Raising interest rates is like blowing up the garden to weed it

Dirk Ehnts, Sten Grahn, Peo Hansen, Jussi Ora & Patrik Witkowsky

This article was first published in Swedish on May 15, 2022, at Göteborgs-Posten.

The Riksbank (Sweden’s central bank) only sets the interest rate. And interest rates have no impact on the energy prices that are driving inflation today. But higher interest rates lead to higher unemployment and lower output – and that can push inflation even higher.

But there are other ways to curb inflation, write Dirk Ehnts, Sten Grahn, Peo Hansen, Patrik Witkowsky and Jussi Ora.

The (Swedish) inflation rate in March 2022 was 6.1%, compared with 4.5% in February. This is largely attributable to higher energy costs. The oil price, which was negative in April 2020 when there was a surplus, has risen since then to around $100 per barrel. Gas prices have also soared.

Is there anything that can be done about the price increases? Today, we give responsibility for inflation to the Riksbank, which has an inflation target of 2%. According to accepted economic theory, inflation can be reduced by raising interest rates. As the Riksbank

writes on its website: “A rise in interest rates also makes it more expensive for firms to finance investment. As a result, higher interest rates normally curtail investment. If consumption and investment fall, total demand also drops and there will be less activity in the economy. When activity is low, prices and wages usually rise at a more modest rate.”

Blunt tool

However, a slowdown in economic activity also leads to an increase in unemployment. The Riksbank thus fights inflation by increasing unemployment. The idea is that a higher level of unemployment weakens the bargaining position of wage earners, as the threat of unemployment is now more acute.

Raising interest rates is therefore both a blunt and harmful tool. It can be likened to blowing up a bomb in the garden to get rid of the weeds. The job of weakening the economy gets done, but at a very high price. In addition to the economic and social damage done to those who lose their jobs, unemployment further divides society.

A second problem with raising interest rates is that it is unlikely to reduce inflation at all. Energy prices today are largely imported and therefore have nothing to do with Swedish wages. In other words, even if we blow up the garden, it is highly likely that weeds will continue to flourish. Moreover, we can expect higher interest rates to increase business costs. Swedish companies are very indebted today.

Therefore, if interest rates rise, companies can raise their prices, and thus inflation, to stabilize the profits they need to pay off their debts.

In other words, even if we blow up the garden, it is highly likely that weeds will continue to thrive.

An interesting example is the situation in the Czech Republic and Slovakia, two countries with similar economies. While the Czech central bank started

to raise interest rates last summer from zero to the current five per cent, in the eurozone country of Slovakia the rate has remained at zero. Last summer, inflation was the same in both countries. Today it is higher in the Czech Republic than in Slovakia.

Sweden produces more electricity than we consume, but since Swedish energy operators operate in the integrated European energy market, this means that, under current legislation, they will raise their prices if market prices rise. Our current energy prices, therefore, do not reflect a change in production costs, or in supply and demand in Sweden. Higher energy prices are transmitted via the international energy markets. They create profits for Swedish energy operators as a result of events outside Swedish control.

Investments in public transport

So, are there any alternatives to raising interest rates? One option is to subsidize petrol and diesel, as the government did by cutting the fuel tax and paying a transfer to car owners. However, this only adds fuel to the fire by throwing money at it, which will end up as profits for the energy companies.

Another option, which curbs both inflation and climate impact, is to heavily invest in public transport, as well as electric vehicles and other solutions that reduce energy demand. Germany is an interesting example. There, the citizens can buy tickets for the national public transport system (everything except long-distance trains) for just 100 crowns (about 8 pounds sterling) a month this summer. This fills empty trains and encourages people to park their cars, reducing energy consumption.

In the longer term, a more strategically robust price stabilization policy is needed. Instead of raising interest rates, we need to transform our energy and transport systems. This means massive public investment in renewable energy, public transport, fossil-free vehicles and energy efficiency. This also includes a major investment in local renewable energy production. To achieve this goal, the fiscal framework needs to be reformed, as it currently hinders public investment, weakens our infrastructure and makes Swedish consumers and industries vulnerable to foreign energy markets.

It is easy to blame the Riksbank for inflation. But this is completely the wrong way to go. Blowing up the garden by raising interest rates is associated with major social costs and it also risks increasing inflation further. The best way to fight inflation is to rebuild and rethink our energy and transport systems.

Source: https://gimms.org.uk/2022/05/17/blowing-up-the-garden-to-weed-it/

This work is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License. This article was first published in Swedish on May 15, 2022, at Göteborgs-Posten.

Dr Dirk Ehnts is an affiliated researcher at the Institute for International Political Economy Berlin.
Dr Sten Grahn is a specialist and resear- cher in Production Engineering. Malardalen University.
Dr Peo Hansen is Professor of Political Science, Linköping University
Jussi Ora is the Director of Positive Money Sweden, and is a Board Member of the International Movement for Monetary Reform
Patrik Witkowsky is the Founder of the Centre for Employee Ownership