These are tough times for central bankers. As they tighten monetary policy to combat inflation, governments in the U.S., U.K. and EU spend too much, and supply-side problems are becoming endemic.
Central bankers tend to view inflation and unemployment through a Keynesian lens.
Aggregate demand fluctuates above and below the productive potential of the economy. The result is either too much inflation, when demand exceeds supply, or too much unemployment, when households and businesses are pulling back on spending.
Raise or lower rates
If inflation is too high, central banks can raise interest rates to curb investment—especially on housing—and consumer spending.
The machinations can be complex, because monetary policy works with a considerable lag. But higher interest rates drive up monthly payments for homeowners with variable rate mortgages and for those looking to purchase their first or bigger home. Fewer houses get built and fewer kitchen cabinets, furnaces and appliances get installed.
Similar logic applies for cars, appliance replacements and home improvements. As they can, buyers wait for the inevitable easing of monetary policy.
When inflation is tame—defined by central bankers as 2% or less—and unemployment is too high, lower interest rates. All these forces go into reverse to boost demand and reduce unemployment.
Supply capacity is a given
In this world, the capacity to produce goods and services grows at the sum of the rates of productivity and labor-force growth. Keynesian monetary policy assumes those to be given—etched in stone by a higher power.
Climate change and droughts, Russia’s invasion of Ukraine, and China’s saber rattling, Iran’s intransigence on nuclear weapons, and the pandemic have dramatically reduced aggregate supplies of basic agricultural commodities, energy, and workers, and the reliability of stretched global supply chains.
have fallen, because President Joe Biden has burned through about one-third of the Strategic Petroleum Reserve since August 2021. When that stops, his curtailing of drilling on public lands could summons sharp upward pressures on prices and other nasty surprises.
We can’t feed the world without natural gas. It’s a key component in making ammonia for commercial fertilizer, high gas prices are shutting down most European production, and abundant U.S. natural gas reserves are a potential solution.
Sourcing from China is often now seen as less reliable. Apple
is making iPhones in India, and other assembly lines are moving to Mexico and elsewhere in Asia. In those places, the networks of component suppliers are not as robust and that will push up costs.
Along with the mismatch between the skills, expectations and locations of the unemployed and businesses needs, those combined supply-side constraints—not too much demand—account for at least half of U.S. inflation in recent years.
U.K. supply-side experiments
Former U.K. Prime Minister Liz Truss’s proposed policies weren’t as radical as critics scream. Spending to shelter Britons from this winter’s surge in energy prices is in line with EU plans, but the rest of her agenda–—lower taxes, fracking for gas and deregulation—was boilerplate supply-side economics.
Prime Minister Rishi Sunak will have to spend to shelter Britons from this winter’s surge in energy prices but against the backdrop of massive pandemic aid, like other EU leaders, he’s limited by what the bond markets
British taxes are already at the highest level since the early 1950s. And what the United States, the U.K. and much of Europe really need is a kick in the pants—fewer government benefits that discourage work, reforms at universities, and more vocational and technical education.
Former Prime Ministers Theresa May and Boris Johnson made unfortunate concessions to the EU to accomplish Brexit. Now German manufacturers and French vintners have free trade access to the U.K., but London’s finance industry lacks equal access to continental clients.
The U.K. should implement industrial policies to reduce imports, increase exports and borrow less from abroad by growing and manufacturing more of its needs. These do not appear to be on Sunak’s radar screen.
Whereas British conservatives suffer from an error of omission, Biden’s progressives are imposing the reverse.
Too many subsidies
What Britain suffers on trade with the EU, America endures with China, which exports what it does best and protects and subsidizes most of the rest.
Biden’s infrastructure package, CHIPS Act, Inflation Reduction Act and student loan forgiveness address some of our most pressing problems but too expensively. To accomplish 2% inflation, the Fed and Bank of England may have to create tough recessions and then enforce near zero growth.
Writing for Bloomberg, physicist Mark Buchanan questions economists’ obsession with growth and the planet’s capacity to sustain it. But to get to zero, we would have to reduce the global population or eliminate productivity growth.
Without constant improvements in how we make things and feed ourselves—and consequent economic growth—we are on the path of rapid resource depletion, shortages, destabilizing mass migrations, and civil unrest.
Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.