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Labour’s economic policy and the public sector pay round

Newly released documents shed light on how a Labour Chancellor ran a pay policy thirty years ago. Then, as now, the government was concerned with expectations of future inflation.

Still, despite current talk of stagflation – low growth with high inflation – the situation today is a long way from the 1970s.
Inflation is back however. So says the Bank of England. To combat inflation, the government intends to limit increases in public sector pay.

Government ministers have been calling for limits in public sector pay rises.  They have linked these calls not to the rising budget deficit, just expanded by Northern Rock, but to the fight against inflation.  In the autumn, the government stated that it had limited headline awards for Pay Review Body groups to 1.9% and that pay rises would be consistent with the 2% inflation target.  The Prime Minister linked public sector pay and inflation in his first press conference of 2008 when he said that ‘To keep inflation low we made difficult decisions to stage public sector pay awards in the last year in the knowledge that higher inflation would wipe out higher settlements.  That helped to break the back of inflation in Britain in 2007.’  Supporting long-term pay deals, he said ‘The whole purpose of this is keeping inflation under control.’  He wanted to pay public sector workers more ‘…but we had to make this difficult decision so that interest rates could come down at the end of the year, as they did, and we could get inflation completely under control.’

There could be difficult negotiations this year with many claims above 2%.  Unions representing council staff and, separately, further education staff, are looking for 6% pay increases for example.  They point to the Retail Price Index (4.1% in January) which includes housing costs, and to large rises in utility and council tax bills.  Meanwhile, evidence from Incomes Data Services suggests that private sector pay deals in January were running at 4%.

At his press conference, the Prime Minister added ‘…there is no point in a big salary rise that is wiped out by a big inflation rise.  Everybody has seen that in the past.  That was the pattern of the 1970s, the 1980s, and the 1990s.  We have moved beyond that over these last few years.’  As it happens, at the same time the National Archives released Cabinet memos from 1977 from the then Chancellor, Denis Healey.

The economic situation was very different to today, though we can see some parallels.  Inflation in autumn 1977 was running at 14%, ten percent above today’s level.  Writing in October, Chancellor Healey noted that his pay policy had shown some success.  General expectations of pay awards had fallen from 20% in the summer to perhaps an outcome of 12-14%.  The government targeted 10%.  However, problems remained.  The Police Federation had increased its campaign for ‘an excessive pay increase’, which the Conservatives supported.  Any relaxation in the government’s stance would have knock-on effects in other pay negotiations.  The Chancellor saw the stakes as being high, noting that ‘If we are succeeding in running a relatively tight overall pay policy…the climate of expectation – and the reality – will be that the rate of price inflation is likely to continue downwards.’

Before Christmas 1977, Healey ‘took stock’.  A ‘wage explosion’ had been avoided but difficult negotiations remained.  His thoughts turned to continuing the pay policy.  With trade unionists ‘tired of being paid in confetti money’, the ‘dramatic fall in our inflation rate is rightly seen as mainly due to moderation in pay settlements.’  Healey argued that a public sector incomes policy was unavoidable, as public sector union leaders recognised.  However, he noted that ‘…it would be difficult to operate a pay policy successfully in the public sector if freedom is exercised irresponsibly in the private sector.’  Despite initial success the policy was not sustainable.

After years of low prices, inflation is once again a concern.  Just as in the 1970s, we are seeing a rise in costs such as fuel and food which lowers productivity and the standard of living.  This is partly due to demand from Asian economies.  The fall in the pound will also raise import prices (though exporters will benefit).  If we try to compensate with large pay increases, living standards will not improve because inflation will rise accordingly.  The squeeze in company profit margins might lead to higher unemployment.  This would come when the credit crunch has reduced access to credit and when businesses are less confident about investing.  Higher inflation leads to a less stable economy and higher interest rates, which choke off investment and jobs.

However, statements on public sector pay have led to a perception that an inflation target of 2% means pay increases must not exceed 2%.  As the recent ‘Green Budget’ from the Institute of Fiscal Studies (IFS) highlights, this is not the case.  The Bank of England believes average earnings increases of 4½% per year for the whole economy (currently at 3.8%) would be consistent with the target.  Headline increases in the public sector might be lower because some areas see high ‘pay drift’ as people move to higher grades.

Ministers seem less concerned with average wage growth than with sending out a clear signal on inflation.  This is because the Bank of England is worried about inflation expectations at a time when economic growth is slowing because of the global credit crunch.

In its Quarterly Inflation Report in February, the Bank predicted that the economy would slow but that ‘…inflation is set to rise sharply in the near term, posing risks to the medium term inflationary outlook if inflation expectations become de-anchored from the target.’  The Bank believes inflation might exceed 3% this year.  A slowing economy should, it forecasts, lead to lower inflation in later months, but the Bank fears that rising inflation will lead to people expecting a higher level in the long term. 

So the government is faced with an economy that is slowing amidst a credit crisis which requires lower interest rates, and a Bank of England determined to keep the lid on inflationary pressures, which limits the extent to which interest rates can fall.  In this context ministers appear determined to use the public sector pay round to sound firm on inflation.  If inflation expectations can be controlled, there may be scope for lower interest rates.

No one knows if using public sector pay to control inflation in this way will work, as the IFS highlights.  It also affects many public sector employees who are already amongst the lowest paid (even if pensions are better than the private sector on average).  It cannot work in the long term.  Limiting pay rises, even if allowing for (lower) public sector productivity, eventually leads to people leaving for better paid private sector jobs.

It will be down to the Bank of England.  Its credibility rests on the independence Labour gave it in 1997.  It will be a difficult year but we are not in 1977 and if inflation expectations can be kept under control there may be scope for more cuts in interest rates than people expect.  So if we get it right, we will have lower inflation and lower interest rates.

This article previously appeared in Tribune magazine.
Stephen Beer, February 2008
Tribune 1 February 2008, 01/02/2008

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