We just moved to a 5% interest rate here in Canada. The reason, we are told, is to combat inflation. There certainly does appear to be inflation; prices are noticeably higher after the pandemic. But are interest rate hikes the cure?
The argument is that inflation is caused by increased spending, especially on debt-funded high-ticket items like cars and houses, or purchases on credit cards. Make the interest rates higher, and this makes these purchases more more expensive, so we’ll make less of them. That decreases spending, thus lowering inflation.
We are all familiar with the pain caused by higher interest rates. All those purchases we’ve already made on credit now cost more after we’ve made them. The same for government debt; the money available for social services and government operations drops a lot as government pays more money to its creditors.
All this creates real hardship. I remember the days of inflation in the 1980s where mortgage rates were up to 21%. People were losing their homes and their jobs. Inflation was not stopped by interest rate hikes; the government had even introduced wage and price controls. We plunged ourselves into the deepest recession we had seen since the Great Depression of the 1930s.
What got us out of the recession? Government spending. In the U.S., this came by meas on Reagan’s tax cuts, which gave business more money to invest. In Canada, recovery didn’t come until the 1990s and arrived with prime minister Jean Chretien’s infrastructure program. People were employed again, were able to send again, and both inflation and interest rates began to fall.
Here’s the thing about interest rate hikes: they hurt most people who don’t really have any control over their spending. We all have to have a place to live, we all have to have food to eat. We all have to have transportation. Clothing. Education. It’s not like we’re all sitting there deciding whether to buy a second boat. Te only people impacted by interest rates are those wealthy enough to have discretionary spending – and they don’t care. They can afford it.
Where we do see an impact is in business spending. WE don’t see new start-ups because it costs to much to borrow seed money. We don’t see businesses expanding because they can’t get financing. Even debt-funded corporate acquisitions are slowed because it cost too much to convert assets to debt. This does impact spending, but it doesn’t reduce inflation, because businesses respond as business has always responded: by converting higher costs to higher prices. The more business hurts, the more things cost.
And that points to the real cause of inflation: not increased spending, but rather, increased extraction of money from the economy by business. With less money to go around, production stagnates, and prices increase.
After all, if we look at the current round of inflation, we do not find a cause in increased spending. Quite the opposite. People didn’t have money, not even with the government assistance programs. The economy had suffered a shock due to Covid. Nobody was making more money. Pay raises were non-existent. And yet, prices began to rise. During the three years of the pandemic, corporations reached huge, even record-setting, profits. They extracted billions from the economy. And – because they could – they started raising prices.
If we want to see this in action, look at housing. We have 40 million people in Canada; this number is not doing to go down. Everyone needs housing. But house prices are going through the roof, because we are not producing enough housing to meet the demand. Raising interest rates will not increase the supply of housing; it will decrease it. If we want to see more housing, we need to put money into the economy – specifically, in the form of new housing. Prices decrease, and inflation abates.
If we want to reduce inflation, there is really only one way to do it: restore production. When we produce enough of what we need, prices drop. But production requires investment; where is the money to come from? Well, where has all the money gone? The huge windfall profits extracted by corporation are what have caused this crisis, and that’s where we’ll find the solution. Restore the money extracted from the productive economy.
Or, in other word, tax the billionaires and the windfall profits, and invest this money t produce the things that are in short supply, thus reducing demand, and hence, inflation. The infrastructure program was a great example of that; it increased productive capacity across the board, by making it cheaper and easier for Canadian businesses to leverage social infrastructure to ramp up production.
There are ways to make such a program more directly responsive to inflation caused by the extraction of wealth. For example, indexing corporate taxation to inflation could be a start; the more they force an increase in prices, the more taxes they will have to pay. Putting a cost on windfall prices might also be a solution, reducing the benefit companies like grocery stores earn from arbitrarily raising prices.
I don’t know whether our current governments – who are financed by the wealthy – will have the capacity to act. In previous recessions we have seen a lot of hardship and unrest precisely because the wealthy don’t care; higher rates benefit most those who have the most money. But a government that has the interests of the people – and the state of the nation in general – would be urged to act.
We’ve been luck in the past – we’ve been able to recover from recession. But as history shows, societies don’t always recover from recessions; sometimes, they fall into rule by the oligarchies, with all the misery that entails.