Life on Mars: is Seventies stagflation on the way back?

Rises in the cost of living are bringing riots and big pay demands and stirring gloomy memories. Mike Foster reports

American investment banks don't usually do politics. So things must be bad when one of the world's biggest securities houses, Merrill Lynch, starts talking about civil unrest, power blackouts and higher interest rates in the same breath.

Merrill has just raised its 2008 forecast for underlying global inflation to 4.2 per cent, against 3.9 per cent for global GDP. Taking account of all the bits and pieces that don't get measured, the true inflation rate would exceed 6 per cent. Economists say this level can prove something of a watershed: when rates rise to between 7 and 10 per cent, individuals cease to assume that inflation will stay low and start demanding action to protect their standard of living.

That's why riots in Egypt and the National Union of Teachers' recent vote in favour of strike action are causing such tremors and why Merrill's warning is not so surprising. Here in the UK, the NUT vote in favour of a strike over a 10 per cent pay claim has brought back uneasy memories of the 1970s, when a string of inflation-busting pay settlements came close to pushing the country into ruin.

The NUT's demand is twinned with an alternative request for £3,000 per teacher – whichever is higher. This compares with an offer from the Government of 2.45 per cent, roughly in line with the consumer price index, its preferred measure of inflation. But the broader retail price index has hit 4.1 per cent and the cost- of-living index produced by Asda stands at 5.2 per cent. Affluent individuals, meanwhile, are enduring 6 per cent, according to the Salli index produced by wealth adviser Stonehage.

NUT president Bill Greenshields has said he does not want his members to suffer a fall in living standards: "We don't do the job for money, but we can't do it without money. If a society values its children, it will value its teachers."

Fair enough. But Mr Greenshields' mission is dangerous at this stage in the economic cycle. Union rallying cries like his echoed across the UK in the 1970s, as people struck en masse for higher pay to stay ahead of inflation. By a delicious irony, schools minister Ed Balls, who made his name for economic competence at the Treasury, is responsible for heading off the NUT threat. He will know that salaries typically account for no less than two-thirds of company costs.

Stephen Lewis, chief economist at Anglo-Dutch bank Insinger de Beaufort, sees parallels between the present day and the years leading up to stagflation in the 1970s. "I've never been convinced that the UK has kicked the inflation habit," he says.

The current situation is made worse by global inflationary trends. Egypt has been paralysed by strikes for higher pay to cover a massive increase in the price of food. Unrest in Tibet, as was the case at Tiananmen Square in 1989, is fed by discontent over high levels of inflation (currently 8.7 per cent) in China. Wages are rising faster than their five-year average in two-thirds of the world's larger economies.

Behaviour theory confirms that individuals are highly averse to being left out of pocket – a factor which persuades people in a casino to keep gambling after they lose large sums of money. When inflation eats away at savings, they view this as little short of theft.

If enough people get angry, they start to listen to the siren call of union leaders, and peer-group pressure encourages them to vote for strike action. Unions put other demands – such as the NUT call to nationalise private schools – on the agenda.

The situation gets totally out of control when generous pay deals are offered to one set of workers, but not to others, who become jealous as a result. "Inflation is more destabilising to society than depression," says Mr Lewis. "With depression, people just stay in bed all day."

Back in the 1970s, as now, the world had to deal with rising commodity prices. Previous pay settlements in the UK had already pushed up the underlying rate of inflation, and unions scrambled to make up lost ground when a sharp hike in the price of crude oil sent inflation sharply higher. It hit a peak of 24 per cent in 1975.

Successive governments patched together national pay deals over beer and sandwiches with union representatives led by Jack Jones, general secretary of the Transport and General Workers' Union, and Hugh Scanlon of the Amalgamated Engineering Union. But the deals failed to hold, as militancy became embedded in the union psyche and managements failed to get a grip.

The Conservative Thatcher government of the 1980s dealt with the situation by raising interest rates to control the money supply, privatising companies and standing up to union leaders. But its success was also based on a slump in the price of commodities.

The past 20 years have been a golden era, during which time commodity prices have been depressed. Cheap imports from the emerging economies and the arrival of migrant workers have helped to push inflation down to extraordinarily low levels.

But the situation has been going into reverse all over again, as a result of emerging econo- mies starting to consume energy and hard commodities at a prodigious rate to fuel their burgeoning economies. Scarcity has developed. Price pressures have also appeared in the agricultural sector due to bad harvests and a growing demand for both meat and biofuels. The world is vulnerable to the same kind of super-spike in commodity prices that hit the UK in the 1970s.

The one-off benefit from lower pay, resulting from the arrival of migrant workers in the UK, is probably at an end. Many migrants, led by the Poles, are returning to their native land. In his book The Age of Turbulence, former US Federal Reserve chief Alan Greenspan says migrant labour was a big factor behind low inflation in the 1990s. He argues that the next decade could be more inflationary.

But others say sudden cuts in interest rates by the Fed to fend off stock market catastrophes, followed by more gradual rises, were equally inflationary because they generated too much credit. Now that bad loans are appearing, the ability of borrowers to repay mortgages has been undermined. The resulting fall in house prices is disinflationary, but still it makes everyone feel poorer as inflation keeps going up elsewhere.

Meanwhile, falling equities are damaging savings plans. Emerging economies are being worst hit, but the situation is getting worse in the US and UK as the the dollar and sterling fall in value.

Analysts at Lehman Brothers reckon the Bank of England's Monetary Policy Committee is facing the most difficult balancing act since it was put in charge of interest rate strategy in 1997. On the one hand, Britain needs a sharp cut in rates to avoid recession. On the other, the MPC might need to keep rates up because "a prolonged period of above-target inflation could lead to inflation expectations becoming detached, risking their hard-won credibility".

More moderate views within the teaching unions might yet prevail. But, right now, Bill Greenshields isn't making the Bank of England's job any easier.

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