Mr Bootle’s analysis differs from Liam Halligan’s yesterday more in the headline than in the argument. He, you will remember, points to inflation as bound to come and my private contacts in the City support that view though timing is far from certain.
The banks are hoarding cash in vast quantities gainedv through Quantitative Easing and sooner or later they swill release that cash and inflation will take off. The talk of deflation comes from those wedding further fiscal stimulkus and more debts.
But Bootle also draws some perfectly valid lessons as well.
Christina
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19.9.09
Deflation lurks in the shadows as pay increases continue to shrivel
Pay is back in the news. Admittedly it is bankers' pay which has hit the headlines, but it is ordinary pay that is economically significant.
By Roger Bootle
While economists and even the average punter down the Dog and Duck fret about the inflationary consequences of movements of the money supply and the arcane details of Quantitative Easing, before their eyes something big is happening that has a direct bearing on household finances and business costs. Despite the return of gargantuan pay packages in the financial sector, the overall trend for pay increases is firmly downwards.
At the start of the credit crunch in August 2007, the annual growth rate of nominal average earnings (including bonuses) was 4.3pc. In August 2009, the annual rate was 1.6pc. Moreover, the annual rate got as low as -0.7pc in January and -2.3pc in February, as a result of substantially lower bonus payments in the financial sector. Such negative rates are unprecedented in the 44 year history of the average earnings data. You would have to go back to the 1930s to see anything like it.
These ultra-low figures have not been brought about solely by falls in bonuses. The figure excluding bonuses has also fallen. In August, the annual rate was 1.8pc, down from 3.8pc in August 2007.
What is causing these falls? The Bank of England has suggested that the low growth of pay may be due to the high growth of import costs.
Essentially, in order to keep overall costs under control, firms have had to squeeze labour costs. If this is right then, with import costs now growing less fast, [Eh? As the pound falls import costs - especially of oil and gas - go up! -cs] perhaps pay growth will start to pick up again.
Although this argument is interesting, and although there may be something in it for particular firms, I doubt that it is the fundamental explanation for what has been happening across the economy as a whole. Pay growth has slowed pretty much across the board, including the less import intensive sectors, and covering both manufacturing and services.
I think the reason is quite simple. It is the recession, coupled with the recent sharp falls in inflation, which are, of course, related to the same general cause. Businesses have been hit hard and are having to contain costs to survive. Meanwhile, unemployment has risen sharply.
This has important implications for the future. It is well known that unemployment lags the economy. So unemployment will continue to rise long after the economic recovery has begun. What's more, in the past, pay growth has not risen until after unemployment has started to fall. Given that unemployment will probably continue to rise well into 2011 – and to stay close to its peak for a long time – pay growth should fall much further.
Causality between earnings growth and inflation clearly runs both ways, but the bigger picture is that both tend to move closely together. It looks as though, if pay growth were to stay at current low levels, then CPI inflation would be likely to be not much above zero, and RPI inflation to be below 1pc. In conditions of high and rising unemployment, inflation that low might even prompt pay growth to edge even lower, thereby setting up the conditions for still lower rates of increase of prices. This is how a deflationary spiral starts, mirroring what we have got used to with inflation.
The factors that I have emphasised so far really apply only in the private sector. Public sector pay dances to a different beat. Recently, pay growth in the public sector has been stronger than in the private sector. In August, while average earnings growth was 1.2pc in the private sector, it was 3.1pc in the public sector. If this trend of much higher public sector pay rises were to continue then it could upset the logic outlined above. But it surely cannot and will not continue. Public sector earnings growth looks set to fall considerably. [It has started its fall already -cs] Shadow chancellor George Osborne has committed "... to recommend no headline increase in pay for all public sector workers in 2011, except for the lower paid one million who should be protected."
But in relation to the scale of the fiscal problem and the Conservatives' ambitions to tackle it, this won't go anywhere near far enough. They will either have to extend the freeze for longer or bring in substantial public sector job cuts, or both. Job cuts would not automatically bring down pay inflation but they would have an indirect influence, both within the public sector and outside it. [Such cuts are inescapable -cs]
Overall then, falling inflation, rising unemployment and public sector pay freezes suggest that the growth rate of average earnings should slow much further. I expect that the figure may be only 0.7pc this year, and minus 2pc in 2010. By 2011, with the economy recovering and unemployment topping out, and possibly falling by that stage, pay growth may then recover, but only to about zero. And I doubt that it would rise much further any time soon after that. Now there's something to get the tongues wagging down the Dog and Duck.
This prospect may seem far–fetched, but then so have all the previous sharp slowdowns in pay inflation that we have experienced since the early 1980s. And in Ireland the overall rate of pay growth has already turned negative.
This outlook for pay has implications for wide swathes of the economy – for business costs and therefore for prices and inflation, for consumer spending and for households' ability to service debts. Because it is the average rate of growth of productivity, 2pc is the magic number. A lower rate of growth of pay than 2pc implies falling unit labour costs. And if labour costs fall then, once the influence of changes in oil and commodity prices and the exchange rate have passed through the system, a negative rate of price inflation – i.e. deflation – is warranted. I am often asked which economic variable is the most significant to watch out for. The answer changes with changing times but at the moment my answer is pay.
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Roger Bootle is managing director of Capital Economics and economic adviser to Deloitte. His new book, "The Trouble with Markets" has just been published by Nicholas Brealey
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