“Smart fiscal policy—not just monetary tightening—is what’s needed to address the root causes of today’s inflation.”

Joseph Stiglitz, Nobel Prize in Economics 2001

In my final chapter, indulge me in a maverick idea to better control inflation and grow government revenues. I’m stepping well outside my comfort zone, but if it sparks a conversation, I’d achieve my goal. Here goes:

Context

  • A stable economy is one of the vital prerequisites to growth.
  • Inflation is one of the biggest dangers to a stable economy.
  • One of the main functions of central banks, and to a lesser extent government, is to control inflation.
  • The primary tool to control inflation is the raising or lowering of interest rates to limit the supply of cash in the economy.

Interest rates — how they work

When inflation is high, the central bank raises interest rates. This makes borrowing more expensive and saving more attractive, leading to:

  • Less consumer spending: People have higher mortgage and loan repay- ments, so they cut back on spending.
  • Less business investment: Companies borrow less for expansion, thereby slowing down economic growth.
  • Less spending depresses demand, with price increases coming back under control.
  • Higher rates attract foreign investors, increasing demand for the pound (strengthening it), which makes imports cheaper and reduces inflation further.

“Monetary policy is not well-suited to deal with supply-driven inflation. Interest rate hikes won’t fix supply chains.”

Mohamed El-Erian, CEO & Co-CIO of PIMCO (2007–2014)

The problem

Interest rates are a blunt instrument. They are useful for suppressing demand — take people’s money away, and their demand for goods will fall (or at least their ability to satisfy their demand). Some factors, especially external ones, limit supply, e.g. war. If demand is flat and supply falls, prices will rise. In this case, interest rates are targeting the wrong problem; they will not make more goods appear.

Even in demand-driven inflation, interest rates prove to be sub-optimal. They impact those we least want to penalise: homeowners with the highest mortgages, many of them young parents just on the housing ladder who’ve yet to pay down the principle; businesses looking to create wealth and jobs. And everyone else, as the interest on our national debt increases, meaning fewer resources for public services.

The poor are especially affected as they have less money to pay for the basics — the affluent middle classes might choose to forgo that nice meal out — but their experience of loss is different, some might say, immoral. Interest rates also take time to work because many loans are fixed-term, so the impact is only felt once those deals expire — often more than 12 months out. The beneficiaries of higher interest rates are banks, overseas investors and savers. Obviously, helping savers is a good (and popular) thing. But the other two…?

What if…?

An additional tool was made available to the Central Bank to target inflation — not to replace interest rates, but to supplement them? This tool being a variable tax rate or the equivalent thereof.

The advantages would be:

  • More immediate impact, so inflation peaks faster and lower
  • Pain spread more evenly across society, not unevenly on those we least want to target
  • Government gets the increase, not banks and overseas investors
  • Lower interest rates mean less paid on government debt
  • Stronger economic fundamentals (increased government income means smaller deficits), support the pound, lowering import costs, offsetting the loss of benefit of higher rates

Clearly, this needs to be thought through. The Bank of England would need to remain 100% in control of managing inflation, but would now have two tools instead of one. They would decide when and how to apply which lever and the level at which they were applied. Savers benefit less, but offset with savings eroded less by lower, shorter inflation. As inflation recedes, so taxes can be reduced, allowing more money to flow into the economy. Or lower the interest rate to make borrowing cheaper.

My initial thought was to use VAT as the tax vehicle, but this won’t work — it’s controlled by the government (and so not independent), requires legislation to change, and would be a nightmare for retailers to implement. Perhaps the BoE could simply have a +/- 2% bandwidth on PAYE taxation? It could be implemented in the next pay packet and would have less impact on the poorest. Interest rates might remain the primary tool, but if the situation allowed, we could apply the secondary tool, with the ‘benefits’ flowing to the Exchequer (and in theory back into public services, i.e. taxpayers would get their money back)

( Just) some of the obvious questions

It all sounds a bit voodoo economics to me; the sort of wheeze Jeremy Corbyn might come up with. The last thing we’d want to do is spook the markets. As with all the ideas in this book, it’s designed to prompt a conversation. If greater minds than I thought this idea had legs, maybe market acceptance might arise from this context? If a government addicted to spending and borrowing decides to mess with how we control inflation, we should anticipate a nasty reaction. But taken as part of a package to get spending under control, grow the economy, reduce debt, etc., maybe the environment would be created for a limited, controlled pilot?

What Next?

Well, I wrote my book. Maybe I’ll get some feedback? If so, then I will have started a conversation. It might spur me on to write another. I have no great desire for frontline politics, but a huge passion to see our country back on

the right track. I have met many of our public representatives. Contrary to popular belief, many (not all) are bright, interested, and passionate about improving the UK too. They are served by a huge community, including civil servants, thinktanks, and public affairs professionals who, between them, have the skills and opportunity to transform the country. For those with the ambition, creativity, and the will to do so, I’d be happy to help.