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Interest, inflation, incentives and Keynes

27/10/2021
Ian_jackson

Dr Ian Jackson, Senior lecturer in Economics in the Wolverhampton Business School blogs about interest rates and inflation over the years.

In February 1936, John Maynard Keynes published his influential and pioneering work: The General Theory of Employment, Interest and Money.  Set against the devasting backdrop of mass unemployment during the Great Depression, this book established the importance of positive Macroeconomic policy.  Furthermore, it created a compelling narrative to establish a wider role for government in the economy through demand management aimed at creating full employment.

Eighty-five years later, the global economy is emerging from a period of prolonged economic problems.  One, the Great Recession caused by the Financial Crisis of 2007-08 and two more recently the effects of the Covid-19 Pandemic.  In the UK, the second quarter of 2020 witnessed the largest single drop in UK growth in 300 years (since the Great Frost of 1708-09) when a national lockdown effectively created the first-ever “voluntary” recession in our economic history.

By the end of the third quarter of 2021 and the economy is beginning to bounce back with a “V” shaped recovery.  This is not surprising as the whole economy is now open for business after the end of the Furlough Scheme and other measures designed to buy time while the vaccination programme was created and rolled out.  We will never know if Keynes would have agreed with all the responses, as he died in 1946, but his work provides many invaluable pointers for the future.  These interventions are known as the “Keynesian Steering Wheel” designed to help navigate the economy.

Firstly, as the UK economy emerges from the lockdown there is an inevitable consequence of price inflation as more money chases goods and services.  In September 2021, inflation was about 3% well above the Bank of England target of 2%.  Also, there is the prospect of wage inflation as workers seek to cover the higher costs of living.  These price and cost pressures are likely to trigger a higher base rate as the UK Government will want to avoid an “overheating” economy later in 2022.  In any case, base rates are at an historic low of 0.1%, so there is room for manoeuvre.

Secondly, the UK Government will need to adjust spending and taxation to ensure there is sufficient aggregate demand in the economy.  However, this will be a challenging task given the epic levels of public debt used to finance the recent lockdown of the economy, which is a scenario understandably never truly envisioned by Keynes.  There will need to be higher levels of taxation to repay our debts but this should be over many decades in what is known as “overlapping generations” of repayment.

Keynes is famous for the 1923 quote: “In the long run we’re all dead.” This is not a pithy comment from an uncaring intellectual.  It is a recognition that the national economy should not be run in the short term like a household budget to balance expenditure with revenue.  We can borrow money now and pay back much later to help incentivise recovery.  However, this action should be with the sole purpose to help steer the economy through difficult times so that the national debt can be repaid when the economic conditions are more favourable again in the future.

         

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