Stephen King: Why globalisation may grant the Bank of England its wish for low pay rises

Fancy a pay rise? With higher gas and electricity bills, rising mortgage payments and a bigger tax burden, most of us would doubtless like a bit more money. The Bank of England knows this. It's worried that our demands for compensation in the light of rising bills will lead to inflationary wage increases.

The Bank, like an exasperated headmaster who knows the school inspectors are about to turn up, is asking us all to behave ourselves in the wage negotiations that are currently taking place up and down the country. The interest rate increase a fortnight ago was doubtless designed to warn us that bad behaviour will not be tolerated. The Bank thinks a short sharp interest rate shock is in our collective interest. Far better for us to learn our lesson now before the Bank has to administer much more painful thwacks from the interest rate cane later on.

Inflation has clearly been rising rather too quickly over the past few months. In December, consumer price inflation (CPI) stood at 3.0 per cent, a full percentage point above the target set for the Bank of England by Gordon Brown. CPI, though, has tended to understate inflationary pressures. Those of a nostalgic disposition will be more interested in the 4.4 per cent inflation rate as measured by retail prices (RPI) or the 3.8 per cent inflation rate as measured by retail prices excluding mortgage interest payments (RPI-X).

So far, wage earners have received no compensation for these higher inflation rates. In real, inflation-adjusted, terms average earnings growth has collapsed over the past year or so. At the end of 2006, most wage earners were no better off than they'd been at the beginning: the 4.4 per cent increase in retail prices over the past 12 months has offset any apparent increase in spending power.

Admittedly, I'm taking the headline measure of retail prices as my gauge of perceived changes in living standards. The problem with the headline measure is, of course, the inclusion of mortgage interest payments. These go up whenever the Bank of England raises interest rates to squeeze inflation out of the system and thus, paradoxically, so does RPI inflation.

Nevertheless, the Bank knows all too well that people's perceptions of inflation matter and that, for many, headline RPI is a decent gauge of the cost of living. The Bank worries that inflation expectations may be on the rise and frets about the difficulties of bringing inflation expectations back under control if they were to rise beyond the bounds of acceptability.

In truth, there is a bit of room for wages to pick up without threatening higher inflation. The UK's whole economy productivity performance has shown brisk gains over the past 12 months, justifying some non-inflationary wage increases. The Bank fears, though, that wage gains will go beyond what might be justified by gains in output per hour.

I fully understand why the Bank is worried. Nevertheless, I'm not convinced that inflation really is a major problem. Rather, the rise in prices relative to wages may, instead, be a side-effect of globalisation. Inflation may be higher, but the real story is the squeeze in people's purchasing power reflecting international forces beyond the control of either the Bank or the government. Seen this way, a higher price level is merely the mechanism by which wage earners lose out.

To understand why, it's worth thinking about some of the effects of globalisation on income distribution. There are, of course, all sorts of diverse interpretations of globalisation but, for me, its essential features - at least in its latest guise - are the heightened mobility of labour and capital across borders and the process of economic catch-up which is driving the rapidly expanding economies of China and India.

Capital mobility allows Chinese and Indian workers to be incorporated into the global labour market. China's and India's resulting economic success has led to faster-than-expected global economic growth. Strong global growth has, in turn, lifted demand for basic commodities like oil, aluminium and copper, forcing their prices higher over the past few years.

As a Western worker, these developments lead to a double squeeze. The increase in global labour supply because of the increased integration of China and India - and, for the UK, heightened immigration of workers from eastern Europe - places downward pressure on wages. The increase in global growth stemming from Chinese and Indian success places upward pressure on commodity prices and, hence, on UK inflation.

Put the two together and you have a significant squeeze on UK workers' real purchasing power. UK economic growth over the past 12 months may have exceeded most economists' expectations but, as a wage earner, the story may have passed you by.

Not everyone agrees with this interpretation. Jagdish Bhagwati, a professor of economics at Columbia University, wrote in the Financial Times on 4 January that "technology, not globalisation, drives wages down". He argues that new technologies are allowing capital to supplant unskilled labour at a pace never seen before. For him, China, India and other emerging markets are not so relevant in explaining the squeeze on wages.

Admittedly, Professor Bhagwati's comments relate to the US and, in subsequent remarks, he notes that Europe, with its more unionised workforce, might be more vulnerable to the forces of globalisation, because capital will head elsewhere if wages are higher than the "market rate".

For the UK, though, this really doesn't work. Like the US, the UK has seen a sustained decline in union membership over the years. Unlike the US, however, the UK has not enjoyed the same increases in productivity, suggesting that technology has played a smaller role in any wage squeeze.

In any case, I'd question Professor Bhagwati's core assumptions. In his Financial Times article, he asks, rhetorically: "Can it be that globalisation has reduced the bargaining ability of [US] workers and thus put a downward pressure on wages?" He thinks not. "The argument is not relevant when employers and workers are in a competitive market and workers must be paid the going wage." As I understand it, he's saying that unionisation is low in the US and, as a result, workers have always been paid the market wage.

I'm not convinced by this argument. Technology and globalisation go hand-in-hand in altering wage levels. The market wage for US or UK workers has shifted in response to the changing nature of the global labour market. Because capital can more easily flow to China or India, there's been an effective increase in global labour supply increasing the competition for jobs across a wide variety of occupations, sometimes dramatically so.

Put another way, Western workers may have been paid above the market wage for many decades because political and technological barriers prevented Chinese and Indian workers from gaining a foothold in the global labour market.

It is for this reason that wages in the UK may not respond to the rise in inflation. Recent price increases are not part of an old-fashioned wage price spiral. Rather, they're a redistributive device, designed to squeeze the incomes of those who are facing the heightened competitive pressures stemming from globalisation. The Bank may succeed in preventing wages from rising in the light of higher inflation. We shouldn't forget, though, that forces beyond the UK's control may be behind the resulting real pay cut.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com