Britain Needs a Pay Rise

Real incomes are falling as inflation rises. Are rising prices really the problem? As I've mentioned before, looking at the numbers, inflation in 2017 is closer to the government's target than it has been for some time. The real threat is deflation and the real cause of falling incomes is low wage rises.

Despite the growth in per capita GDP, the average worker isn't securing the full fruits of her labour.

I set out the argument in an article published by Left Foot Forward on 17 July 2017.

The latest inflation figures will be out tomorrow, here’s why there’s no need for alarm

Tomorrow, the latest inflation figures will be published. The reaction, if recent months are a guide, will be panic and alarm at the continuing high level of consumer prices, the impact on household budgets and the possibility of rising interest rates.

I want to question whether we are drawing the correct policy conclusions from the recent rise in inflation. I would argue that the focus on higher prices is misplaced and risks drawing attention from more important economic questions.

The government has set an inflation target of 2 percent. If the rate of CPI is more than one percentage point away from the target then the Governor of the Bank Of England must write open letter to the Chancellor explaining why the target has been missed and what action the Bank intends to take.

What to expect

If on Tuesday inflation is above 3% then Governor Carney will be sharpening his quill to write to Mr Hammond. This will be the first such letter since December 2016. That’s right it is only a matter of months since the Bank last missed the government’s target.

From May 2015 until last December the inflation index was more than one percentage point below target, at times touching 2 percentage points below target. While commentators were less alarmed by low inflation, for economists the reverse is true. Zero inflation is far more dangerous than inflation at 4%.

High inflation can always be addressed by raising interest rates. However, central banks have no ready answer to deflation – when prices are falling. Deflation combined with high levels of debt is a recipe for recession.

In the US economists have been pushing the Federal Reserve to raise its inflation target above 2 percent. Janet Yellen, America’s central banker, has acknowledged the importance of the issue.

So if 3% inflation is healthier than the levels we saw last summer, should we not still worry about living standards?

Wages

The true cause of declining real wages is the slow pace of wage rises pursued as a deliberate policy. Imposing a 1 percent pay cap is unjust precisely because it takes account neither of inflation nor of rising national income.

When the economy is growing we should expect wages to keep pace. In Figure 1 (above -sources Bank of England, ONS) I compare the level of the median wage to the level of GDP per head, with both scaled to 100 in 2010. It shows that the pay of the average worker has grown more slowly than the growth in national income per head. The average worker is not gaining the full fruits of her labour.

There are two possible explanations: firstly, the share of national income going to wages has fallen or, secondly, more of the wage share is going to workers earning above the average. So inequality is also part of the problem.

Interest rates

It is likely that inflation will begin to fall, if not this month then later this year. The rise in prices is mainly driven by rising import prices due to the fall in sterling after the referendum last June.

A one off rise in prices affects the inflation index for 12 months. So price rises last June drop out of the inflation figures this June. The rise in import prices isn’t passed on to consumers right away. Firms may sell existing stocks at the old price or may take a hit to profit margins. The effect of sterling’s fall takes time to reach the consumer price index but the index falls back at the same pace as it rose.

For this reason the Bank of England would be making a serious mistake if it chose to raise interest rates in response to the change in sterling. The index will fall back of its own accord.

Indeed it could be that rising import costs are masking an underlying problem of low inflation or deflation. When the sterling effect wears off we may find inflation once again dangerously low.

Conclusion

The analysis here is out of favour with most commentators.They prefer a narrative which blames Brexit for all economic ills, including falling real wages. The referendum triggered a fall in the value of sterling which caused inflation eroding household incomes.

This story ignores the fact that real wages were falling from 2010 to 2015 well before the referendum. Leaving the EU will not make us richer, but it should not blind us to the true economic challenges.

The underlying problems are low wages and the risk of deflation.The solution to both is higher pay. Britain still needs a pay rise.

Pessimism Takes Hold

Back in May, before the negotiations on leaving the EU got underway, I wrote that the differences between the UK and the EU need not be insuperable.

The EU had adopted an approach to the talks that would make finding the necessary trade offs difficult. I warned of the difficulties caused by the long period of not talking to each other; the had EU insisted that there would be no informal talks, no probing, no sounding out in advance of formal notification and that all negotiations would take place within the prescribed framework. As a result, I thought, the two sides had developed their understanding of the issues in separate bubbles.

When Mr Juncker accused the prime minister of being on a different planet, he should have realised that both parties were on different planets and needed to invent some quick form of space travel.

I made the case here on Left Foot Forward:

https://leftfootforward.org/2017/05/how-deep-is-the-may-juncker-divide-and-can-it-be-bridged/

Once the talks got going, my concerns deepened. I am acutely aware that the EU is not run by disinterested experts but it has a democratic structure where the centre right has been in power for a number of years. As I explained in this piece on Left Foot Forward:

https://leftfootforward.org/2017/06/brexit-will-be-negotiated-by-europes-tories/

Not only is the EU negotiation mandate inconsistent and illogical, as you might expect from an agreement thrashed out by 27 parties, but it is defensive and negative. It sets out what the EU27 don't want but has little to offer on what they do. The idea that both sides should be aware that they have interests in common in finding a solution that serves all Europeans, those who remain as well as those who are leaving.

The detail is here in Left Foot Forward:

https://leftfootforward.org/2017/06/what-does-the-eu-want-from-the-brexit-negotiations/

CLP Influence on the Manifesto

Labour's manifesto was one of the stars of the 2017 election. I read over the document to see what signs I could find that Labour International, my CLP, had had on the policy-making process that had led to the manifesto.

I found quite a few places where our ideas had been taken up and reported back through the LI website:

http://www.labourinternational.net/labour_international_influence_on_the_manifesto

It's the Demand Side Stupid

During the General Election it was clear that Labour's radical manifesto was one of the major factors driving the campaign. The Labour Party set out a credible alternative to continuing austerity in a document that offered hope to the many.

I felt that the economic case against austerity needed to be made more fully. I wrote a short article which drew on my experience on the  economy commission of the NPF, to argue that we needed to explain the importance of the demand side. It was published on 30 May 2017 on Left Foot Forward:

The Tory economic strategy can only fail – Labour must do more to make that clear

This election campaign has been unusual in many respects, yet one peculiarity stands out. In contrast to recent elections, the economy has barely featured as an issue.

Labour has done an excellent job of turning the agenda away from Brexit and has had success with the double launch of its manifesto. Whether accidental or intended, the leak allowed a focus on the policies to revive public services while the official launch gave an opportunity to establish a strong, credible fiscal stance.

The attention paid to fiscal policy was a defensive move intended to address a potential weakness. Excellent handling of the issue has persuasively demonstrated that there is an alternative to austerity. However, tax and spend is not economic policy and Labour has a position on future prosperity which will be effective, which is different from the Tories and which deserves to be sold in the later stages of the election.

A key plank of Labour’s economic strategy is investment. The manifesto promises a National Transformation Fund to invest £250 billion over ten years on improving infrastructure. Private sector investment will be facilitated by a National Investment Bank supported by a network of Regional Development Banks. Labour’s industrial strategy will give direction to private investment through a mission oriented approach to address the challenges of the future and pushing Britain towards the technological frontier.

By contrast, the Tory path offers yet more austerity, with a continuation of the low wages and low investment that has held Britain’s economy back.

Labour hasn’t yet done enough to explain why the Tory economic strategy failed and could only fail. The explanation lies on the demand side. Suppressing wages, low public investment and poor private investment weigh on demand and lead to low growth. The main source sustaining demand in recent years has been household spending financed by credit. That is unsustainable. Household indebtedness cannot rise forever and will sooner or later end catastrophically.

Labour’s path boosts demand by infrastructure investment, private sector investment and allowing wages to rise. The distinction between Labour’s economic policy and the Tory programme is most evident when we look from a demand side perspective.

It is possible to argue Labour’s case from the supply side. The investment focus not only sustains demand in the short term but provides for sustained growth in prosperity in the long run. Public infrastructure helps firms to be more productive and private investment drives increasing productivity of labour. In contrast to the unsustainable demand based on household debt an investment based strategy provides the continual increase in productivity which pays for higher wages.

After decades when Keynes was neglected and supply side policy dominated political discourse, it may be tempting to frame the issue this way. However, while technically correct, the supply side argument fails to explain of why wage control and cuts do not lead to a healthy economy.

Labour made a strong start to the campaign when it accused the Conservative government of ‘holding back Britain’. In the closing stages of the campaign, we need to see the detail of why their polices are a drag on the economy and how Labour offers a distinct alternative.

Labour’s pitch in this election should have two elements. The first is the traditional strength in rebuilding public services, from health and social care to policing and prisons. The second is a new approach to the economy where government acts to sustain investment and keep the economy moving.

The demand side argument makes clear why ending austerity is good economics.

Economic Common Sense

Popular opinion is not a good guide to economic effectiveness. In an article published by Left Foot Forward on 11 April 2017 I tried to point out that many of the ideas we find in political discourse of economic policy are wrong.

We need to free ourselves from the received ideas of the neo-liberal period if we are to design economic policies that work.

Labour needs a bold economic policy that’s electorally credible and effective in government

Labour’s economic policy needs to be both credible in an election and effective when in government. What if policies cannot be both? Sometimes the policies which will work best in practice do not chime with the common sense economic of the electorate.

Popular opinion is not a good guide to economic effectiveness. As JM Keynes said:

“Practical men who believe themselves to be quite exempt from any intellectual influence are usually the slaves of some defunct economist.”

The common sense economics of practical men and women today derive mainly from the neoliberal ideas which have dominated recent decades. Such ideas are not yet defunct but in the 2008 crisis they were fatally wounded.


Policymakers whose views were formed in this period may believe that floating currencies, independent central banks, open capital accounts, inflation targets and fiscal rules are the essentials of economic success. In fact, they are the economic institutions of one period of history which may be superseded in the next.

To design effective policies, we need to free ourselves from the common sense of practical people and listen to the insights of more than one school of economic thought.

Common sense tells us that wages are a business cost which competitive firms aim to minimise, that the productive economy generates the income to pay for public services, that saving is always good and inflation is always bad, that a firm’s only duty is to its shareholders, that people are paid what their work is worth and that exports make us richer.

All of these propositions are debatable, some are just wrong.

Classical economists (Adam Smith and those who followed on) believed that labour was the source of a nation’s wealth. Rather than seeing workers as a cost to enterprise we should understand labour as the key resource and public policy should support giving workers the skills, equipment, and infrastructure to be as productive as possible.

When statisticians compile GDP figures they do not subtract the cost of hospitals, schools and police stations from the total. The value added by public services is an integral part of the estimate of national income or GDP. Public services are not a cost to the economy but a contribution to the nation’s prosperity.

Household savings we think are sensible whether it is for unforeseen events or future indulgence. However, when firms save rather than invest their income, the economy slows.

This was Keynes’s key insight. A nation’s income is equal to the demand for consumption goods and the demand for investment goods. If investment falls then so does overall income. When private investment is low public investment should rise. Governments need to rediscover the importance of effective demand and the techniques of demand management.

Keynes also pointed out that as incomes rise more is saved. Wealthier people save a higher proportion of their income. This is one reason why rising inequality leads to slower growth. If a higher proportion of income goes to richer people who then save more the result is lower effective demand.

A large part of Adam Smith’s most famous book is devoted to refuting the idea that countries grow rich on exports. To the classical liberal the purpose of exports is to pay for imports and the purpose of production is consumption.

Some countries repress wages to encourage exports, not realising that they are sending more of their output to be consumed abroad while denying consumption to their own workers.

Lessons on the true value of exports are available from the economics of development. Countries which have industrialised successfully used exports to provide a market for their new industrial production. Countries which export low value-added goods have failed to develop. The trick is to use exports to support an industrial policy which seeks to expand high productivity sectors of the economy.

Sometimes evidence is more important than theory. For example, empirical studies have shown that inflation at low levels is beneficial for growth. Up to about five per cent more inflation correlates with higher growth. Above eight per cent the negative effects set in. Governments should be cautious about setting too low a target.

We need to free ourselves from the common sense of neoliberal era to design effective policies. At the same time policies must be soundly based on economic theory. The difficulty is that while the old idea is dying no new framework has yet gained ascendancy.

If Labour is to offer a different vision for its economic policy it needs to be eclectic, taking insights from Keynes, the classics, development economics and empirical economics.

Such a vision would lead to a policy which put working people at its heart and aimed to provide the investment in skills, infrastructure and capital to increase their productivity. It would recognise the need for higher wages to incentivise investment as well as to support demand and reduce inequality.

Its macroeconomic framework would take account of demand as well as supply. Its industrial policy would seek to expand the proportion of high value-added sectors in the mix and see trade policy as a means of supporting industrial strategy.

The Risks of Leaving

I've expressed my scepticism about the predictions of dire economic consequences resulting from the decision to leave the EU. It will be bad, but not catastrophic.

That does not mean that there are no risks of a major impact on the economy. Just that to see the risk we need to look elsewhere than the macroeconometric analyses that get attention. The problem lies more in industrial structure and the unpredictable consequences of adjustment.

I explain this in more detail on Left Foot Forward.

Time Is A Great Healer

There is a little too much pessimism in the Labour Party right now. The problem is that the party seeks to represent both Remainers and the "left behind" who voted Leave. The party is at risk of being squeezed between a Lib-Dem revival hoping to grasp the mantle of the 48% and UKIP targeting working class voters.

If the election is not held until 2020, then will Europe still be the dominant issue?
I think not and I said so in this piece on Left Foot Forward.

https://leftfootforward.org/2017/02/brexit-wont-dominate-politics-forever-and-that-gives-labour-reason-to-hope/

Recession? What Recession?

I've been puzzled that so many of my friends and comrades are expecting an economic catastrophe to follow the referendum to leave the EU. I've written before about how the long term cost of EU exit will not make itself felt as an obvious disaster. Part of the reason for the continuing expectation of some kind of immediate economic shock comes from the exaggerations made in the referendum campaign that a Leave vote on its own would be damaging.

I've taken a look at the predictions of a recession following the referendum result. What I've found is that the memory of a consensus among the experts is false. On the whole there were not the universal forecasts of recession that we think we remember.

I wrote up the detail in an article published by Left Foot Forward on 14 February 2017.

Did the experts really predict a post-Brexit recession?

There was a moment after the Iraq war when we were waiting for the allies to uncover the weapons of mass destruction stockpiled by Saddam Hussein. While the generals asked for more time — they would turn up eventually — some brave souls like Robin Cook, called it correctly; they were never there in the first place.

Waiting for the post referendum recession feels like waiting for Saddam’s WMD. Last May we were told that the Bank of England, the Treasury, the IMF and others forecast an imminent recession if Britain voted to leave the EU.

Other studies of the long term impact of EU exit added to the gloom with predictions of a loss to GDP varying from 3 percent (London School of Economics) to 7.5 percent (HM Treasury)

It is not surprising that many remainers are still expecting an economic catastrophe while smug leavers feel their distrust of experts has been vindicated.

Robin Cook knew early on that no WMD would be found because he had paid close attention to the original evidence. A careful reading of the economic evidence would have shown that the recession story was just as over hyped. While Mark Carney, George Osborne and Christine Lagarde were all reported as predicting a recession, their organisations’ analyses said something else.

Bank of England

The Bank of England’s Inflation Report in May 2016 pointed to the downside risk of a leave vote including ‘a materially lower path for growth and a notably higher path for inflation’. The press conference is a classic example of reporters in pursuit of a preconceived story.

After repeated questioning, Mark Carney finally used the r-word:

“There’s a range of possible scenarios around those directions, which could possibly include a technical recession — possibly include that.”

He emphasised that the Bank had made no formal forecast but the press had their headline.

Treasury

Misleading reports of the Treasury forecast should not be blamed on the press. ‘Scrupulous with the truth’ is not a quality we associate with George Osborne. Indeed the BBC deserves credit for fact-checking the recession claim.

The Treasury analysis included a ‘shock’ scenario and a ‘severe shock’ scenario. The latter included as a kind of sensitivity analysis. Under the first GDP would be 3.6 per cent lower and under the second, six per cent lower after two years. A 3.6 per cent fall in GDP would be a major recession and a six percent fall would be another great recession. That is not the Treasury claim.

A close reading of the document shows that these are projected falls from a ‘baseline’ case where Britain voted Remain. Since the economy normally grows by more that 3.6 per cent in two years the shock scenario is not obviously a recession.

More significant is that the Treasury has no figure of its own for the baseline. The Treasury analysis does not give an independent estimate of the level of GDP after a leave vote. In order to deduce a recession it switches methodology to subtract its estimate from the OBR forecast. This allowed a conclusion of four quarters of growth at -0.1 per cent.

Even if we were prepared to accept that manoeuvre the report makes the unrealistic assumption that, faced with a downturn there would be no fiscal or monetary response. The smallest stimulus would surely nudge that figure into positive territory.

IMF

The IMF also provided warnings of a post-vote recession. It too offered two scenarios. In the limited scenario GDP would fall by 1.5 per cent by 2019 and in the adverse scenario by 5.5 per cent over the same period. Again these are falls relative to a baseline of GDP after a remain vote.

Tracking down the relevant IMF staff report uncovers this useful graph. In one scenario growth dips but remains a long way from recession, in the other a recession is visible.

What can we conclude?

Firstly, the idea that there was a confident consensus that a leave vote would cause a recession is wrong. In each case the possibility of a recession was acknowledged but given too much emphasis in the reporting. A closer look shows that the Bank was not making a forecast, the IMF was more nuanced and the Treasury report lacked credibility.

Secondly, even taking account of the exaggerations, it is clear that most analyses expected a greater negative impact than has so far occurred. It may have been correct to warn of the risks which conventional economics would identify. We avoided those risks and should be relieved. Investment and consumer spending, for example, have continued better than expected.

Risks remain but they should probably be set in the context of the wider state of the economy – household leverage, low productivity and stagnant incomes. EU exit is not the only factor.

Jos Gallacher represents Labour International on the National Policy Forum of the Labour Party

Will Inflation Mean Higher Interest Rates?

There has been a lot of fuss recently about rising inflation. Each months' figures have been greeted by gloomy news stories portraying the upward drift of inflation as a problem. The odd thing is that the rate of inflation is still below the the government's target. Not one of the news stories I've seen or read has pointed out that an inflation rate two percentage points below the 2% target is a much bigger problem than a rate two percentage points above.

Will the Bank of England raise interest rates to slow inflation? Obviously the Bank will not want to push inflation down below today's level when it is below the target. The fear here is of inflation continuing to rise. The fall in the value of the pound from the middle of last year is the main reason for expecting inflation to rise. (Indeed, the exchange rate may also explain why the news reports are so gloomy. Some people are on the lookout for bad economic news to support their view of the world after the events of last June.)

Action by the Bank takes about two years to have full effect. Today's interest rate decision will influence inflation in two years time. A rise in import prices will push up the rate of inflation today and then disappear from the inflation figures in one years time. Of course the fall in the exchange rate also takes time to impact inflation, because firms absorb some of the increase in their costs and because some prices are fixed in contracts.

The conclusion is that a rise in interest rates now would have the effect of slowing inflation at the point when it would be slowing anyway. The result could be to push the economy into deflation.

I don't expect the Bank to make any serious change to interest rates in response to the exchange rate.

What would induce a rise would be if wages  began to rise significantly. Particularly if it looked like firms were paying more because labour was in short supply. Despite the gloom about stagnating incomes, we might be closer to that point than we think.

Labour's Economic Policy Commission

I've been appointed to the Economic Policy Commission as part of my work on Labour's National Policy Forum. The Commission held its first meeting in Westminster in January.

Here is the report I wrote for the CLP:
http://www.labourinternational.net/policy_commission_on_the_economy_gets_down_to_work

Political Economy and Trade Deals

Trade agreements are in the news at present; mostly because commentators think the UK is desperate for any deal it can get. I shared some thoughts on the political economy of trade deals on Left Foot Forward originally published on 27 January 2017.

Why there’s no such thing as a quick trade deal

How easy would it be to agree a quick trade deal? Do negotiations need to drag on for seven years or more? Can a UK-US trade deal really be done in three months? If trade is a win-win, agreement should be simple.

There are two problems. Firstly the economics of trade deals are straightforward; the political economy is not. Secondly, modern trade deals are mostly not about trade. They are about the free movement of capital, the protection of intellectual property rents and the subjugation of regulatory policy to commercial interests.

Political Economy

The key economic fact is that the benefits of trade come from imports: consumers have more choice, cheaper goods and services become available and resources are released for more productive use. Exports, according to economists, are needed to pay for imports.

In trade talks, by contrast, the aim seems to be to promote exports. Negotiators reluctantly accept imports as the price of access to export markets. To liberal economists trade negotiations are a game where delegates pretend to care about exports when in fact they want the benefits of imports.

Political economy explains the paradox. Consumers seeking more choice or cheaper products have little power. Firms which might employ the resources freed by imports have less power than existing incumbent producers.

Incumbent firms have developed their business strategies based on a competitive advantage that wins extraordinary profits. For some trade offers the capacity to extend their competitive advantage into new territories. The more successful incumbent firms are, the greater their influence will be with governments and trade representatives. They can point to the jobs and tax revenues generated by access to new markets. Thus exports become the focus of attention.

Some incumbent firms may be threatened by competition from more efficient foreign producers. While their arguments have less appeal to policy-makers than those of successful companies, it does explain why certain favoured sectors are often exempted from trade deals. Agriculture is the obvious example.

Deals should not be called “free trade” deals. Most agreements are a mix of market opening and protection driven largely by the power and influence of incumbents.

Non-Trade Trade Issues

Protection is evident in some of the non-trade issues in modern trade agreements. Intellectual property rights were a major item in TPP, the US-Asian deal recently abandoned by President Trump. IP rights are a source of market power and so of extraordinary profits. US firms were keen to extend the generous protection offered by American rules to Asian countries.

The I in TTIP stands for investment and created one of the most controversial problems for the US-EU talks. People making inward investment decisions want to minimise the risk of their capital being appropriated or their contracts not being honoured. Special arrangements to settle investment disputes have been included in many recent trade agreements.

In countries where the rule of law is well established, courts are independent and corruption is low this should not be a concern. In fact the reputation of Britain’s courts is a source of comparative advantage much valued by the finance sector among others. Investor protection clauses are not needed in deals between advanced democratic countries.

Government procurement is another item on the agenda of modern trade deals. Government purchasing can favour domestic suppliers and so act as a form of protectionism. Equally, such purchasing can be a major tool of industrial policy not just supporting favoured sectors but also to encourage investment in innovation.

From a trade perspective, standards and regulations are seen as non-tariff barriers. For example the EU ban on growth hormones in beef production was seen by US producers as a trade barrier. The EU saw the application of the precautionary principle and the dispute was taken to the WTO.

More recent deals have sought mechanisms to harmonise standards. The problem here is that rules designed for consumer safety, public health, environmental protection and so on can all impact on trade, but they need to be set through mechanisms which are democratically accountable not frozen in trade agreements.

It is significant that when the EU created its single market it did not just have a court it created a parliament as well.

Easy

Trade deals might be easy if they were just about trade. Traditional issues of tariffs, quotas and subsidies have been joined by a vast new agenda of complex issues. With traditional barriers to trade already low, some claim that the future benefits will come from removing non-tariff barriers.

Economic analysis shows that these benefits are tiny. The extensive agreement which the EU was seeking with the US included all of these new issues. Its expected impact on the EU economy was an eventual increase in GDP of 0.5 per cent, according to the EU’s own analysis. To be clear that is not an increase in growth of 0.5 per cent but an increase after 10 years equal to about two months of growth.

Even tinier is the expected benefit of the ‘comprehensive’ agreement with Canada. The EU forecast an eventual increase in GDP of just 0.02 per cent to 0.03 per cent .

The secret to a quick trade deal is to limit it to trade. The more linkages there are with other issues the more difficult become the trade-offs and the longer the process will take.

Jos Gallacher represents Labour International on the National Policy Forum of the Labour Party.