Why consumers need to feel the pinch

Why consumers need to feel the pinch
January 19th, 2011
Author: Dominic Dean aka The Misplaced Economist

The lesser-spotted Great British Consumer has had a torrid time of it over the past few years. First there was the massive global recession, where UK high-street banks were explicitly bailed out and implicitly supported with taxpayers’ money. The resulting recession cost fewer jobs than many feared, but on the last count unemployment still stood at 2.5 million – and a further 1.75 million people had been forced to take temporary or part-time work because full-time permanent posts were not available.

Then came the swingeing cutbacks in government spending, with the coalition Government forcing through dramatic real-terms cuts across almost the whole of the public sector. Policing, education, local government and even defence will see falls in real spending between this financial year and FY2014/5. The resulting squeeze on the public purse will cost thousands of jobs, and inevitably hit the provision and quality of public services.

Finally, as if that wasn’t enough, consumers have been clobbered by rising prices at exactly the time with private sector earnings growth has been incredibly weak – as the over 4.25 million under-employed will attest.

This last trend, in particular, has garnered increasing press coverage in recent weeks, despite Bob Diamond’s civilised attempt to keep bankers in the spotlight. How is the average UK household supposed to cope when petrol prices are soaring, there are fears about softer commodities and the price of bread, and the Government has also forced through the rise in VAT to 20%? There are already calls for earnings growth to rise to keep pace with the rising cost of living.

Unfortunately, this would be completely the wrong thing to do. As I have spelt out in previous columns, much of the recent strength of CPI inflation (and RPI inflation, too) reflects tax changes like the VAT hike. Without these, CPI inflation would have been below 2% throughout last year, broadly keeping track with private sector earnings. The (hopefully) one-off nature of these tax rises has encouraged the MPC to keep interest rates at record low. But the fact that ‘high inflation’ – and, to put this in context, 3% or even 5% is not really high to anyone who remembers the 1980s, let alone the 1970s – reflects tax changes, rather than what companies receive for selling their wares, is critical.

When companies need to cut costs, they typically look right across the range of their spending. Investment can be the first to go if demand from the company’s customers has fallen – if you already have spare capacity, why bother building another factory? But when businesses move on to consider staff, they will also look at the services those individuals provide to customers and the revenues they bring in.

This means that, when companies think about employment, they compare wages not to CPI inflation or even RPI inflation, but to the price that the company receives for its goods. This ‘reference price’ does not include VAT or other duties. And, in a country with far fewer jobs than just a few years ago, it is the comparison of wages with this reference price that will influence a company’s decision to hire new employees (or not).

The bottom line is that, with unemployment still at 2.5 mn (plus the extras outlined above), we have yet to see enough of an adjustment in wages, compared with the selling price that companies get for their goods. If we had, unemployment would be falling steadily. The worse news, of course, is that with consumer prices rising faster than firms’ output prices – that tax wedge again (with a bit of delayed help from sterling’s fall in 2008) – from households’ perspective things look that much worse.

Unfortunately, there isn’t much alternative. If workers do push aggressively for higher pay, to compensate for ‘high’ CPI/RPI inflation, that will just discourage firms even more from hiring (and probably lead to job losses). Worse, this kind of inflationary second-round effect would force the MPC to start hiking interest rates, perhaps aggressively. The best consumers can do is grin and bear it, and hope this process of real wage erosion doesn’t last too long. After all, it wasn’t that long ago that people were more worried about keeping their job than about getting a decent wage rise.

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