Two weeks ago I
described how the UK’s inflation problem has now
become about labour market strength and private sector wage
inflation. Earnings
data released last week has confirmed that view, in
part because of the latest data but also because of revisions to the
previous two months. Here is both year on year wage inflation, and
the annualised three month rate.
Year on year wage
inflation is at around 8%, and more recent increases have been above
that. If that continues it is consistent with 6-7% inflation, which
is well above the government’s target of 2%. So private sector wage
inflation has to come down. Maybe wage inflation will follow price
inflation down, or perhaps further efforts to reduce aggregate demand
and therefore the demand for labour are needed. That question is not
the subject of this post. Instead I discuss why some on the left find
this diagnosis for our current (not past) inflation problem
difficult.
A year or so ago,
when inflation in the UK was primarily due to higher energy and then
food prices, mainstream economists could legitimately be divided on
what the policy response should be. On the one hand, decreasing
aggregate demand in the UK was not going to have any effect on the
drivers of inflation. On the other hand, it could be argued that
policy should become restrictive to prevent higher inflation becoming
embodied in expectations, because if that happened then inflation
would remain too high after the energy and price shocks had gone
away. To use some jargon, opinions will differ on what the policy
response to supply shocks should be. Until the beginning of 2022
central banks went with the first argument, and did not raise
interest rates. When nominal wage inflation started rising, and it became clear the labour market was tight, interest rates started to rise.
Now mainstream
economists, at least in the UK, are on clearer ground. Excess demand
in the labour market is pushing up wage inflation, and therefore
aggregate demand needs to be reduced to bring private sector wage inflation down.
There may also be excess demand in the goods market, pushing up
profit margins, but the remedy would be the same. (Data on profits is
less up to date than earnings, but as yet there is no
clear evidence that the share of profits has risen in
the UK.) Excess demand in either market needs to be eliminated, which
requires policy to reduce aggregate demand, leading to fewer
vacancies and almost certainly increased unemployment.
The understandable
difficulty that many have with this diagnosis is that real wages have
fallen substantially over the last two years, and nominal wage
inflation is only just catching up with price inflation, so how can
wages be the problem? I have addressed this many times, but let me
try again in a slightly different way.
Inflation over the
last two years has been about winners and losers. The winners have
been energy and food producers, who have seen prices rise
substantially without (in the case of energy at least) any increase
in costs. To the extent that the government can (and is willing),
profits from energy producers can be taxed and the proceeds returned
to consumers through subsidies. But the reality is that much of these
higher profits on energy and food production are received overseas,
and there is nothing the UK government can do about them. As this is
essentially a zero sum game, those who have benefited have to be
matched by those who have lost. The only issue becomes how those
losses are distributed between UK consumers, the profits of other UK
firms, the government and its employees.
Workers in this situation could try and raise nominal wage inflation to
moderate this loss in real wages, and that is one interpretation of
what has been happening. Yet if those in the private sector are
successful in this, who are the losers? They can only be firms,
through lower profits. Why should firms reduce their profit margins
when wages are rising across the board? In a weak goods market they
might be prepared to do so, but there are no signs of that in the UK.
So firms are likely to match higher wage inflation with higher price
inflation. That is the major reason why the price of UK services has
been increasing steadily over the last two years (now at 7.4%).
The key point is
that UK real wages didn’t fall over the last two years because the
profits of most UK firms rose. They fell because the profits of
mainly overseas energy and food producers increased. Trying to shift
this real wage cut onto the profits of other UK firms will not work,
and instead just generates inflation. It is also why nominal wage
inflation, not real wage inflation, is the crucial variable here. We
could debate whether it would be a good idea to see real wages
recover at the cost of falling profits, but it hasn’t happened so
far and is unlikely to happen in the future unless excess demand is
replaced by excess supply.
Those on the left
who find it uncomfortable to hear that nominal wages are growing too
rapidly need to remember that since at least WWII sustained real wage
growth, or the absence of growth, in the UK has not come from lower
profits, but instead comes mainly from productivity growth, with
occasional contributions from commodity price movements and shifts in
the exchange rate. The reason
UK real wages have hardly increased over the last 15 odd years
is because productivity growth has been very weak, energy and food
prices have risen and sterling has seen two large depreciations. [1]
The interests of workers are served by policies that help real wage
growth, and not by seeing nominal wage growth well beyond what is
consistent with low and stable inflation.
If high inflation is caused by excess demand then policy needs to decrease aggregate
demand, which will reduce the demand for goods produced by most firms
leading in turn to a reduced demand for labour. That almost certainly
means unemployment rises. If you worry that the costs of additional
unemployment is too high, then something like a Job Guarantee scheme
makes a lot of sense, although the potential
costs of such a scheme also need to be recognised. Such a scheme does not change the logic, however, that inflation that
is caused by excess demand needs to be corrected by decreasing aggregate demand.
Is there an
alternative to using weaker aggregate demand to bring down inflation?
If wage inflation is too high, it is because firms are having to
grant large nominal wage increases in order to get and keep workers.
To avoid the symptom (high inflation) you need to remove its cause (a
tight labour market), which means either increasing the supply of
workers or reducing the demand for workers by firms. Because the
former is not easy to do quickly (e.g. because of controls on
immigration) then the latter requires a reduction in aggregate
demand.
In the 60s and 70s,
before oil price hikes made a bad situation worse, UK politicians and
some economists were unwilling to see unemployment rise enough to
stop inflation rising. Instead they tried to use price and wage
controls to keep both inflation and unemployment low. This failed,
and UK inflation rose from around 2% in the early 60s to 8% in the
early 70s, before oil prices rose fourfold. The reason is
obvious given the logic in the previous paragraph. If demand is
sufficiently strong (and therefore unemployment sufficiently low)
that firms want to grant nominal wages increases that are
inconsistent with low inflation to attract more workers, then
controls on prices and wages have to persist to stop inflation
rising. But permanent aggregate controls stop productive firms
attracting workers from unproductive firms, which damages long run
real wage growth. Inevitably governments come under pressure to relax
aggregate wage and price controls, and therefore all controls do is
postpone the rise in inflation.
Judging by comments
on past posts, the reaction of some on the left to all this is to
deny the economics, by claiming for example that the Phillips curve
doesn’t exist. This also happened a lot in the UK of the 60s and
70s. The Phillips curve may be hard to estimate (because of the importance of expectations), and may not be
stable for long periods, but the core idea that unemployment and wage
inflation are, other things being equal, likely to be inversely
related at any point in time is sound, as has been shown time and
time again since Phillip’s first regressions.
Evidence should
always trump political preferences in economics. Occasionally I’m
called a ‘left-leaning’ economist, but this is partly because on major
issues since I started this blog economic evidence has pointed in a
leftward direction e.g. austerity and Brexit were terrible ideas.
Neither of those examples has anything to do with political values
beyond the trivial [2]. Facts, at least since I have been writing
this blog, tend to have a left wing bias.
Inevitably, things
are very different for many outside economics (and a few academic
economists as well). The discussions I find hardest following my
posts are those with people whose politics do determine,
intentionally or not, their economic views. Those exchanges are hard
because however much economics I try and throw in, it’s never going
to be decisive because it will not change their political
views. In addition, if I’m arguing with them, their natural
presumption may be that disagreement must arise because my politics
is different from theirs, or worse still that the economic arguments
I’m putting forward are made in bad faith because of hidden
political motives.
To those who do this
the best reply was
given by Bertrand Russell in 1959:
“When you are
studying any matter … ask yourself only what are the facts, and
what is the truth that the facts bear out. Never let yourself be
diverted either by what you wish to believe, or by what you think
would have beneficent social effects if it were believed.”
[1] Brexit is
responsible for one of those depreciations, and it has also lowered
UK productivity growth.
[2[ By trivial, I
mean that reducing most people’s real incomes by large amounts for
no obvious gain is a bad idea.
