Hamish McRae: With 1.7 billion people after our jobs, the cost of oil is the last thing we should worry about

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It is not just pain at the pumps; it is also slower growth. The medium-term impact of higher energy prices is starting to feed through into inflation in the developed world. Just on Friday came news that it had risen to 2.2 per cent in the eurozone, while in the UK it is now above the Bank of England's 2 per cent central target, after running below it for several years.

If we don't get another cut in interest rates before Christmas it will be largely because of the inflationary pressure from the oil market. In the US, the increase to above 3 per cent is putting pressure on the Federal Reserve to push rates up further, despite the signs of a softer economy.

Quite how soft the economy will be through the rest of this year is still not clear but the IMF has cut its forecasts for growth in Germany to 0.8 per cent, in the UK to 1.9 per cent, France to 1.5 per cent and Italy to zero. In demand terms, Europe seems to be harder hit by the oil shock than the US, though in inflation terms it is less damaged.

But, of course, all this is happening at a time when the downward pressure on the price of goods in the shops is as strong as ever. Shop prices in the UK are still lower than they were a year ago - as indeed they are in the US. There are a number of reason for this, including a squeeze on margins from online retailers, but the overriding factor is the growth of China as an exporter. It is not just bras and knickers, the subject of the ill-tempered row between the EU and China - though clothing is one of the areas where global disinflation is strongest. Just about every manufactured product is being affected either by Chinese competition, or the threat of it.

There is a parallel in services, though this is not yet so evident. Just as China is the world's cheapest manufacturer, so India is the world's cheapest provider of tradable services. International trade in services is still smaller than trade in goods but it is growing rather faster. So expect international competition in services to increase, too.

On the other hand, the growth of the Chinese and Indian economies is putting upward pressure on the price of raw materials, especially oil. So we are now moving into a world where inflation in goods is either zero or negative and in tradable services is very low. But in non-tradable services (including government services) it is continuing to rise, while in commodities it has become very serious.

This raises two obvious questions. Is this a blip or something that will continue for a generation? And if the latter, what are the consequences?

For the first, I think it is now accepted that it is likely that growth in China and India will continue at a high level for some years, and that accordingly there will continue to be heavy demand for resources. While most raw materials are in reasonable supply, oil is not. There is a robust debate as to whether the peak in the world's oil production will be another decade away or whether it is imminent, and obviously that affects the price of oil in the next few years. But there can be no dispute about the finite nature of oil supplies and the growing demand from the two new economic giants. So fairly expensive - maybe very expensive - oil seems likely to stay.

The two charts demonstrate how the growth mantle of China appears set to pass to India. The projected growth rates come from the Goldman Sachs' notable BRICs study about the future growth of Brazil, Russia, India and China. As you can see from the left-hand graph, Chinese growth does seem likely to decline somewhat but still remain high for another generation. Indian growth seems likely to carry on at an increasing rate.

Whether or not you buy the Goldman calculations, the numbers in the second graph are less open to dispute. As these workers become better educated, an increasing proportion of the combined 1.7 billion working people will be competing against the workforces of the developed world. They will naturally also want to consume the goodies of a developed world's lifestyle. So short of some unforeseen catastrophe, the competition from lower-cost labour will continue for a generation at least. That will continue to exert downward pressure on our own wage rates but also hold down the price of traded goods and services.

What are the consequences of all this? On the energy side, I think you have to acknowledge the power of the price mechanism. We are hugely overdependent on oil, and from any long-term view - environmental, economic or strategic - this makes no sense. But it is hard to change because the installed infrastructure is extremely expensive to replace, even if an alternative were readily available. However, at $60 a barrel or more, all sorts of substitutes become economic propositions. We will, for example, grow crops for fuel, with biodiesel and ethanol already on the market. We will find more oil; we will substitute where practical; and we will economise in its use.

So we can come to terms with that. It will be much harder to come to terms with the continual, relentless downward pressure on costs. Anyone in the retail trade or in manufacturing understands this but those of us in jobs not subject to offshore pressure hardly feel it. Mercifully, the Chinese have not yet figured out a way of producing a clone of The Independent on Sunday.

What seems likely to happen is that our economy will increasingly split into two halves: the parts that are reasonably protected and the parts that are not. The parts that are not will see falling prices; those that are will see rising ones. In other words, what we are seeing now is merely the early stages of a revolution in relative prices that will continue for a generation. Already professionals in the UK complain about the inaccuracy of the retail price index because the things they tend to buy as they become richer - mostly housing and services - have gone up faster than the RPI. The fact that, say, computers or clothing have become cheap does not help because proportionately less is spent on these.

An economy of two halves has already had some troubling social consequences, widening income gaps between the skilled and less skilled being the most obvious. Expect these to grow as more of the lower-paid jobs in the traded sector are replaced by even lower-paid ones among those 1.7 billion workers in the graph above.

And the answer? Protectionism, even were it practicable, would be morally disgraceful, for it would seek to exclude people in much poorer countries from improving their living standards. The only acceptable answer is to upskill our workforce and allow the market to signal what jobs we can really do better.

Worrying? Well, yes, in the sense that this is an unknown land: a level of global competition that the world has never known. But, no, in the sense thatwe seem to be able to figure out a lot of things we can do, in creating the strongest job market in Europe and raising living standards almost as fast as the US. But that trick will become harder from now on.

Germany's malaise prompts healthy debate

The German polls are on a knife-edge and it really is hard to see which way the voters will jump. On the other hand, it is easy to see that even if Angela Merkel's Christian Democratic Union-led coalition does achieve a working majority, carrying through a convincing reform policy will be much harder than it seemed when the election was called.

This is because the ideas floated by the CDU, including radical tax reform, seem to have contributed to the apparent decline in support for the party, making what looked a certain victory a much closer race. The slow economic growth continues: as noted above, the IMF has now cut its forecast for the German economy to below 1 per cent, a level that means parts of the country will stay in recession because some parts are growing faster. But absolute living standards remain acceptably high for many people, and any form of reform would put some at a disadvantage.

Besides, the effect of any reform programme in the short term is negative. The costs are immediate, while the benefits take years to be felt. It was an adverse reaction to the costs of the labour market and welfare reforms of Chancellor Gerhard Schröder that forced him to call an election: unemployment shot up. So without a clear mandate, Mrs Merkel would find it equally hard not just to nudge a programme through the complex negotiations required, but also to sustain reform as the initial adverse impact hit home.

If all this sounds a bit dispiriting, there are two silver linings to these clouds. One is that German companies are doing very well, having been able to squeeze domestic costs down and push a lot of production out to the new EU members to the east. The other is that the whole theme of this election, with its open debate about the need for, and the costs of, economic reform, is the sign of a truly healthy democracy. Remember that reforms in the UK were rammed through without much debate beforehand: we had to make it up as we went along.

At least Germany has a road map, even if it is not too sure whether it wants to head along the road just yet.

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