The Prime Minister has raised the spectre of a wage-price spiral as a way of justifying the Government’s opposition to wage increases for strikers. For Conservatives of a certain vintage, it is a helpful bogeyman: nobody wants a return to 1970s-style wage and prices controls negotiated between the Government and the unions, especially if it involves haggling with Mick Lynch.
Nevertheless, the waving of the wage-price spiral bloody shirt has received criticism from economists, and deserves further analysis.
A wage-price spiral refers to rising prices leading workers to demand higher pay, which pushes prices up further, and which pushes workers into asking for further higher pay. In a tight labour market with stagnant growth like ours, that can ensure that expectations of inflation become baked in for the foreseeable future.
It was the pressure of avoiding such an outcome that pressed the Heath, Wilson, and Callaghan governments into various wage and price agreements with the unions – all of which eventually collapsed, as inflation spiralled upwards and the ‘Winter of Discontent’ swung into view.
The Government would obviously like to avoid such an outcome – especially as it would antagonise Thatcherite backbenchers. But not everyone agrees giving in to wage demand would make our inflation problem worse.
On the one hand, you have the left-wing view, expostulated by such figures as the tax writer, Richard Murphy. On Twitter this week, he pinned inflation on “failing to plan for the reopening from Covid, profiteering by energy companies…war, sanctions, genuine food shortages” and those three greatest targets of leftie ire: Brexit, climate change, and bankers.
Since Murphy suggests inflation is not tied to wage increases, he argues it is safe for the Government to pay those currently striking more. Such an argument has long been a useful get-out clause for those on the left. It allowed the governments of Wilson and Callaghan to square soaring inflation with signing off on ever-growing pay settlements to the trade unions.
Yet pinning inflation solely on an imbalance between supply and demand does not square perfectly with what caused inflation in the 1970s – or today. To explain why, I need to deploy a word familiar to anyone else who saw the era of strikes and Kate Bush the first time around: monetarism, the theory of economics that prioritises the role of governments in controlling the amount of money in circulation when analysing the roots of inflation.
For example, governments across the western world faced a similar situation as today following the 1973 OPEC oil embargo. As Tim Congdon, the leading monetarist, has highlighted, the UK saw consumer price increase of 9.2 per cent in 1973, 16 per cent in 1974, and 24.2 per cent in 1975.
But, as Congdon has also indicated, whilst West Germany faced the same inflationary pressures as Britain from oil price rises, it only saw consumer price rises of seven per cent, seven per cent, and 5.9 per cent for each respective year.
Why? Because of the monetarist’s titular fascination: differences in monetary policy, and the rate of increase of the money supply.
In West Germany, economists terrified of a repeat of Weimar-style hyperinflation, clung to the view that inflation was a product of the rate of growth in the money supply. By contrast, the overwhelming Keynesian consensus in Britain believed that inflation was a product of short-term fluctuations in the relationship between supply and demand, to be managed by spending cuts or increases and kept in check by wage and price controls.
The economic Gotterdammerung of the late 1970s put that theory temporarily to bed, and the triumph of the monetarists has been the cause of one of the relatively low inflation rates we have seen for the last 40 years.
Murphy suggested in his post that this was disproved by the lack of a surge in inflation following the introduction of quantitative easing from 2009 onwards. Doing so neglects the sharp uptick in asset prices since then – not included in many inflation calculations – and the simple fact that, in the first year of the pandemic, the Bank of England increased the money supply by more than in all the previous eleven years put together.
Moreover, as Mervyn King, the former Bank of England governor, has highlighted, post-2009 QE went into propping up government finances, whilst the £500 billion or so spent in the last two years has gone directly to the wider economy via furlough schemes and other measures.
Consequently, whilst the velocity of money in the UK – the reflection of the desired holdings of money against incomes – was stable in the 2010s, it collapsed from 2020 onwards as Covid plunged the economy into crisis. All this monetary expansion has now fed through as inflation.
Nonetheless, this does not mean Murphy is wholly wrong to highlight the impact of supply issues and price rises. As with the 1970s, where differing monetary policies combined with universal price increases to produce differing inflation rates between countries, so have different levels of largesse with the money supply produced different inflation rates today.
American inflation has been faster and higher than European and Japanese inflation, as so was its money growth – an estimated 26 per cent from June 2020 to June 2021. So Murphy, one would hope, is knocked into a cocked hat: the origins of our current inflation lie in post-Covid supply-demand shocks twinned with excessive monetary expansion.
The most ardent monetarist and the Murphy might agree on one thing: that wage rises are not the source of the inflation we see. In that sense, they are right: inflation was increasing before the wage rises we saw last year.
But average pay was up by more than 10 per cent between February 2020 and February this year. The demands of Lynch et al reflects a situation in which private sector pay increases have been running as roughly double that of the public sector for the last two years – and catching that up would not be without pain, or consequences.
With the rate of unionisation in the public sector five times that of that in the private sector, it is the taxpayer who will be on the hook for any settlements granted nurses, teachers, or other potential strikers, as Karl Williams of the Centre for Policy Studies pointed out on this site yesterday.
Paying for these would require more spending – and that would likely mean more borrowing. That is something the Treasury would very much like to avoid – especially as it would constitute monetary expansion. So whilst inflation, to credit Milton Friedman, might always and everywhere be a monetary phenomenon, it can have political origins.
But more importantly, pay rises today will bake in the expectation of pay rises tomorrow if inflation continues. The Murphys – and Andrew Baileys – of this world would tell you that inflation will trend downwards as post-Covid supply-demand problems are resolved.
But with the huge expansion of the money supply in the last two years and ongoing high energy and food prices, that seems more unlikely by the day. Inflation will be around for a while yet – and will become more persistent if workers form a habit of chasing inflation with big wage demands.
To prevent this, the Government must hold firm in the face of union disruption. It should also aim to support President Biden’s effort to get Saudi Arabia to pump more oil.
It should also take a long, hard look at the amount it is spending: can it justify paying for the triple lock as it urges restraint on workers, and whilst growth remains anaemic? A full spectrum response is required to prevent inflation from gaining a permanent hold – like the economic cancer that it is.