Sunday, December 18, 2011
Inflation fall should start to ease the misery
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

Many will be familiar with the Phillips curve, the economic relationship defined in the 1950s by Bill Phillips, a New Zealander who came to the London School of Economics after a dreadful time in a Japanese prisoner of war camp.

His relationship - when unemployment is rising, wage rises (and therefore inflation) will fall- was both logical and simple. It was subject to subsequent revision, most notably by Milton Friedman, but it remains central to policy thinking.

The reason the Bank of England expects inflation to fall is because of spare capacity in the economy. Unemployment, of course, is the human side of spare capacity.

For some time, however, the relationship between unemployment and inflation has seemed to go awry. Inflation has risen for most of this year alongside an increase in unemployment. Much more of that and people would seriously talk of stagflation.

Now, however, normal service is being resumed. Unemployment is rising, the rate for the August-October period was 8.3%. Inflation is falling, and on the consumer prices index measure has dropped from 5.2% to 4.8% in the past couple of months.

That should be the prelude for a much bigger fall in the coming months, notably as January's Vat hike drops out of the annual comparison. Spencer Dale, the Bank's chief economist, said last week that inflation should be in the "low threes" by March. Weaker growth in China, India and other emerging economies is putting downward pressure on commodity prices.

It is important inflation does fall, both to ease the squeeze on real incomes and for the Bank's credibility. It will also be significant in other ways. Inflation affects everybody while unemployment, or the fear of it, affects only a minority.

Even so, it is appropriate to think of the misery index: the unemployment rate plus the inflation rate. The index has risen this year to its highest since the early 1990s - higher than the recession proper - making us all feel thoroughly miserable.

Now, even if unemployment continues to rise, as is likely, it should be more than offset by falling inflation. We will not be happy in the coming months but we should be a little less miserable.

What of unemployment? A month ago we had some genuinely bad unemployment figures. The wider Labour Force Survey measure, having been stuck at 2.5m for two years, rose to 2.622m. Employment fell sharply over the summer.

The latest numbers were not nearly as bad. The new total, 2.638m, was up by a modest 16,000. The monthly claimant count rose by a tiny 3,000. Yet the way they were reported, you might have thought both sets of figures were equally awful.

Some newspapers laid the gloom on with a trowel while the BBC talked of “another leap” in unemployment. No self-respecting salmon would describe it as a leap. Unemployment will rise further but we should not overdo the gloom.

Indeed, something interesting is happening in the data. A month ago, so bad were the figures I thought we would see a sharp fall in both public and private sector employment in the third quarter.

Sure enough public sector employment fell, by 67,000, but private sector employers added 5,000 to payrolls. In the past 12 months public and private have roughly balanced out, a fall of 276,000 in the public sector and a private sector rise of 262,000.

Something else has been happening and on the face of it is rather surprising. In the latest three months the number of self-employed people rose by 166,000 to 4.14m, the highest since records began in 1992.

I wrote last month that we are entitled to be a little suspicious of strongly rising self-employment at a time of weak growth, the suspicion being that it is involuntary rather than a spontaneous outbreak of entrepreneurial spirit.

The statisticians have investigated this and found the new self-employed include the young, the old, some who have left employment but also some who were economically inactive but have set themselves up as self-employed. So it is widely-based.

I wonder, too, whether something else is happening. The public sector is more than meeting expectations for cutting headcount. There is a well-known phenomenon in central and local government, which is that people are made redundant and then re-hired as a self-employed contractors.

It is possible we are seeing some of that in these numbers, so the drop in the public sector headcount exaggerates the squeeze. It would help explain both some of the rise in self-employment and why public sector job cuts have been so much bigger than the Office for Budget Responsibility expected.

Finally, an aside. Given Britain’s financial services sector has been in the news, how important is it? The City UK, which represents the industry, claims financial and professional services together account for 14% of gross domestic product and employ nearly 2m. That, however, includes many in professional services who have nothing to do with finance.

More often it is claimed, including by letter writers to The Times, that financial services are 10% of GDP. That, however, is too high. According to the ONS, the 2008 weight of financial services and insurance in gross value-added was 8.9%. Since then the sector has suffered a bigger decline than the economy as a whole, so its contribution in 2010 was nearer to 8%.

Financial services and insurance employ 1.1m people, according to the ONS. The insurance industry has nearly 300,000 employees, the Association of British Insurers says, leaving roughly 800,000 in financial services alone. If we assume a similar split in terms of contribution to GDP, that suggests financial services are closer to 6% of GDP, perhaps 7% at the outside. That fits the more detailed ONS data.

Financial services are important, and Britain does well exporting them. But they are no more than half the size of manufacturing. Perhaps David Cameron's next veto should be to protect British industry.