Sacrificing the economy on the cross of inflation

The Commentariat are spooking themselves themselves with ‘frightmares’ about the “spectre of inflation”. The charge is led by the BBC’s economics team with Hugh Pym warning in his News At 10 report (17th June) that inflation was “haunting the economy….” . Tonight Michael Crick of Newsnight piled on the horror by flashing images of the strikes and inflation that brought down Callaghan’s government……

The Governor of the Bank of England, dismayed by the shock-horror his earlier inflation-hype has caused, has belatedly tried to calm nerves and contradict these irrational fears in his now famous ‘Letter to the Chancellor’ of 16th June. Recanting of his earlier assertions he wrote: “there are good reasons to expect the period of above-target inflation we are experiencing now to be temporary” (my italics). (More about this inflationary squeeze being temporary in my next blog.)

Furthermore the Governor damped down expectations of further hikes in interest rates – noting that ‘if the Bank Rate were set to bring inflation back to the target….the result would be unnecessary volatility in output and employment”. That is putting it mildly. As I remarked in an interview on the BBC’s ‘World Tonight’ a rise in interest rates now would not just cause volatility, but a 1920s-type economic failure. Why? Because Anglo-American economies are weighed down by borrowers (both individual and corporate ) who were force-fed loans and mortgages in the 1990s to pay for their spending and house purchases. This borrowing boosted consumption and gave the strong impression of economic growth.

Yet today these borrowers are drowning in a rising tide of debt repayments. At the same time their incomes are falling as a share of GDP. (UK Average earnings including bonuses, rose only 3.8 per cent in the year to April 2008, down from 4.0 per cent in March and a lot lower than the Retail Price Index of 4.5%. Furthermore incomes (compensation) as a share of the UK’s ‘national cake’ (GDP) is falling, is as low as it was in 1989, and much lower than in 1945 and 1970. Average disposable income (after tax) is £14,000 p.a. )

It is at this unfortunate moment that the UK Chancellor, Alastair Darling, has decided to call for deeper cuts in income. He gives every indication of wanting to cut incomes in real terms by bearing down on pay rises set in line with, or above inflation.

Cutting incomes further would be calamitous – not just for millions of debtors – but for those sectors that rely on debtors to go shopping (remember household consumption makes up 60% of UK GDP and 70% of US GDP).

Above all such income cuts would be calamitous for banks, building societies and financial institutions that rely on debtors to repay their debts. Indeed, if these sectors are to recover, then it will be vital to raise incomes, so that debtors can honour their side of society’s contract with lenders…Namely that if debtors are paid a decent income, they will repay their lenders. Cut their incomes from underneath them, and they will do what US defaulters are doing…..drop the keys of the house on which debts can’t be repaid into an envelope, and post them back to the lender/bank. This is a phenomenon dubbed ‘jingle mail’ in the US… a phenomenon terrifying not just bankers, but also government policymakers. For herein lie the seeds of social and economic breakdown.

If the habit of defaulting spreads…….then we really will have something to be spooked about.