I really
must return to the subject of interest rates.
Interest rates are commonly regarded as the government’s primary tool –
or perhaps only tool – in tackling inflation.
Let us
consider what happened in the late 1980s when Nigel Lawson was Chancellor of
the Exchequer. He cut income tax, with
the result that many people were destined to be better off. Inflation rose, and he increased interest
rates. As a result, many people lost
their homes to mortgage arrears.
Let us
consider what happened from the point of view of a typical working person at
the time. Income tax has been reduced,
and you can look forward to having more money.
You will not have that money immediately however. Every month you will be paid your salary, and
you will be paying less tax than before, and so each monthly payment will be
slightly more than you are used to.
You have the
option of saving this money, but I am going to assume that you choose to spend
it. If you spend this extra money as you
earn it, and if everyone else does likewise, then maybe no harm will be done.
The problem
arose that many people did not want to wait until they had earned their extra
money before spending it. They decided
to spend their extra money in advance of receiving it, and so either take out
personal loans at the bank or else reach for their credit cards.
The impact
of large numbers of people spending more money than usual in the shops tended
to push up inflation. Remember that
economics is all about supply and demand.
People spending more money created more demand for certain goods, and so
the prices tended to rise. At times of
low demand, shops will often cut prices or maybe use gimmicks like two-for-one
offers (not much different from a price cut) in order to attract customers, but
at times of high demand there is little incentive to keep prices low.
With
inflation rising, the government raised interest rates. This made borrowing money more expensive, and
so people had an obvious incentive to put away their credit cards. However this appears not to have happened at
once, and inflation remained high, and so the government kept on raising
interest rates.
There were
two main effects of higher interest rates.
One was that people were less likely to borrow money, which in turn
dampened down spending in the shops. The
other was that people with mortgages were paying far more in repayments, and so
had less money to spend on other things.
Again, this resulted in less spending in the shops. With fewer people spending money, the shops
had to start cutting prices to attract customers, and so inflation began to
fall.
I feel obliged
to repeat that the money that homeowners were paying in increased mortgage
interest payments did not evaporate.
Some of it presumably went to savers in higher interest rates, but the
savers did not necessarily go out and spend their extra money. A lot of them probably carried on
saving. Some of the money was profit for
the bank, and some of it would have found its way into the coffers of the Bank
of England. Although this money was then
available to create new loans, the higher than normal interest rates
discouraged people from borrowing.
Economics is a complex subject, and it is hard to explain it without resorting to simplification. It is not inevitable that tax cuts will prompt a spending spree, or that inflation will follow. It appears to be true that raising interest rates tends to result in lower inflation, however the parrot cry that interest rate rises somehow damage the economy has little or no basis in reality.
Previous posts on the economy include:
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