June 27, 2023

“We are living in an expensive and increasingly poor country,” thundered The Guardian‘s political editor, furious at the crumbling state of the nation unable to pay its workers properly. “It is not much use lecturing people about paying themselves more than the country can afford. A better way of putting it is that increasingly the country cannot afford to pay people enough.” A fair point, perhaps. But this was not a column from the weekend, taking aim at the blundering Bank of England governor, Andrew Bailey; it was written 45 years ago, in the depths of the Winter of Discontent. As much as some things change, it seems much else never does.

Are things as bad as they were in 1978? Not on the surface, at least. Back then, the dead were left unburied and rubbish piled up in the streets as the government and trade unions entered into a battle to the death that both would lose. But today, like then, spiralling inflation is tearing at the fabric of society, forcing policymakers to squeeze the life out of the economy just to contain rising prices. And this time, it comes after 15 years of stagnant living standards; in the Seventies, life for the ordinary worker had improved year on year thanks to strong unions who could squeeze real-terms pay rises from employers.

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Britain’s post-war economic history could be seen as one long battle against inflation and the search for an “anchor” to stop the doom loop of stop-start, boom and bust. In the Sixties and Seventies, both Labour and Tory governments adopted a “prices and incomes policy” believing that the way to control inflation was to manage people’s pay rises and what companies could charge for certain goods. This collapsed with the Winter of Discontent and the election of Margaret Thatcher, who came into power with her own grand theory, monetarism, which also failed.

Next, the European Exchange Rate Mechanism was taken up — only to spectacularly collapse in 1992, along with John Major’s economic credibility. At this point, we formulated the “inflation target” and then outsourced the problem to the Bank of England in 1998: a monetary policy committee of technocratic experts was allowed to set interest rates which would keep inflation to this target. With this, we believed we had solved the problem.

For most of the next 20 years, inflation was not much of a story. First came the boom years of Blair and Brown when, apparently, the business cycle had been abolished — an era Mervyn King referred to (tongue firmly in cheek) as the “nice” years of “non-inflationary consistently expansionary” economics, his point being that no such thing existed. This was in 2005 and King was worried about rising oil prices fuelling inflation again. But then came the crash of 2008 and the subsequent years of austerity and stagnating living standards, cushioned only by the record-low interest rates which have now spectacularly come to an end.

Today, with inflation almost in double digits, the Bank of England is squeezing the economy hard, ratcheting up interest rates. Sunak, meanwhile, is hinting at further wage restraint on public-sector workers to put even more downward pressure on the economy in order to hit his own political target to halve inflation by the end of the year.

This, some might say, is merely the Bank doing its job: force-feeding the country some necessary bitter medicine. The problem, in other words, is not the system, or even those in charge of the system, but conditions beyond their control.

But the Bank can’t have it both ways. Were those decades of low inflation really thanks to its good judgement? Or could other structural reasons have played a part? After 1998, China flooded the world market with cheap goods; immigration from poor parts of Europe soared; and trade unions were no longer powerful enough to protect their workers’ living standards.

Many regard the period between 1992 and 2008 as Britain’s golden age, when sensible politics reigned; inflation was low, the economy grew, deficits were sustainable, debt was low and Britain’s place in Europe was settled. This was the post-Maastricht, post-ERM settlement: Britain was in the EU but outside the euro, conveniently placed within both the European single market and the great global financial system — a trusted, stable, liberally regulated investment opportunity, perfectly placed to boom in the 21st century. After decades searching for our anti-inflationary anchor, we had found it. We had solved politics. Many people still yearn for this settlement to be rebuilt.

And yet almost every plank of this settlement has collapsed. The financial system blew up in 2008, shattering the British economy and, with it, the New Labour political settlement on which it was built. A few years later, the eurozone crisis revealed the diplomatic weakness of Britain’s place outside the single currency, precipitating David Cameron’s failed attempt to renegotiate the terms of British membership, leading to Brexit. Our faith that the Bank of England could control inflation is one of the last remaining planks left in place. And now that looks close to breaking.

There are good arguments that our current spike in inflation is a blip caused by the pandemic and Russia’s invasion of Ukraine. But there are other reasons to believe it might be here to stay. China, for example, is no longer simply a mass producer of cheap goods, but is turning itself into a high-skilled, hi-tech manufacturing superpower — a kind of super-Germany. Meanwhile, the great power rivalry between the US and China is bifurcating the world economy, throwing up protectionist trade barriers which will inevitably drive up the price of goods. And finally, the free movement of workers from Europe has ended with Brexit. In short, the three structural reasons which might have kept inflation low for 30 years are no longer in place. And this is before taking into account the energy transition to “net zero” which most Western governments are currently pursuing.

If we are entering a world of persistent inflation, high interest rates and the return of stop-start economics, you can bet that, as night follows day, the search for a new easy fix will commence — a new “anchor”. If only we returned to the EU, our problems would be solved, some will argue. If only we replaced the Bank of England’s monetary policy committee with better people; if only we returned to some kind of collective pay bargaining; if only we unilaterally abandoned our trade barriers. If only, if only, if only.

The truth is we have far less control than we like to admit. To think that we have solved the inflationary conundrum by outsourcing it to the Bank of England is as hubristic as all the other assumptions we made about the end of history in the Nineties.

Britain’s central bankers can’t solve the inflation problem in isolation. It has one set of tools — interest rates — and these are blunt instruments at best. In both the Seventies and Eighties, it quickly became clear that monetary policy alone was not enough to deal with inflation; fiscal tightening was also necessary. And even then, sudden shocks in the global economy completely changed the domestic picture, whether the oil price rise of 1973 or oil price crash of 1986.

The other lesson from history is that the battle to control inflation is, by its nature, political not technocratic. Whichever method you choose to keep it under control, the burden necessarily falls on one group in society over another. In the Seventies, unionised workers protected themselves with good pay rises, while those living on fixed incomes, like the elderly, were badly hurt. Over the past 15 years it has been the opposite. Today, meanwhile, it looks like the burden will fall on those with mortgages — a group that has largely avoided the pain until now.

While inflation seemed under control in the Nineties and early 2000s, few paid much attention to the distributional consequences of the system, but today the whole structure is back under scrutiny. And so it should be. Not only is the Bank’s competence fair game, so too is the system itself, resting as heavily as it does on interest rate rises over other tools.

With an election on the horizon, we may find ourselves in a new world where the Bank of England is working to meet a medium-term target set by a government whose other policies are making it harder to reach that target. This was briefly the case under Liz Truss, when she tried to put rocket boosters under the British economy regardless of the inflationary consequences. In doing so, she was not acting like her hero, Margaret Thatcher, but far more like Ted Heath in 1972 who ordered his chancellor Anthony Barber to unveil an expansionary budget in time for Britain’s entry into the European Economic Community in 1973, wrongly believing a virtuous cycle of growth and modernisation was on the horizon.

Truss is unlikely to be the last prime minister to find themselves in conflict with the Bank. Will Sunak really be able to avoid the temptation of an inflationary tax cut before the next election? Don’t bet on it. And if he does cut taxes, prepare for the squeeze after the election — and the stop-start cycle begins again.

The eternal truth is that there is no magic cure for Britain’s economic ills — no framework which solves our problems forever. Governance is art, not architecture: the management of circumstance, not the building of permanent structures. Inflation is back and so too are the politics of inflation. Strap in for a bumpy ride.