The Ernst & Young ITEM Club – an independent economic forecasting think tank which uses the same economic models as the Treasury – yesterday published a report on the inflation outlook for the UK over the short to medium term [PDF]. Coverage of this has been slow and not terribly helpful. I caught a snippet on Radio 4, but to get anything even vaguely meaningful, you would have had to listen to Radio 5 Live’s Wake up to Money at 5.30 yesterday morning.
On “Wake up to Money”, Neil Blake, a senior economic advisor at the ITEM club suggested that a lot of the inflation we have seen over the last three or so years has been “imported” or outside the control of the Bank of England’s Monetary Policy Committee (MPC). This kind of imported inflation was due to sharp increases in commodity prices, primarily food and energy. “Domestically generated inflation”, he said, was relatively low. Given the economic outlook, Mr. Blake suggested, the MPC’s current inflation target of 2% may be unrealistic and he proposed two options for addressing this:

• Option 1 would be to increase the MPC’s inflation target. Even a modest increase of half a percentage point for 2.5% would give the MPC considerable flexibility to absorb imported inflation.
• Option 2 would be to target a different measure of inflation – one that allowed us to strip out elements beyond our control such as food and energy, and enabled us to focus on the “domestically generated” part of inflation.

It is that “domestically generated” inflation that I want to look at. In basic terms, inflation is a general rise in prices: items which yesterday cost you £1 to buy today cost £1.02. The same amount of money, therefore, buys less “stuff”. Obviously increased prices of raw materials or energy will have an impact on inflation. So will raising sales taxes such as VAT – something which has happened twice in the last two years, once at the reversal of the temporary VAT cut and once at the beginning to this year when the rate went up to 20%. These are either external factors beyond our control or one-off occurrences which will not affect inflation next year. There are, however, other factors domestic factors which can influence inflation, and by far the biggest of those is wages, followed by profits. These are the “domestically generated” pressures on prices and components of inflation. What Neil Blake is therefore saying is that while food and energy prices will continue to rise and that is beyond the MPC’s control, one way of keeping inflation down is to focus on – essentially – keeping wages down. It is an interesting euphemism, that “domestically generated inflation”.
In all fairness, if you read the full ITEM Club report, a slightly different picture emerges. Far from making any specific recommendations, the report acknowledges the weaknesses of both options. It stresses that any attempt to keep the domestically generated parts of inflation down is likely to have a strong negative impact on growth and thus highlights the challenges facing policy makers. It also looks at the shares of wages and profits in gross output – in other words, how much of GDP goes to labour and how much to capital. There are a few items of note here:

• Over the last 40 years, there is a slight but perceptible downward trend in labour’s share of GDP and an equally slight but perceptible upward trend in capital’s share. The downward trend for wages as a share of GDP is particularly pronounced from the 70s until the mid-90s (say around 1997), after which labour’s share of the pie stabilises.
• The ITEM club looks at the effect that changes in the share of GDP of imports and indirect taxes have on the shares of labour and capital. What they find is that taxes tend to squeeze labour’s share of the economy, not capital’s.
• Globalisation, together with rising commodity prices and competition in international labour and product markets, is likely to further squeeze labour’s share of the pie.
• Finally, “the recovery when it comes will benefit capital more than labour.” This will, of course, further exacerbate already high levels of inequality in the UK.

Overall, the ITEM club report makes for very interesting reading and acknowledges that we will continue to face economic challenges over the short to medium term. The most important conclusion I draw from the report is this: If the government suddenly decides to change what the Bank of England is targeting in its efforts to manage inflation, and particularly to “exclude factors beyond our control”, remember what this means. Remember that “targeting domestically generated inflation” is code for “keeping wages down”.

This is a bit of a drive-by blog post – a collection of short thoughts with a common theme: market failure (and in one case, success). Remember, out of my three-year economics degree, we spent about a week learning how the market worked, and the rest of the time learning about all the entertaining failure modes.
Let’s start with the banks.
The Independent Commission on Banking has made some recommendations in its interim report, including firewalling retail banking from casino banking, and increasing the cash reserves required for the retail side of the operation to 10% of capital. According to Robert Peston on the Today Programme this morning, the banks’ first reaction was to complain that these measures would increase costs. I find bankers’ lack of a grasp of basic economic principles (We’re talking Introductory Microeconomics here!) both amusing and disturbing.
Let me introduce you (probably not for the first time on this blog) to the concept of externalities. Externalities are costs or benefits which for some reason are not reflected in the market. The Introductory Microeconomics textbook example of a negative externality (a cost) is pollution. Say you run a factory which makes some sort of chemical. You pay for your raw materials, for your staff, transport, electricity, water, etc. However, your factory’s waste is leaking into my local river, killing the fish and giving me cancer. I can no longer fish for a living, and I have to pay for cancer treatment, but because this has no direct cost impact on you, you have no incentive to clean up your act. Essentially, I’m picking up a part of your production costs because the market by itself has no way of making you pay up for the damage you’re causing.
Now imagine you’re a banker. You run a bank which includes a retail operation and an investment operation. There’s very little regulation on what you can and can’t do. You can promise all sorts of things without having the cash to back it up, you can take unreasonable risks on your investment side and absorb the impact on the retail side, and if you fail, the tax payer will pick up the bill, because you’re so vital to the economy that you’ve got them by the balls. The true cost of the risks you’re taking is not reflected in your operating costs – it’s picked up by the tax payer when you fall flat on your face, and then the rest of us suffer a spectacular hit to our disposable income while you still wave your £10-notes in our faces. Now, here’s a textbook externality if I ever saw one.
What that new proposed regulation would do is not increase costs. It would simply help you internalise your cost, correcting a market failure, so that you can make informed choices about how you run your business without holding a gun to my head. There’s a minor difference here.
Who do you trust more – Nick Clegg, or the guy who fixes your car?
My car’s at the garage today, having its break fluid changed and its handbrake looked at. The way such adventures invariably go is that halfway through the morning I get a call from the garage, and someone babbles at me in a thick Geordie accent and deliberately throws incomprehensible words at me trying to get me to panic and ask them to do more work than I originally intended. I’m getting better at stopping them, asking some questions and trying to sort out what actually needs doing from what they would simply like to charge me some money for because they’re having a quiet day. But I still suspect they’re getting away with way more than is strictly speaking necessary.
This is a classic example of a different kind of market failure: asymmetric information. See, when Conservatives and Libertarians tell you how great and efficient the market is, what they mean by the word “market” has nothing to do with what exists in the real world. A theoretical, efficient market relies on a whole house of cards of entirely unrealistic assumptions, including the one that states that all parties have perfect information.
As, however, I am not a car mechanic, the actors in this particular market have far from perfect information. I know nothing about fixing cars, while the mechanic knows everything. What’s even worse is that he knows perfectly well that I know nothing, and is willing to exploit this fact. So he gets to tell me all sorts of horror stories and I’m left there trying to work out which of these things will kill me if I don’t pay him to fix it. Today is one of those days when I wish we lived in the Tory Utopia of Market Efficiency. Instead, I find myself in the paradoxical position of trusting Nick Clegg, a man known for breaking promises, more than I trust the guy who’s supposed to make sure my car doesn’t malfunction in an entertainingly fatal sort of way.
And finally, thank you, Rupert Murdoch!
This one’s a story where arguably the market has worked. For those who haven’t noticed, the Times paywall is down today. I don’t know whether this is a glitch – there certainly has been no formal announcement – or if they’ve decided to quietly drop it. The universal reaction I’ve seen on the web, however, has been a resounding “Meh…”
You see, for the last six months or so, Rupert Murdoch and the Times have been persistently training us not to click on any Times links, and not to link to the Times. Any fool who clicked was asked for money, while anyone who linked risked a barrage of abuse from their readers who did not appreciate being directed to the paywall.
Humans, therefore, do appear to respond to incentives. And the incentive in this particular case has been to quietly let the Times online presence fade into digital obscurity. I am amused by how well this has worked.