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19 January 2022

Why inflation could break Britain

Inflation has reached 5.4 per cent, the highest level since 1992; high prices and falling wages will intensify the UK's systemic weaknesses.

By Will Dunn

In a conference speech to Conservative Party members last October, Boris Johnson announced that the country was changing direction. “The present stresses and strains,” he said, were “mainly a function of growth and economic revival.” Wages were rising faster than before the pandemic struck, as Brexit turned off the tap of cheap foreign labour and brought better pay, more employment and higher productivity to British workers and businesses.

In the US, similar sentiments were held by the Biden administration. Even before the pandemic, Janet Yellen – now the US Treasury secretary – had expressed a desire to “run the economy hot”, allowing the pressure of demand to deliver higher wages. Policymakers reassured one another that the impending arrival of inflation would be “transitory”.

For governments that had just raised trillions to stimulate their economies during the pandemic, a little inflation was also attractive: higher prices and wages can mean higher tax receipts. But the heat has arrived faster and hotter than many anticipated. Inflation (as measured by the Consumer Price Index, or CPI) reached a 30-year high of 5.4 per cent in December. The 5 per cent inflation that the Bank of England had predicted for April 2022 arrived almost six months early. In the US, consumer price inflation is already more than 7 per cent, its highest level for more than 40 years.

The higher wages Johnson celebrated are arriving, but so too are galloping prices, a cost-of-living crisis and deepening inequality, which could do even greater damage to public services already stretched perilously thin. The current period of inflation looks less and less like the transitory effect of a revitalised economy, and more like a long-term trend – the beginning of a period of great uncertainty, and one for which Britain in particular is systemically unprepared.

Energy prices – as in the sudden rise in oil prices in the 1970s, or the price of gas today – are an important factor in inflation because they affect the cost of everything; nothing is manufactured, no one is employed, without energy bills being paid. A period of inflation sets in when these price rises spread out into the costs of goods and services, and people demand higher wages to keep up with rising prices – as with the “wage-price spiral” that characterised the 1970s. This particular wage-price spiral was sustained partly by the unions, which enabled workers to bargain collectively for higher wages.

Today, as the Prime Minister has trumpeted, we have Brexit, which is indeed putting pressure on wages, as skilled and readily available staff from Europe are no longer an option. A survey by the British Chambers of Commerce found that 83 per cent of construction and hospitality businesses have had difficulty finding staff. Whitbread, which owns hotels and restaurants including the Premier Inn chain, raised wages in October; the company expects to do so again in the spring. The Pret a Manger sandwich chain has raised wages twice in the past four months.

But prices, too, are rising, and faster still. “It’s across the board, from house prices to wages in certain sectors, energy prices, prices of food, prices of goods,” says Jim O’Neill, the former Goldman Sachs chief economist and commercial secretary to the UK Treasury. “It’s the first time we’ve seen a number of factors that drove 1960s and 1970s inflation, all occurring at the same time.”

Paul Mortimer-Lee, deputy director of the National Institute of Social and Economic Research, agrees that “it’s not just a few things. If you look at the distribution of inflation, even the bottom 10 per cent of goods – their rate of inflation has picked up… the whole distribution is moving up.”

Mortimer-Lee says the increase in the price of goods is partly down to a relative increase in demand for goods rather than services – people are shopping online rather than eating in restaurants, for example. One important question is whether goods will get cheaper again, or if services will simply catch up. “If that happens,” he says, “you get very sustained inflation.”

Today, the price of goods in the UK is much more dependent on what happens elsewhere in the world than it was in the 1970s. The price of a car in Britain relies more on how many semiconductors are made in Asian factories than how many workers go on strike in British ones. New cars are already in such short supply in the UK that some second-hand vehicles are selling for more than the retail price of a new model, thanks to a global chip shortage. But the supply of goods and components may get worse. On 10 January, the co-head of Asian economics research at HSBC, Frederic Neumann, wrote to clients that a spread of the Omicron variant – yet to become dominant in Asia – could create the “mother of all supply chain stumbles” if a new wave of infections caused factories to close.

It is also much more expensive to move goods that have been made in other countries – such as the 98 per cent of our clothes that are made abroad – to Britain. In 2019, the world’s shipping containers flowed around the planet as if on a river, following the path of least resistance. In 2020, lockdown interrupted the flow everywhere as factories closed and trucks remained parked. Containers were marooned inland while the ships that carried them headed back to Asian ports. As economies restarted, the demand for shipping shot up and the supply of containers was restricted. Prices doubled, and doubled again. Data collected by the shipping consultancy Drewry puts the profit forecast of most of the world’s largest shipping lines at more than $150bn for 2021. This is more profit than the same lines have made in the past 20 years. The British International Freight Association has called this “blatant profiteering” and appealed to competition regulators. But it is a cost that manufacturers, importers – and by extension, consumers – in the UK will have to bear for some time.

Persistent inflation will create a difficult environment for the government and the Bank of England. “We live in an age of wishful thinking”, says O’Neill, in which “governments think that they have to always do what everybody wants. So raising interest rates a lot, and tightening fiscal policy, especially when we’ve come out of this horrific pandemic – that’s not what policymakers want to do.” But action will quickly become unavoidable.

This April, persistent high inflation – previously an abstract concept to anyone who was not a working adult in the 1970s – will become a factor in people’s everyday lives once more.

The cost of domestic energy in the UK, already punishingly high, will rise by at least half again as the energy price cap – the maximum amount that an energy company can charge an average household on a standard tariff – rises by about £600, according to analysts at Cornwall Insight. Households will also take on the cost of rescuing customers from failed suppliers (estimated at £2.4bn, or £90 per household) through their bills.

As the country returns to more in-person work, doing so will become more expensive. Rail fares will rise in March by up to 3.8 per cent, increasing the cost of an annual season ticket between, say, Reading and London by more than £184, to more than £5,000. For the two-thirds of the country that drives to work, the price of fuel – which reached its highest ever level in October – is already adding more than £10 to the cost of every tank, but oil prices may have further to go. A faster economic recovery in other parts of the world, especially Asia, could push oil to more than $100 a barrel (as Goldman Sachs has predicted), moving prices at British pumps well beyond £1.50 a litre.

According to the latest survey by the British Chambers of Commerce, 58 per cent of businesses are planning to raise prices – but wages will not keep up. Data from the HR services company XpertHR shows that of more than 1,000 pay deals covering 5.5 million British jobs, the average pay rise over the past 12 months was 1.8 per cent, while inflation in the 12 months to November was 5.1 per cent for the Consumer Price Index (CPI) and 7.1 per cent under the Retail Price Index.

At the same time, households will begin paying more tax. Higher National Insurance contributions, imposed to pay for social care, will cost the average earner about £230 per year extra. And for those who get a pay rise in the new financial year, more income tax will be due. The freezing of the personal allowance and higher-rate income tax thresholds will cause 1.5 million people on thelowest wages to begin paying at 20 per cent (on their taxable income) over the next four years, according to the House of Commons Library. Another 1.2 million people will be nudged into the higher (40 per cent) tax bracket, and parents in this group will lose some or all of their child benefit.

While prices and taxes are increasing, benefits are being cut. Not for all; the government is reducing the “taper rate” for Universal Credit payments and increasing the in-work allowance, making 2.2 million families who are employed and claiming benefits better off. But a further 3.6 million families will be worse off than they would have been if the government had kept the £20-a-week uplift to benefits instead, according to the Resolution Foundation.

Debt will become more expensive, too. Between now and April, the Bank of England’s Monetary Policy Committee will meet twice to decide on whether to raise interest rates. Making borrowing more expensive is the Bank’s primary means of curbing spending, dampening demand and reining in inflation – but this will also lead to bigger payments on the mortgages, credit cards and other elements in the UK’s £1.7trn of consumer debt.

The UK consumer, O’Neill points out, “has a higher degree of fixed-rate, long-term debt” than those in other countries, “so the UK consumer is definitely more vulnerable” to these cost pressures.

Two of the biggest sources of this long-term debt are house prices (which aren’t included in the CPI inflation measure) and the cost of education. In the UK, housing affordability – the median cost of buying vs the median wage – is approaching ten times earnings, a level not reached since the late 19th-century – when about two million people lived as servants in other people’s houses. Britain also has the world’s highest and fastest-growing university tuition fees. A country that already spends more than one-third of income on housing costs will begin to have to make hard choices. Under such pressure, the cracks in the British system will widen.

During the 2008 financial crash, the UK government was credited with having “saved the world financial system”, as the American economist Paul Krugman put it, with a vast programme of equity injections and loan guarantees to prevent a collapse of the credit system. But in the years that followed, the rationale of the coalition and Conservative governments was that the rescue would have to be paid for through radical cuts to public spending.

Frank van Lerven, senior economist at the left-leaning New Economics Foundation, says the policy of austerity created a systemic weakness in the British economy.

“Because government spending is such a big part of spending in the overall economy,” he explains, cutting government spending “effectively shrinks the size of the economy, and shrinks private-sector incomes.” Van Lerven says the then chancellor, George Osborne, was aware of this problem, but expected foreign investment from countries such as China – attracted by the prospect of the UK “getting its house in order” – would make up the shortfall and provide economic growth without public spending. But with the single largest source of spending in the economy reduced by almost one-third, “investors see that your economy is shrinking [and] they know people aren’t spending”.

O’Neill publicly warned Osborne against cuts to public services at the time. He points out that the current pressures “are evidenced in virtually every Western society, and others”, most of which did not follow the same programme of cuts, but he says the fiscal policy of low spending and low corporate tax “didn’t seem to lead to any permanent benefit in the trend growth of the economy – and once it’s been abandoned, as we’ve seen during Covid, the financial markets haven’t been concerned about it, until they saw signs of inflation. So why was it, in hindsight, so crucial?”

Whether a lower deficit played any role in keeping the British economy afloat, it created one serious problem for a future chancellor facing inflation: public sector pay. Between July and September last year, 27,353 NHS workers resigned from their posts, more than at any point in the health service’s history. But this may be only the beginning of even greater level of resignation from public services, driven partly by rising inflation. The problem, explains David Bell, professor of economics at Stirling University, is that the pay offered to nurses, doctors and police officers in the Spending Review last October formed part of a “tight Budget” from Rishi Sunak – one that appeared to account little for a higher cost of living.

“If the increase in wages that the government has assumed doesn’t meet the increase in prices, then you’re looking at real falls in the standard of living of public-sector employees,” Bell warns. This is a problem that the NHS, which has lost more than 20,000 workers from the EU because of Brexit-related effects, can’t afford, but it is not a problem confined to the health service. Last year, a National Education Union survey found that 35 per cent of teachers planned to leave the profession within five years.

The austerity years were also characterised by a long period of stagnant wage growth, which is still happening. Van Lerven says the “shock to income” of the 2008 crash “translated into this manifestation of insecure work in the gig economy”. Unemployment peaked in 2011, then fell as a new type of employee – the gig worker – began driving for Uber and riding for Deliveroo. “Instead of laying people off,” says Van Lerven, “we gave them zero-hours contracts.”

O’Neill agrees that “the winners of the technology era have been spectacular, but a pretty narrow few”, but sees the problem as broader still. “It’s almost like the economy is – rigged might be too strong a word – but the mechanics of market economics haven’t really worked properly… All this era of strong profit growth, low interest rates, low corporate tax rates, and so on, should have led to a big rise in private-sector investment spending. It’s supposed to lead to a lot of new entrants and competition; it’s supposed to lead to productivity improvements, and it’s supposed to lead to higher real wages. None of those things happened.”

In the North Sea, 18 miles off the Yorkshire coast, stand two platforms that look much like oil rigs. These are the platforms of the Rough gas field, and in the porous rock deep beneath them 72 per cent of the UK’s gas reserves were once stored. In 2017 the Rough’s owner, Centrica, closed the 32-year-old facility, and no storage was built to replace it. Despite warnings from the energy industry, it was decided that pipelines from Norway and container ships from Qatar could supply all the gas the UK would need.

These rusting hulks are emblematic of the predicament that Britain faces: first, that this inflation is not a domestic phenomenon, but the product of global competition for resources. Gas is not suddenly more expensive because the Bank has printed money, lowering the value of money against gas, but because there is huge demand and limited supply in a global market. They also represent a failure by the British government, and a private sector it has not properly regulated or held to account, to insure against coming uncertainty.

In energy prices, more extreme weather events caused by climate change will make both the disruption to supply and swings in demand more pronounced. The supply of liquefied natural gas (LNG) delivered by ship – the UK’s back-up to its pipelines – is very precarious: when the Ever Given blocked the Suez Canal last year, freighters carrying half a million tonnes of LNG sat waiting behind it.

This will affect a much greater problem that successive governments have also failed to address: inequality. The poorest 10 per cent in the UK spends three times as much, as a share of income, on electricity, gas and other fuels as the top 10 per cent. By the end of the year, millions could be spending 15 per cent of their income on fuel. And without changes to public sector pay, the services that even more of the population will be likely to need may not be available.

Some economists I spoke to cast this as a political choice, but it may be something more fundamental still. Most, if not all of those with power in the economy – executives and politicians – would like to do something about the inequality and inadequacy that inflation reveals. So why can’t they?

Perhaps efficiency itself – the just-in-time, waste-free economy – is the problem. It is a goal of which Britain, which employs twice as many management consultants as China, has been the most committed proponent, but this has been at the cost of resilience. In the new age of uncertainty, a new model may be needed.

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This article appears in the 19 Jan 2022 issue of the New Statesman, The end of the party