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.