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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.

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