Money, inflation and interest – the labyrinth of capital

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By SERGIO GONZAGA DE OLIVEIRA*

There are solutions to reduce the impact of the dispute between the scourge of inflation and the bitter medicine of rising interest rates

Legend has it that Daedalus, the Greek architect, designed and built the labyrinth of Crete to contain the Minotaur, a mythical creature, half man, half bull, who imposed severe penalties on the inhabitants of that city. Even imprisoned in the bowels of the labyrinth, Minotaur demanded constant sacrifices from young virgins to appease his wrath. Crete's misfortune only ended when Theseus, a hero of Athens, managed to defeat and kill the Minotaur. Theseus found his way back through the labyrinth thanks to Ariadne who gave him a ball of yarn to mark the route.

Like Crete in Greek antiquity, Brazilian society struggles to contain its demons. Real interest rates in Brazil are by far the highest on the planet.

One of the most controversial issues in the economic area today is probably the fight against inflation. Despite the intensity of the debate, many questions are not satisfactorily answered. For example, why is the reduction in economic activity, by raising interest rates, practically the only instrument used by the Central Bank to combat inflation? Even knowing that this path is very harmful to the economy and the most vulnerable sectors of society? Why in Brazil, interest rates are so high? Could it be that public deficits are solely responsible for the high rates? Is raising interest rates the only possible solution?

Answering these questions is not very simple. This article proposes to approach the subject in its historical context, trying to understand how the recent financialization of the economy established the rigid contours of the current monetary policy. More than that, it explains how the monetarist approach, via interest rate increases, leaves aside the structural constraints that fuel inflation; as if these were of no importance or could not be equated and resolved. Furthermore, it discusses how raising interest rates, far from being a technical and precise solution, is endowed with a high degree of uncertainty.

Many claim that capitalism is essentially a money exchange economy. It took its first steps when our ancestors began to exchange production surpluses. To facilitate trade, they created the most diverse types of currency. First, shells, grains, salt, fabrics and craft objects. Then precious metals, gold, silver and copper. Later on, paper money and book-entry money; a simple note in the accounts of a bank. Finally, digital currency such as cryptocurrencies.

At the beginning of this evolution, the correlation between currency circulation and the functioning of the productive system was not very well understood. As far as is known, the first attempt to understand this phenomenon was made by the Scottish philosopher David Hume, considered one of the exponents of the Enlightenment. David Hume, in the essay “Of Money",[1] published in 1752, recommended that currency be supplied to the market in adequate quantity since an excess causes prices to rise and scarcity hinders trade and production.

He also understood that an increase in the quantity of money, beyond the needs of the economy, has two different effects over time. The first, in the short term, causes an increase in economic activity and the second, in the longer term, results in an increase in prices. The logic described by Hume prevailed for a long period in which the issuance of currency was controlled by a central authority.

In recent decades, however, the issuance and circulation of currency, or more precisely the means of payment, has undergone profound changes. Book-entry currency began to be issued by private agents from deposits in commercial banks. Payments, transfers and receipts are then carried out without the use of physical currency. In addition, banks, companies and the government have developed multiple financial instruments that are equivalent in practice to demand deposits. These are medium and long-term investments that, thanks to secondary markets, can be redeemed at any time. They are called “quasi-coins”. When these processes increased, Central Banks lost their monopoly on issuing most means of payment.

in your book Stabilizing an unstable economy,[2] Hyman Minsky wrote: “As banking innovations intensified in the 1960s and 1970s, it became evident not only that different types of money exist, but also that the nature of the relevant money is changing as institutions evolve. The significance of money, banking and finance cannot be understood without considering financial evolution and innovation: money is actually an endogenously determined variable – rather than something mechanically controlled by the Fed, supply tends to adjust to it. passively to demand”. Not by chance, in 1972, the USA abandoned the gold backing, leaving behind the quantitative control of the currency.

 

The scourge of inflation

Over time, it became clear that inflation is not a purely monetary phenomenon as it seemed to David Hume. That it is not just the change in the amount of currency in circulation that generates inflation. The general increase in prices can have several origins.

Conjunctural phenomena such as excess demand, insufficient supply, the sudden increase in production costs, exchange rate fluctuations and the dispute over national income between wages and profits can create or fuel rising prices.

In the years 2020 and 2021, a pandemic caused by a coronavirus reached a large part of the world's population. While vaccines were being developed and tested, many measures restricting the movement and agglomeration of people were adopted by governments. As a result, in 2020 the level of economic activity dropped sharply. According to the World Bank, Covid 19 has thrown the economy into the worst recession since World War II. When, at the end of the pandemic, economic activity began to recover, production chains were largely paralyzed. Manufacturers and traders had great difficulty obtaining products and raw materials, featuring a rapid increase in demand in the face of a shortage of supply.

The following year, when the recovery of the production chains had not yet been completed, war broke out between Russia and Ukraine. The war quickly reduced the supply of oil and gas from Russia, causing the price of these products to rise. As these inputs interfere in almost all production chains, the increase in their prices led to a general increase in costs.

What was observed, then, was a relatively quick sequence of increased demand, shortage of supply and rising costs. Unsurprisingly, inflation rose in most countries. In the USA, in the accumulated 12 months, it reached 9,1% in June 2022, a value that had not been registered since the 80s of the last century.

Both in the heating up of demand and in the scarcity of supply, inflation results from business action in search of higher profits. Companies raise prices by taking advantage of the market imbalance. Profit rates rise throughout the economy. Likewise, when production costs rise sharply, entrepreneurs raise prices to try to maintain profit margins. These types of inflation often manifest themselves as shock waves, that is, they appear, reach a maximum and dissipate over time, as the production chains adapt to the new conditions or cease the phenomena that gave them origin.

In the wake of these shock waves, not infrequently, there are disputes between wages and profits. With rising prices, workers and their unions are pushing for wage increases. Successively, price adjustments by businessmen and wage increases set up an inflationary spiral. In fact, this phenomenon is not so simple, as it can manifest itself when the expanding economy promotes a drop in the unemployment rate. Under these circumstances, an appreciation of wages via the market or an increase in union bargaining power causes a rise in labor costs. To maintain profits, entrepreneurs raise prices.

However, far beyond these conjuncture shocks, structural constraints alter the inflationary dynamics. Market concentration, especially in the banking sector, exchange rate sensitivity to free capital movements, need for foreign capital to close external accounts, maladjustment of production chains, dependence on international commodity prices, structural deformations in the labor market, high government deficits and persistent, complex and costly tax structure, low economic productivity, political instability and monetary correction in long-term contracts are the most recurrent.

In the economies of peripheral countries, these constraints can be very significant, creating an inflationary base that is very resistant to traditional monetary instruments to combat inflation.

In summary, the general increase in prices is a complex phenomenon. More than that, inflation damages the economy and society. Workers find it difficult to replace wage losses. On the other hand, those who have capital income or loan funds suffer less from inflation. In the end, inflation becomes a perverse tax that falls heavily on the most vulnerable population. In addition, price variation causes uncertainty in the planning of companies that make long-term decisions.

 

The silver bullet: interest rates fighting inflation

Since the issuance of means of payment migrated from the Central Banks to the financial market, the most used instrument to combat inflation has been the reduction of economic activity through the increase of basic interest rates in the economy.

In the introduction to the aforementioned book, Stabilizing an unstable economy, economist José Maria Alves da Silva explains this change well: “The financial developments that were felt, notably from the 1980s onwards, showed the directors of central banks in developed nations that if they took the traditional concept of M1 (paper money held by the public plus demand deposits at commercial banks) would be trying to control an aggregate that became increasingly negligible as a proportion of GDP; if, on the other hand, they looked at larger aggregates (M3 or M4) they realized that they were far beyond their control possibilities. Conclusion: the “traditional amount of money” was irrelevant as a monetary policy goal and the “relevant amount” was out of control. This was perfectly in line with the propositions of Minsky and Nicholas Kaldor, among others, who advocated the hypothesis of monetary endogeneity. From then on, instead of trying to control any monetary aggregate, central banks began to use policies to control interest rates, as recommended by James Tobin in the early 1970s, in the debate in which he opposed the Friedman rule. ”.

When the Central Bank increases basic interest rates, the other rates go in the same direction. As interest rates rise, economic activity tends to decline. With the reduction of activity, unemployment increases and consumption decreases. Entrepreneurs find it more difficult to recompose or increase profits. However, this relationship is not direct. There is, in practice, a time lag, difficult to measure, between the action of the Central Bank and the general increase in interest rates. And also, a delay between the general rise in interest rates and the effective reduction in activity.

In addition, the monetary authorities, with their actions, intend something more than, occasionally, to reduce economic activity in order to contain inflation. In the medium and long term, they want to create an expectation among economic agents that they will act rigorously, in any scenario, to avoid the installation of a dispute between wages and profits in the wake of inflationary shocks. In the end, maintaining this expectation has been a significant component of monetary policy.

It is not by chance that the Central Bank is very concerned with disclosing its intentions, through communiqués and minutes of meetings, obviously to influence the agents' expectations. For this reason, indicators of expectations about future inflation or the intention of the monetary authority are relevant indicators of Central Bank action. The major problem underlying this understanding lies in the definition and interpretation of these indicators, since they are traditionally volatile, difficult to measure and unreliable, especially in peripheral countries.

In summary, the fight against inflation by raising interest rates contains a good deal of inaccuracy, whether in the lag between Central Bank action and the economy's reaction, or in measuring agents' expectations. As a result, it can be said that conducting monetary policy involves a high degree of uncertainty. The margin of error can be very high, causing serious damage to the economy and society. Furthermore, the fight against inflation in this way is a conjunctural action, not taking into account structural factors that put pressure on price levels.

 

The perverse face of fighting inflation

Much recent empirical research has shown that the tendency towards income concentration is insistently recurrent in the capitalist production system. This trend has been reinforced by the current anti-inflationary monetary policies adopted by Central Banks. The perversity of these policies lies in the fact that they seek to keep a portion of workers unemployed, as a way of putting pressure on those who are working not to claim wage gains. More than that, rising interest rates directly and negatively impact the budget and public debt, restricting the government's ability to maintain essential services or invest in economic and social development.

As in the legend of the Minotaur, the system demands many sacrifices from the population, especially the poorest, to contain the wrath of inflation. But this Minotaur is selective. The increase in interest rates, as the main instrument for reducing activity, harms the most vulnerable and companies that operate in the production of goods and services. In perverse compensation, it favors rentiers; the wealthy elite holding financial investments in the capital markets.

Certainly there are solutions to reduce the impact of this dispute between the scourge of inflation and the bitter medicine of rising interest rates. It certainly involves institutional changes that synchronize fiscal, monetary and exchange rate policies. But, above all, it depends on the State's ability to implement structural reforms (including micro and macro prudential measures) to make the economy and society more resistant to inflationary shocks. In peripheral and still underdeveloped countries, dysfunctions are much more serious, requiring an enormous political-institutional effort.

In Brazil it is no different. Many structural constraints, such as those mentioned earlier in this article, put pressure on inflation. As a result, it has been recurrent to drastically reduce economic activity, via interest rate increases, to obtain poor and short-term results.

However, correcting these distortions requires political conditions that the current model of Brazilian presidentialism is incapable of providing. It will most likely be necessary, first of all, a political reform that installs a minimally functional relationship between the legislature and the executive, in line with the article “The Mother of All Reforms” that I published in January 2022.[3] Certainly, what we cannot do is wait for mythical heroes like Theseus and Ariadne to come to our aid someday.

*Sergio Gonzaga de Oliveira is an engineer from the Federal University of Rio de Janeiro (UFRJ) and an economist from the University of Southern Santa Catarina (UNISUL).

Notes


[1] Hume, David, Of Money and Other Economic Essays, Amazon CreateSpace Independent Publishing Platform, California, USA, 2017

(2) Minsky, Hyman, Stabilizing an Unstable Economy, Novo Século Editora, Osasco, SP, 2013

(3) Oliveira, Sergio Gonzaga, “The Mother of All Reforms”.


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