Why wage-price spirals fuel inflation – and neither the Keynesians nor the Monetarists are completely right

23 Jun

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.

The post Why wage-price spirals fuel inflation – and neither the Keynesians nor the Monetarists are completely right first appeared on Conservative Home.

David Willetts: We aren’t getting an explanation from the Government of its pay policy that is honest about the coming pain

21 Jun

Lord Willetts is President of the Resolution Foundation. He is a former Minister for Universities and Science.

Paul Goodman’s excellent piec on this site yesterday admitted that he was so old that as a student he remembered the Battle of Orgreave. I’m even older. I was working for Margaret Thatcher at the time, and remember meetings punctuated with messengers straight from one of Shakespeare’s history plays: “Nottingham is with us.” or “Kent is hostile”.

We wrestled with inflation and pay demands then. There are some lessons which are still relevant today.

First, there is still some truth in the economic proposition that pay increases on their own do not cause sustained inflation which can be brought down by a tight financial policy. Monetarism is often seen as some esoteric economic doctrine, but it was actually a political strategy as well.

If you believe pay demands cause inflation, then the Government has to tackle inflation by doing deals with workers on their pay. Back then, Labour’s links to the trade unions meant they were better placed to do such deals than Conservatives.

So Tories needed a credible way of controlling inflation that did not depend on their relationship with trade unions. The refusal of ministers to get involved even in public sector pay negotiations today is a version of the lesson that was learnt then.

There was a second Thatcherite insight which is relevant today. Inflation is not just a matter of economic theory. It is also deeply political. It is how a society reconciles inconsistent and over-ambitious claims on resources.

Thatcher saw it as the evidence of a moral failure – a failure to recognise we had to live within our means. If we all promised ourselves more than the economy could afford, then one way to reconcile these conflicting claims was to reduce their value by inflation.

Some people and organisations with incomes set in cash without inflation protection lose out. Responsible Government has to deliver the unpalatable but honest message that we are not as rich as we think we are. That is key to Britain’s problem today. We are poorer than we hoped because of a combination of the costs of Russia’s invasion of Ukraine, the higher cost of energy including the costs of the investment to move to Net Zero and the economic effects of Brexit.

So if you were to add up the incomes we all think we are going to get next year, that figure is ahead of the economic reality, and inflation is the only way to make the figures add up. Thatcher’s stern Methodist explanation of these truths barely appears in modern politics.

Apart from these enduring insights the parallels with the 1970s and 1980s are very different from today. Trade unions have much lower membership now. Indeed compared with the 1970s employers and capital are stronger and workers are weaker. That is one reason a lower proportion of GDP goes on wages. Trade union power is almost entirely in the public sector – there are few private sector strikes.

The public sector is much slower-moving and less responsive to economic shifts than the private sector. So when Covid hit us, public sector employees were more likely to keep their jobs and pay – also, partly, because more of their jobs deliver essential services. Public sector workers have more protection of jobs and pay in a recession.

But when inflation is rising fast then lagging, public sector pay puts them at a disadvantage. Public sector pay loses out when inflation is high. So at the moment total private sector compensation including bonuses is rising by eight per cent. Basic pay in the private sector is rising by five per cent. In the public sector that is closer to three per cent. So the sector of the economy with higher rates of unionisation also has lower increases in pay. Strikes are the result.

Ironically, inflation may reduce real pay in the public sector whilst also in the short term boosting public revenues. More people are pulled into higher rates of tax. Public budgets set in cash terms lose some of their value.

Overall, pay is rising less than inflation. This is not some inflationary spiral. It looks as if the adjustment to our being poorer is partly happening through pay rates. The disappointment of expectations which inflation brings is particularly felt amongst workers. They are unhappy, but they are not getting an explanation of what is going on around them which is honest about the economic pain and recognises who is bearing it.

The Government has indeed belatedly tried to protect people, especially those on the lowest incomes from rising energy prices. But it still needs to pull all this together in an account needs to show the scale of the adjustment we are going through and that whilst the sacrifices will be widespread there will also be some protection for the groups worst affected.

The post David Willetts: We aren’t getting an explanation from the Government of its pay policy that is honest about the coming pain first appeared on Conservative Home.

David Gauke: Johnson’s health and social care plan. A betrayal of Conservative principles? No – because, at one level, there aren’t any.

13 Sep

David Gauke is a former Justice Secretary, and was an independent candidate in South-West Hertfordshire in the 2019 general election.

The Government’s plan for increases in National Insurance (NI) contributions to fund higher health spending and increased health spending has provoked a furious response from some on the right.

It “sounded the death knell to Conservatism” and drove “a coach and horses not only through the Tory Party manifesto, but Toryism itself”  according to Camilla Tominey in the Daily Telegraph.  In the same paper, Allister Heath fumed “shame on Boris Johnson, and shame on the Conservative Party…they have disgraced themselves, lied to their voters, repudiated their principles and treated millions of their supporters with utter contempt” and that “an entire intellectual tradition now lies trashed”.

In the Times, Iain Martin declared that “at this rate, the Conservative Party might as well rename itself the Labour Party”  and in the Spectator, Fraser Nelson questioned whether the “Boris Johnson” definition of conservatism as “a protection racket, where the tools of the state are used to extract money from minimum-wage workers and pass it on to the better-off?”

Meanwhile, Dominic Cummings has argued that “if you think you’re ‘conservative’, and you give those speeches about ‘enterprise’ and ‘responsibility’, why would you support making many more dependent on state money and bureaucracy?”

It’s all jolly strong stuff. And there are elements of the criticisms with which I have sympathy. I share the scepticism about prioritising a tax-funded social care cap, in that those who will gain most are those who have the most (thanks to rising house prices) and that is the wrong priority for public money.

There is a need for risk-pooling, but I think Peter Lilley’s proposal on this site is worth close examination (I suggested something similar when in Government). I also dislike NI as the choice of tax because of the narrowness of its base – and the distortions that this causes – and the dishonesty of employers NICs (no, Prime Minister, it is not a tax on business: it is a tax on jobs and employees’ wages).

In fairness to the Government, raising taxes is difficult, NI is less unpopular than income tax (largely because much of the public misunderstand it) and, being cynical, it is not surprising that Ministers exploit that misunderstanding.

Having said all that, is it a fair criticism to state that Johnson’s Health and Social Care plan undermines everything for which the Conservative Party stands? For a number of reasons (some of which reflect better on the Party than others), I think not.

First, the Conservative Party has an honourable record of fiscal responsibility. When the public finances are in trouble, Conservative governments have been willing to raise taxes in order to put the public finances on a sound footing – not least Margaret Thatcher’s, when Geoffrey Howe raised taxes in 1979 and 1981. The advocates of Reaganomics always find this disappointing, but responsible Conservatives do not believe that lower taxes will pay for themselves (as they did not for Reagan).

In reality, even putting aside any new commitments on social care spending, the prospects for the public finances are not great. Not only do we face some immediate challenges (Covid catch up, net zero and levelling up), but demography and rising health expectations will mean a tax-funded healthcare system will require higher taxes.

Some on the Right will argue for further cuts in spending or an alternative health model, but the political feasibility of such an approach is highly dubious. If we are going to spend more (and we are), taxes will need to rise to pay for it.

Second, the idea that a Conservative government prioritising homeowners is a complete break from the past does not bear scrutiny. Look at the arguments that Thatcher made in resisting the removal of mortgage interest tax relief (although the Treasury rightly prevailed in the end), or the general dislike of inheritance tax from the wider Conservative world. The reaction to Theresa May’s social care policy in 2017 suggests that the instinct to ‘defend our people’ (and their inheritances) amongst Conservatives is a formidable one.

Third, complaints about the Conservative Party not being the party of business are (how can I put this?) a little rich from some quarters. Imposing higher taxes, whether on employment or profits, is not great for business – but making it substantially harder to trade with our largest trading partner is a bigger problem.

It is all very well complaining about the anti-business instincts of this Conservative government, but hard to do if you have been a cheerleader for anti-business policies or, for that matter, Boris “f*** business” Johnson. If your expectation is that the Conservative Party would automatically be on the pro-business side of the argument, you have not been paying much attention in recent years.

The reason why the Conservative Party moved in the direction of an anti-business Brexit is that was where the votes were. And this brings me to the fourth and most important observation about the Conservative Party.

It has one purpose: to be in power. At one level, it is not possible for it to repudiate its principles because it does not have any. This can give it a tremendous advantage in a democracy because the public, as a whole, does not have political principles either – opinions and political alignments shift over time.

The Conservatives have been protectionists and free traders, the party of Empire and the party that facilitated the retreat from Empire, Keynesians and monetarists, the party of price controls and wages policies and the party of market economics, the party of Europe and the party of Brexit. It never stays on the wrong side of public opinion for long.

What is happening to our politics at the moment is that party support is realigning along cultural lines and, as a consequence, much more along generational lines. This has worked to the advantage of the Conservatives, so it is no surprise that it pursues policies that prioritises health spending over lower taxes for people of working age.

Polling suggests that the new, Red Wall voters who switched to the Conservatives at the last election are notably more left-wing on economic issues than traditional Conservative voters who are, in turn, to the left of Conservative MPs. The decision was made to pursue those voters and, if the Conservative Party wants to keep them, it cannot risk the NHS collapsing under financial pressure – which means higher spending and, ultimately, higher taxes.

Johnson’s critics are right to think that this will not be the end of it. Last week’s package was supposed to be an answer to how we fund social care. The reality is that it was a package to boost spending on the NHS. As Damian Green has argued on ConHome, it is hard to see how resources will be taken out of the NHS and switched to social care in three years’ time – and that, at that point, some expensive social care commitments will come into effect.

here will another funding gap and, on the basis of last week’s revealed preference, a further increase in the Health and Social Care Levy. Those who see the purpose of the Conservative Party as delivering low taxes are right to be glum.