Mervyn King said this morning that he does not expect GDP growth to have much effect on inflation for the foreseeable future. That may sound mundane, but the ramifications are immense, for several reasons. For a start, as Chris Giles was quick to point out, it suggests that the Bank is unlikely to do any more QE. Taking it a step further, Duncan Weldon suggests that King has “thrown in the towel” on supporting the economy. If King is right, the government’s “monetary radicalism” approach is shot, and the fate of the UK economy now largely depends on the volatile tides of the global economy.
But can growth and inflation really have become uncoupled, as King suspects? And if so, how? It is a surprising idea, because growth and inflation are supposed to be closely linked. If growth rises too much, inflation also tends to rise, because the economy runs out of capacity and companies put their prices up. For decades, governments and central banks have mostly (the 1970s not withstanding) faced a balancing act between inflation and growth, seeking to get a trade-off between the two. For the Governor of the Bank of England to suggest that growth and inflation are not currently closely linked is a bit like Stephen Hawking suggesting that gravity doesn’t have much effect on the earth’s orbit. It needs a good explanation.
The way that the Bank explains this phenomenon is that “demand and effective supply may move together reasonably closely in the future”. In other words, when the demand for products and services grows, the supply of them also seems to grow. Instead of leading to inflation, growth in demand leads to further growth, but falls in demand also reduce supply. How could that work?
There are two possible theories that the Bank draws on to explain this. The first is known as “demand deficiency”, the idea that the drop in productivity (ie. supply) may actually have been caused by the fall in demand. (This concept is best explained by Bill Martin and Robert Rowthorn here). Here’s the intuition:
Imagine that you are a consultant (like many people in the UK workforce). Before the financial crisis, your company got paid a 100% mark-up over your salary for every hour you worked. Since the crisis, there is less work for your company, so the firm responds by cutting their margin to 50% to win work. In the process, your value to the firm (your productivity, as measured by GDP per hour) has fallen by 25%, but you’re still working the same hours (in reality you’re probably working even harder out of fear for your job). You may well end up taking a pay cut, in real terms at least if inflation is high.
Scale this up across much of the economy, and the whole economy has seen a drop in productivity (assuming that inflation from imports of manufactures, oil, food etc. has prevented the price level falling in line with this – I’ll address this further down). So the initial drop in demand also creates a drop in supply, and inflation and growth are not closely linked.
The second possible explanation is that the weakness of both demand and supply is being caused by the same thing: credit constraints. Firms can’t invest in increasing supply, because they are struggling to get finance. Consumers can’t spend (and the lower investment also reduces demand), so demand also falls. Both supply and demand are dragged down together, and again we can get high inflation without high growth – “stagflation” by another name.
Both of these possible explanations appear to possess some bite, but there is something deeper lying behind them: Britain’s dependence on the global economy. The Bank acknowledges this: it says that the “future path of GDP will depend critically on developments in the global environment”. But what does that mean?
In part, it’s about all of the obvious factors – the impact of the Eurozone crisis on UK banks and confidence, the depressing effect of a weak global economy on UK exports, fears about the US fiscal cliff and so on. But it also runs into something more fundamental, about the changed nature of the global economy and Britain’s place within it. Our rate of inflation is increasingly determined by global markets, and wages for many jobs are also becoming increasingly subject to global competition.
As a small, open economy, the UK is becoming more and more tied in to the global economy. Many of the goods we consume – especially food, oil and some manufactures – come from overseas, and are traded in truly global markets. When the global prices of food or oil go up (as they’ve been doing often of late), inflation in the UK jumps. That squeezes UK incomes, reduces margins for many UK businesses, drains money out of the country (through pricier imports) and thus lowers GDP growth. Quite often, rises in inflation have nothing to do with Bank of England policy or with an overheating economy.
Equally, many of the jobs we do are subject to increasing global competition. This has already largely happened with manufacturing – huge numbers of UK manufacturing jobs have shifted to countries with lower wages – and competition is also intensifying in many high-value, research-intensive jobs. Global competition doesn’t much affect jobs in retail or transport (where you need to be located where you are selling things), but it affect s many other jobs.
The UK, like most countries, used to have a very effective counter to global competition: its exchange rate. Normally, when a country becomes less competitive relative to others, its currency weakens, making its exports more attractive and its workers’ wages seem more competitive. A devaluation in the pound helped give the UK a quick, export-led recovery from it s last recession in the early 1990s. But this time around, devaluation doesn’t seem to have helped. Sterling lost 20% of its value in the initial stages of the financial crisis, and yet exports have barely shifted since. Export-led growth, founded on a weak pound, was supposed to be the foundation of the Coalition’s growth strategy, but for reasons unknown it has failed to materialise.
Why? The reasons are not entirely clear, but there could be several explanations. First, many other countries have been very aggressive in trying to keep their currencies weak (through quantitative easing and the like), and this has blunted UK efforts somewhat. The pound may not be particularly weak at all compared to where it should be. Second, the direct link between exchange rates and exports may have become frayed in the modern global knowledge economy. Luxury export items, such as iPhones and BMWs may not be very responsive to price changes, and so can withstand shifts in exchange rates. Equally, many service exports (the area in which Britain excels) are based on relationships, and are not very easy to value. Exchange rates may have very little impact on service exports, leaving the UK unable to escape its trap.
If this picture of the UK economy trapped in a global storm, with neither government nor Bank of England able to do anything about it, is correct, it makes for terrifying viewing. Are we living in a global economy where many UK workers are competing on wages with people around the world, and where inflation is influenced as much by global fluctuations as domestic decisions? Mervyn King and his colleagues increasingly appear to think so, and that does not bode well for the coming years.