Thursday, 26 June 2008

Don't count on unemployment to reduce inflation

If the Bank of England think that there is a gentle trade off between inflation and unemployment, they should take look at the last time the UK went into recession.

Back in 1989, the UK had a raging housing bubble. As house prices increased, people felt richer and went out to the shops and spent like millionaires. Inevitably, inflation surged, and for one or two months, it reached 10 percent.

The chart above illustrates what happened next. The housing market crashed. People woke up and found out that they weren't as rich as they previously thought and stopped shopping. The UK slipped into a recession. Unemployment increased from around 7 percent of the work force to over 10 percent.

As the chart suggests, it took almost 4 years to bring inflation under control. It took 7 years for unemployment to return to the level reached in 1989. High levels of unemployment were not that effective at reducing prices.

There is a simple reason for this; so long as workers are not in any immediate danger of being fired, they will try to maintain the relal value of their earnings. When recessions fire up, only the most marginally profitable firms go under. Even in deep down turns, most people are not in any real danger of losing their jobs. Therefore, they keep demanding inflation adjusted pay increases.

The MPC thinks it can negotiate with inflation. Once inflation gets going, it doesn't pay much attention to unemployment. There is only one tried and tested way to reduce inflationary pressure; reduce monetary growth.

9 comments:

Anonymous said...

Alice,

You are starting to sound like an Austrian. What happened?

Nick

Alice cook said...

Nick, money matters. Always believed that. alice

VADO said...

Unemployment never went away. Today, it is called incapacity. The government still hands out the dole.

aSteve said...

It seems obvious to me that unemployment lags crisis... it takes time for each company to move from downturn to crunch to lay-off. Thereafter, it takes time for the dismissed to turn up among the unemployment statistics.

CityUnslicker said...

Two huge holes in this. Pay rises are currently below inflation on figures out today.

Secondly there is a huge reduction in money at the moment, M4 is down alot as well as the de-leveraging credit destruction.

Enough has been done to light the touch paper of recession. let's not pour oil on it.

vodka drinker said...

Cityunslicker, your first point is correct, but likely to remain so for very long.

The second point is incorrect - monetary growth is still over 10 percent.

Finally, I doubt that publishing a picture of inflation and unemployment rates ten years ago will contribute significantly to the probability of a recession.

Vodka drinker

Vodka drinker said...

Sorry, I meant to say below inflation wages increases are UNlikely to remain so for very long.

Anonymous said...

I want the way to reduce the level of unemployment

so in addition thanks for helping me

Iotaake said...

thanks for helping me Iotaake Titaka

so thanks again for the inflation that u show us