In the decade and a half before the financial crisis of 2008, the United Kingdom, along with the rest of the industrialised world, experienced a period of macroeconomic stability with economic growth. Labour productivity grew steadily, unemployment was low, and the granting of independence to the Bank of England in 1997 helped it maintain monetary stability with low inflation. The growth in trade and the emergence of new digital technologies promised a long period of low-inflation prosperity. This was the period of the ‘Great Moderation’.
But then the financial crisis came, the construction and housing sectors virtually collapsed, and several banks were threatened with bankruptcy. The newly elected government of 2010, faced with increasing debt levels and with a looming sovereign debt crisis in Europe, embarked on a ‘debt reduction’ policy, which necessitated cuts in public spending, including public investment. Despite this policy, debt levels continued increasing, from 42 per cent of GDP in the year before the crisis to 85 per cent just before the Covid-19 crisis, and productivity growth stalled. Because of this, and the Covid lockdowns, output per worker dropped below its 2010 level, and unlike its main competitors, Britain is still struggling to recover national output to pre-Covid levels.
A combination of insufficient public investment and ageing infrastructure, combined with the uncertainties brought by Brexit, Covid-19, and the frequent change of government policies – and personnel – removed the incentives necessary to invest in new technology and compete successfully in international markets.
It is not surprising that the main problem faced by government during this period became the ‘productivity puzzle’. It was thought to be a puzzle why Britain, a country with a good business environment and a good record during the Great Moderation, would fail to recover its productivity growth, especially in view of the new technologies that were entering production elsewhere. But looking deeper into the causes, and with the caveat that such complex phenomena cannot have a simple explanation, it seems that Britain’s malaise is due to the lack of technologically advanced investments. A combination of insufficient public investment and ageing infrastructure, combined with the uncertainties brought by Brexit, Covid-19, and the frequent change of government policies – and personnel – removed the incentives necessary to invest in new technology and compete successfully in international markets.
Without productivity growth there cannot be sustainable wage rises; and this may not be too bad if living standards are maintained. But, new technologies, to the extent that they were applied, Covid-19, and especially inflation, conspired to reduce the living standards of workers on low incomes. Almost all new technologies are based on digital equipment, and so complementary to more highly skilled workers. In the Covid-19 lockdowns, jobs that could be done remotely, again mainly the ones that use digital technologies, carried on almost without disruption. But jobs that required personal contact, such as the ones in the hospitality sector, retail or in care, were badly hit. Hospitality, retail, and personal care have a bigger concentration of low-income workers than other jobs, leading to an increase in inequality at a time when the average level of incomes was falling.
During the Covid-19 lockdowns, government tried to avoid massive redundancies by introducing the furlough scheme, which supported workers to remain in their jobs but not work. It paid to employers 60-80 per cent of their wages. It cost 70 billion pounds to support 11.7 million jobs, and it benefited 21 per cent of employers, about 1.3 million. Per job the furlough scheme cost about 6,000 pounds, spread over 18 months.
Normally, at the end of the lockdowns, government would be aiming to repay the borrowing used to finance the furlough scheme, possibly funded by a national insurance surtax on employers. In these circumstances the scheme would be neutral on aggregate and over the long term. The government would have acted as a lender to employers, collecting its ‘loans’ later through taxation; the uncertainties of Covid-19 would not have allowed a private banking system to perform this role, so government policy would have been welfare-enhancing.
Normally, at the end of the lockdowns, government would be aiming to repay the borrowing used to finance the furlough scheme, possibly funded by a national insurance surtax on employers. In these circumstances the scheme would be neutral on aggregate and over the long term.
But as the lockdowns were ending and the global economy was returning to something resembling normal, the war in Ukraine broke out, raising energy and food prices. These products are proportionally a bigger fraction of the consumption bundle of low-income households. Low-income households, who suffered reductions in their living standards before the pandemic through the increase in inequality, were hit by another cost-of-living shock.
The high inflation that followed the Covid-19 spending and the energy crisis associated with the Ukraine war is not easy to deal with. On the one hand monetary policy had to be tightened to reduce the money supply in circulation, and on the other hand some fiscal policy was needed to support low-income families faced with large reductions in their living standards. But even if fiscal policy was tightened to support the anti-inflation stand of monetary policy, as recommended by the International Monetary Fund (IMF), the fact that the rise in energy (and food) prices was a relative price adjustment meant that inflation would not have fallen quickly. Energy and food prices added to inflation, because energy and agricultural products are raw materials to just about every product and every household in the country.
A rise in the general index of prices is not fought with tighter monetary policy if it is caused by a rise in the relative prices of key products. The rise in relative prices necessitated a fall in living standards, because we all had to pay more for our food and energy consumption. The danger from this kind of relative price adjustment is that wages might rise after collective bar- gaining to offset the impact of inflation, and if this rise is accommodated by monetary policy, it can lead to more inflation. It then creates a wage-price spiral which would be much more difficult to control.
Does this risk mean that we should do nothing about the rise in the cost of living? Not necessarily, but the decision of what to do is a political one and not just an economic one. Doing nothing except for fighting inflation essentially amounts to a policy that favours higher-income families, which are not as exposed to the prices of food and energy as low-income families. Supporting households and SMEs (small and medium-sized enterprises) with one-off transfers is a better way of supporting low incomes, and in this respect, a targeted policy would be better than one with general coverage – the policy actually pursued in Britain and most other European countries.
The government’s response to public sector workers, to keep their wage adjustments below the private sector adjustments, exacerbates inequalities.
History has shown that in the labour market the private sector has been able to negotiate reasonably good wage adjustments, but not sufficient to offset entirely the negative impact of inflation on living standards. Such a below-inflation adjustment avoids the build-up of inflationary expectations and shares the burden of the relative price rises, but on balance it is likely that it will not be enough to compensate low-income families for the higher costs that they are facing. But the government’s response to public sector workers, to keep their wage adjustments below the private sector adjustments, exacerbates inequalities. The public sector workers affected are mainly low- income workers, working in the health and education sectors. Their products, which are government-funded services to the community, are not traded at a price that needs to cover costs, so any wage rises would not feed on to prices and lead to a wage-price spiral. The only impact wage rises in these sectors would have would be on either taxation or government debt, which are not inflationary.
Looking at the bigger picture of who bears the burden of the rise in the cost of living, the worst affected appear to be low-income public sector workers. Low-income private sector workers are doing better, but not much better. Inequalities will likely be exacerbated by this policy. In view of the heavy burdens borne by the same low-income public sector workers during the pandemic, this seems to be particularly harsh.
This article first appeared in the Journal of the British Academy as part of a paper Inflation, wages and equality: cross-disciplinary conversations co-authored by Paul Edwards, Charles Baden-Fuller, Christopher Pissarides, Jill Rubery, Colin Crouch and Peter Taylor-Gooby. Thanks to the British Academy for kind permission to reproduce it here.
Sir Christopher Pissarides