent. By the time he’d finished outlining his plans, that had risen to 4 per cent. By Monday afternoon, it was above 4.5 per cent.
The trouble is that the British economy is running too hot, like most developed economies. The supply of things – stuff to buy; people to work – is below the level of demand. Unemployment is low, inflation is high and it’s clear that the Bank of England is going to have to jack up its benchmark interest rate to cool the economy. The U.S. Federal Reserve is doing likewise. So is the Bank of Canada.
The standard monetary cure for high inflation – for rising prices making you feel like you need more and more money to keep up – is to slow the economy, temporarily taking buying power out of our collective pockets.
It’s painful, but it works. However, the bigger the inflation fire, the higher the interest rates that will be needed to fight it, and the deeper the economic slowdown or recession will be. Mr. Kwarteng’s kerosene strategy, which promises to add hundreds of billions of dollars of demand to an overheated economy, means that the Bank of England is going to have to be all the more aggressive about leaning in the opposite direction, and reducing demand through higher interest rates.
The Conservative government of new British Prime Minister Liz Truss has views about the virtues of smaller government and lower taxes. Whether you agree or disagree, this isn’t about that. It’s about something far less contentious. If fiscal policy pumps extra demand into an economy already experiencing excessive demand, the central bank will only be able to bring things back into equilibrium by doing even more subtraction of demand, via higher interest rates. It’s just arithmetic.
There are times when a stimulative fiscal policy is absolutely the right move, such as during the Great Recession, or the pandemic recession, when Ottawa and the provinces borrowed hundreds of billions of dollars to support the economy, mostly by giving money to people who had no work. The patient had dangerously low blood pressure; government raised it.
Nearly three years later, Canada and the rest of the developed world are suffering from the opposite condition. But many governments – the British government on an epic scale, others to a lesser degree – are still prescribing pills that raise blood pressure, though the patient now has high blood pressure.
Fighting inflation through emergency tax cuts or cheques to voters is always popular, but it’s a bit like sending fire to a fire. There is an alternative. Fiscal policy needs to push in the same direction as monetary policy. How? More on that, later this week.