Monday, 28 March 2011

Our economy is unbalanced

One of the Office of Budget Responsibility forecasts George Osborne gave in his budget last week is that wage growth this year is expected to be 2.0%, and next year 2.2%.

So we currently have RPI inflation running at 5.5% and wages growing at 2%.

This means that on the year spending power will decline by 3.5%.

Then next year spending power will be down by almost 7%, unless inflation is controlled.

Then 10.5%.

And so on.

And as each business receives less revenue so its employees in turn spend less and there's a downward spiral.

The government seems to think inflation will  fix the economy and has tipped the wink to the Bank of England to let rip. The chancellor of the exchequer and the governor of the Bank of England continue to exchange their billets doux every three months when Meryvn King reports he had missed the inflation target again and George Osborne replies that it doesn't matter. MK has been missing the target for years now. In any other job such a poor performance would have got someone canned, but the governor sails serenely on.

It would seem the government actually wants inflation and MK is happy to provide it. The government seems to think inflation will solve our problems. The root cause of our economic malaise is too much debt. And it's true that historically inflation has made the debt go away. Inflation robs savers, but provided you were prepared to take the stick for doing that then the inflation solution used to work.

But inflation is not going to fix the economy. Wage inflation would do the trick, but wage inflation isn't happening. We have the wrong sort of inflation. Our inflation is imported price inflation: higher oil prices, higher food prices, higher textiles, higher raw materials. And we have a service economy. Manufactured goods are price resilient because so much of the cost is raw materials. When you have a service economy and the customers all say "serve me cheaper or I go elsewhere" you have no choice but to take it on the chin.

To fix our economy we need wages rising ahead of inflation. We can either go the hyperinflation route and print enough money to make wages go up or control inflation by raising interest rates. The first option requires increasing the printing geometrically over time to sustain the wage/price differential and sooner or later you run out of paper to print on. And long before that you run out of credibility.

Now normally this wage/price imbalance would cause a recession which would kill inflation because consumers can't afford to pay more. But, to repeat, our inflation is foreign and foreigner suppliers care eff all that we cannot afford their goods. What they don't sell here they sell elsewhere.

So really the options are: raise interest rates now, control inflation and probably have a small recession due to the over-endebted going under, or don't control inflation and have a much longer and deeper recession later.

A small recession now would reduce house prices, land prices, wages, generally deleverage the economy and make UK Plc more competitive all round. Employees paying less for their housing in turn can be paid less for their labour. It becomes cheaper to acquire land, to build a factory or office block, to hire staff and produce goods or services and the country becomes competitive once more.

Or the government can let the wrong sort of inflation rip and have a much worse recession later. Imported raw materials will soar in price away from the affordability of domestic businesses. There will be some attempts to replace imports with domestic production but we cannot make oil out of air. Nor, realistically, will we find replacements for imported food or other commodities. This kind of recession doesn't go away for a generation. In fact the younger generation often decides that it would be better to move abroad where they can get better rewarded work and pay lower taxes. (Already happening in Ireland.) So the ratio of taxpayers to state beneficiaries gets worse and taxes cannot be reduced to stimulate growth and the downward spiral fuels itself.

I seem to recall the before the general election Mervyn King said that whoever won would be out of power for a generation. That may be his only accurate forecast ever!

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