Economics: The big chill

We may be well into the summer months now, but a chill still persists, whistling round the British economy. After basking in years of political and economic stability, 2008 has marked a distinct change in the climate. Some think this a temporary squall, but most media commentary suggests we should brace ourselves for a lengthy period of turbulence.

Talk of recession, a collapsing housing market and a consumer sector struggling to cope with huge debts make for striking headlines. But all this overlooks an inconvenient truth ­ that, in fact, the economy is still growing. The increase in GDP in the second quarter may have shrunk to just 0.2%, but it was still growth. The economy continues to move forward, but more slowly.

Additionally, none of the 44 companies and organisations covered in the Treasury’s monthly Summary of Forecasts for the UK economy expect negative growth for this year and only one predicts GDP to fall in 2009.

Even so, this may still be a semantic argument because, for many households and businesses, what is shaping up to be the sharpest slowdown since 1992 probably feels like recession. Problems associated with weaker spending trends are being aggravated by sharp price increases in items such as imported food and petrol. Discretionary spending by households is coming under severe pressure.

What makes the current situation so confusing is that the conventional tools of economic management are not available. The government’s precarious finances preclude cuts in taxes (as in the US) while the threat of inflation limits the MPC’s scope for reducing interest rates. In fact, some commentators feel that the spike in the CPI means there is a stronger case for rate rises. Although Mervyn King won’t be panicked into increasing rates because of short-term inflation pressures, he will be watching the economy assiduously for signs of inflation taking hold.

Attention will be focused on one area in particular. The labour market has long been the entry point for inflation into the UK economy. Falling unemployment and steady employment growth associated with periods of robust growth is traditionally a signal to pay bargainers to step up their wage demands.

Employers, unwilling to risk a strike, accede to the claim, which goes on to costs and feeds price increases. Months later comes the next pay demand ­ and then, the wage-price spiral is up and running.

This has been a regular feature of UK economic life since the 1960s and has led to stern warnings from the Chancellor and the Governor of the Bank of England recently about the need for pay restraint. But there is little current evidence of a tighter labour market leading to a build-up of wage pressures. In fact, in the past few years, the reverse has been true, which has fuelled speculation that there has been a significant structural shift in the behaviour of the labour force.

As employment climbed to record highs of more than 29 million and the jobless count dropped to mid-1970s levels of around 800,000, earnings growth has paradoxically stayed consistently below 4%, less even than the 4.5% affordability threshold of inflation plus productivity. This is completely contrary to past experience and is probably attributable to at least three factors: the export of manufacturing; industrial relations; and migrant labour.

In the first place, manufacturing ­ a vast chunk of our economy ­ has been exported in the past 30 years to China. This was the most unionised part of the economy, the base for the T&G, AUEW, the EEPTU and the other big union battalions of the 1970s. In 1979, trade union membership was 13.2 million ­ today, it is around 7.5 million, about one-in-four workers; the fastest growing parts of the economy are among the least unionised. Second, union activities have been constrained by changes made in the 1980s to the legislative framework for industrial relations.

Finally, the influx of migrant labour has topped up worker supply and prevented shortages, helping to cap pay settlements.

Policymakers’ concerns about pay are, nevertheless, understandable. As a country, we cannot pay more (to overseas suppliers) for oil and food and try to maintain domestic living standards by increasing our pay. We tried it in the 1970s and it took a generation to squeeze the resulting inflation out of the system. Although, superficially, there seems less to worry about today, the risk is the public sector, where trade union membership is still strong. Having been boosted by Gordon Brown since 2001, its expectations have been raised. The fear is not just about public sector pay, but also that their settlements become the benchmark for the entire economy.

Like it or not, we must accept that if more of our income is going elsewhere, some reduction in living standards at home is on the cards. Just how the pain is distributed is up to the government. But if we think we can get around it with higher pay, King and his colleagues will get us with higher interest rates. At an aggregate level, it is a no-win situation for households.