What can governments do about the cost of living?
The cost of living has been the defining political issue of the post-Covid world. As prices and interest rates spiked in the aftermath of the pandemic, incumbent governments have suffered in elections everywhere. While it is always risky to apply a sweeping narrative across many countries, there is little doubt that the cost of living has become a problem for governments of every shade, in every country.
By contrast, the long period of stagnant growth and ultra-low interest rates before the pandemic did not seem to hurt incumbent governments nearly as much. This goes against conventional wisdom; governments used to stoke inflation in the lead up to an election, presumably on the assumption that a bump in economic output mattered more than a spike in prices. But it seems plausible that this pattern has reversed. Today’s governments may have more to fear from rising living costs than stagnating living standards.
Cost of living crises are also likely to become more common in future. The combination of climate change, geopolitical instability and a greater need for investment make the risk of supply disruptions and higher prices more likely over time. The aim of this piece is to ask, if governments find themselves needing to make the cost of living their top priority, what should they actually do?
My thesis is that there’s not much governments can do about cost of living crises once they’ve already begun. The best thing is to try and prevent them happening in the first place. That is not easy and it is rarely quick, but it is something governments should put more effort in to if they want to survive.
What does “cost of living” means as a political concept?
The term “cost of living” is not as simple as the concept of “inflation” that economists focus on; it bundles together at least three different things.
First, rising prices. What voters seem to care about is not just inflation — the rate at which prices are currently increasing — but the price level. If things cost 20% more than they did two years ago, voters seem unmoved by governments pointing out that inflation has returned to its 2% target.
Second, interest rates. Higher inflation typically means higher interest rates, which can mean dramatically higher costs for borrowers, especially those with mortgages.
Third, tax increases. Taxes have been steadily rising as a share of GDP in many economies, driven primarily by ageing populations and lower growth. Voters seem to dislike this too.
However, the cost of living does not seem to include any corresponding increases in income. Higher interest rates raise incomes for many savers, many of whom are pensioners. The post-Covid bout of inflation has also been accompanied by reasonable wage growth, with the lowest earners benefiting the most, but public opinion seems unmoved by this. It’s open to debate why that is, but the explanation I find most plausible is that people attribute rising wages to their own ability while blaming governments for rising prices.
This is unfortunate, because there is a decent argument that slightly higher inflation can help support higher growth, and that hot labour markets can drive wage increases for those that need them most. Higher growth also typically means higher interest rates. The economy has recently emerged from a period of low inflation, ultra-low interest rates, and stagnating living standards — and those things were not unconnected.
What is clear is that increases in prices and interest rates are a problem for incumbent governments, and it is not enough to point to higher growth and wages, or to more jobs, in response. People just really hate things getting more expensive.
What causes cost of living shocks, and why should we expect more of them?
Cost of living shocks are typically headlined by supply shortages of one or more key goods, often energy or food. Energy shocks have driven the most notable post-WWII inflationary periods — in the 1970s and early 2020s — while rising gas prices were also an under-appreciated backdrop to the 2008 financial crisis. These shocks are mostly international in nature — governments cannot alter international markets any more than kings can turn back waves.
There is a good chance these supply shocks will happen more often in future. Climate change is likely to have direct impacts on food supplies, leading to crop failures and shortages in some foods. The changing climate will also increase disruption to industries and logistics around the world — via floods, fires, rivers laid low by drought and so on — which create supply bottlenecks. Meanwhile, the transition to clean energy, along with a much less stable geopolitical environment, has already made gas more expensive in a lasting way, and leaves us vulnerable to further shocks. And that’s before we get onto the risk of tariffs and trade wars.
But cost of living crises can also be stoked or blunted by subtler conditions of demand and supply. When you have an economy reopening from a pandemic, where consumers have accumulated excess savings, where monetary policy has been extremely loose, you can get surges of demand alongside supply shocks, which further drive up prices. Likewise, issues on the supply side — such as ill health among the workforce, skill shortages or bottlenecks in particular industries — can exacerbate supply shocks.
And again, it is possible that these factors stay weighted towards more cost of living spikes in future. It is plausible that interest rates will remain higher, driven by the need for more investment — in defence, net zero, often in rebuilding infrastructure — and maybe chronic fiscal deficits (yes America, I’m looking at you).
Higher interest rates are a cost of living problem in their own right, and they leave governments and central banks in a delicate position. Raising interest rates further to quell inflation risks raising the cost of living, as well as rising unemployment (voters still hate that as far as we know). But keeping interest rates on the low side risks inflation getting out of hand more quickly, as it did after 2021. Cost of living shocks will probably get more common and more painful in future, but they probably won’t get any easier to respond to.
Governments have few good options once cost of living crises have begun
What can governments do once cost of living crises have begun? The traditional response – tighten monetary policy, raise interest rates – remains crucial, but it seems to carry the risk of a political backlash in its own right.
What alternatives are there? One option is to provide temporary subsidies in the wake of supply shocks. If energy or food prices spike, governments can choose to smooth out price rises. But temporary subsidies have a habit of becoming permanent, and they can quickly blight a government’s fiscal position, putting upwards pressure on interest rates (and maybe downward pressure on the currency). It’s often forgotten that a key part of Liz Truss’ fiscal package was a massive energy bill subsidy, which was sensible on its own terms but didn’t exactly help alongside her wider package of unfunded tax cuts.
Another option is to try price controls. This might work, in the short term, in certain circumstances, for domestically produced goods — although it is probably ill-advised. It almost certainly won’t work for internationally traded goods — if the price is set too low, these goods will simply go elsewhere.
A further option is to try and restrict corporate profit margins, forcing companies to take a share of the pain from rising prices. While there are circumstances where this might work — particularly where markets are not very competitive — it is not always easy to judge when these circumstances exist. The risk of hurting your business base, or of creating actual supply shortages, is significant.
The bottom line is: prices usually rise because things are in short supply. Trying to push back against such price signals is a ultimately a risky business, and can make things worse rather than better for governments.
The best solutions to cost of living crises are long term ones
So what can governments do to tackle cost of living crises? In short, try to stop them happening at all, or at least prepare in advance.
On energy, arguably the biggest cost of living risk factor, governments now have an option that isn’t “discover a new oil and gas field”. The rapid falls in the price of renewable energy and battery storage mean that countries can aspire to produce their own energy, reducing costs and removing themselves from the lottery of international fossil fuel markets.
The catch, of course, is that this can’t be done quickly, or without significant upfront investment. After many years of investment in offshore wind power, Britain may be around 5 years away from becoming largely self-sufficient in electricity if the Labour government’s plans succeed. But even then, the country will still rely on oil for transport and gas for home heating, mostly imported at great and uncertain cost, because it has lagged behind on other parts of its green transition. Investing in home-grown energy is the right thing to do on many levels, but it is no quick fix.
Food is a more difficult issue, which does not have an obvious short- or long-term solution. Unlike energy security, food security does not equate to producing more food at home, despite what the farming lobby would have us believe. Climate impacts, diseases and crop failures can happen at home just as they can abroad, and trading food in international markets should provide a measure of protection against such shocks, along with much wider choice. But supply shortages and price spikes will happen at some point, and there is not much government can do to avoid them.
That said, governments should certainly invest in the resilience of their domestic food industries and global supply chains — managing soil and water better, protecting budgets for tackling animal and plant diseases, securing supplies of fertilisers and other critical inputs to agriculture. They might also want to consider more widespread stockpiling of staples, to release in times of shortage. More controversially, it would help if people could be encouraged to substitute foods more often — switching to other vegetable oils when olive oil crops fail, for instance — but this may be even more painful for politicians than just letting prices rise.
More widely, governments should invest in climate adaptation and resilience. Managing floods, droughts, fires better, and making energy infrastructure, roads, ports more resilient to adverse weather should be seen as a downpayment on blunting future cost of living crises. Of course, as with investing in energy infrastructure, climate adaptation doesn’t come cheaply or quickly, but it is critically important.
Alongside this, governments should also perhaps take a more active interest in their construction sectors. Building more stuff – homes, infrastructure, storage facilities – should help bear down on the cost of living over time. Avoiding labour shortages and bottlenecks in the construction industry should make all of these investments more affordable, and limit price shocks from inflation in construction costs. Investing more in construction skills is the most obvious policy priority here, but providing a smoother, more predictable stream of demand to the industry could also help.
Along with trying to avoid or soften supply shocks, there is another thing that might help governments to ride out the threat of cost of living crises: tighter fiscal policy. Moving government finances from deficits towards surpluses should put downward pressure on interest rates. It would also leave governments with more room for short-term subsidies when cost of living crises do strike. With more robust fiscal controls, some of the tempting short term responses to price spikes might actually work — but only with the right preparation.
Tighter fiscal policy also has its downsides. Most of the options I have set out require investment, much of which governments need to pay for. Raising taxes — often the best way to tighten fiscal policy at present — can directly feed a cost of living narrative. There are trade offs wherever you look.
Indeed, difficult trade offs are likely to be a permanent feature of governing over the coming years. If the cost of living remains a decisive factor in whether governments get re-elected or not, they’ll need a new approach. But the things that actually work to tackle cost of living crises may not fit neatly into electoral cycles. A government that spends its term revamping the energy system or making infrastructure more resilient may find that the electoral benefits come too late, and maybe even accrue to their successors. The best strategy for a country is to invest for the long term, to prepare for short term crises, to persuade the electorate that this approach is ultimately the right one. But what is best for a country and what is best for its government are not always the same thing. In an age of increasing volatility, I fear preparing effectively for cost of living crises may be hard for democratic governments to pull off.
