It's not the labour market, stupid

It's not the labour market, stupid
By Samuel Brittan
Copyright The Financial Times Limited 2006
Published: September 22 2006 03:00 | Last updated: September 22 2006 03:00


Bill Clinton fought the 1992 US presidential election on the slogan "It's the economy, stupid". This slogan, misguided though it was, has prompted me to think of another: "It's not the labour market, stupid".

Although people obsessed with financial markets do not always realise it, the labour market has long been the driving force behind macroeconomic policy and analysis in the developed world. It went through several phases.

The first I will call call phase zero. This was when inflation was assumed to be the product of institutional forces, principally trade unions pushing for more. There was supposed to be nothing finance ministers could do about it except to bribe or force trade unions to settle for less.

Phase one brought the realisation that the labour market was important. This was the era of the Phillips curve, after an economist at the London School of Economics. He promoted a chart in which the unemployment rate was plotted against the wage or inflation rates: it showed that the tighter the labour markets, the higher the rate of inflation. This phase came to an end in the 1970s, coinciding

with the first oil price explosion and the arrival of double-digit inflation,

in spite of high unemployment.

The second phase dawned when it was realised that this inflation/unemployment trade-off could only be temporary. When wage earners got wise to inflation they would insist on higher settlements. There was therefore nothing much to lose by making low inflation the ultimate objective of monetary policy. There was also no way in which finance ministers and central bankers could spend their way into desired levels of employment. In time these doctrines became highly respectable. But instead of talking about unemployment rates, governments and central bankers used the more anodyne term "output gap". This second phase was symbolised by the spread of inflation targets and central bank independence.

At any one time there are numerous knock-on or knock-off influences on the rate at which prices are rising, such as import price changes, changes in indirect tax and so on. But the ultimate influence was seen to be the state of the labour market. Look at the reports of any major central bank. They are all preoccupied with whether the core rate of inflation is going to be raised by catch-up pay increases.

This second phase is also fading away. Signs include the numerous occasions in which large knock-on price increases, or even accelerated growth of the money supply, have failed to trigger the feared inflation. If the US Federal Reserve or the Bank of England allows demand to rise too quickly, the impact is no longer mainly on wages and prices but on the flow of immigrants and/or the volume of imports.

I am not suggesting that inflation targets, which have worked surprisingly well, should be abandoned. If it's not broke, don't mend it. But if you can see some cracks in the machine, look for ways of strengthening it. So I will close with a few policy pointers.

The time for a worldwide labour market approach has not arrived. One big obstacle is lack of reliable information. Some observers believe that there is a reservoir of several hundred million able-bodied Chinese waiting to be drawn into international labour markets. Others believe that a shortage of people with the right attitude and skills has already triggered substantial pay increases for Chinese workers in the coastal belt.

Meanwhile, western policymakers have to pick up what clues and policy pointers they can find.

First, policymakers need to ase their own domestic decisionson the international as well as domestic economic environment.

Second, the financial indicators that our Victorian forebears looked at need to be taken seriously again. For instance, commodity prices (nowadays, of course, including oil), the gold price and asset prices including property and equities.

Third, in view of the greater frequency of so-called shocks, the inflation targets need to be pursued over an average of several years rather than immediately. In the heyday of the gold standard there were years when the consumer price index would rise by 5 or 6 per cent or more. What was different from the 20th century was that these price changes were not projected forwards and there was a belief that a pound or dollar in 25 or 50 years' time would be worth about the same as a pound or dollar today. Mervyn King, the Bank of England governor, has shown signs of sympathising with this approach: he has looked forward to writing a letter to the chancellor of the exchequeron why inflation is more than 1 per cent above or below the 2 per cent target.

Fourth, there is no longer any need to throw out the old concern with employment and output stabilisation, so long as it is not pursued at the expense of letting inflation take off.

Finally, to show that these new attitudes do not mean that we have gone soft on inflation, the eventual target should perhaps be lowered to

1 per cent, or even just "stable prices".