Stephen King: Pay restraint? Punk economics

Are we heading back to the 1970s? It all depends. As with The Hitchhiker's Guide to the Galaxy (a relic of the 1970s), the answer cannot be understood without, first of all, understanding the meaning of the question.

I went to a 1970s-themed party last year, an inevitable consequence of being in my mid-forties. The guests mostly came in disco gear. They were doubtless thinking of Donna Summer and the Bee Gees. From this perspective, the 1970s conjure up images of flares and big hair.

Then again, one of the most important musical releases of the 1970s was the Sex Pistols' "Anarchy in the UK", one of the earliest punk records. This seminal single came out towards the end of 1976. In the following year, while the Queen celebrated her Silver Jubilee, the Sex Pistols released "God Save the Queen". According to Johnny Rotten and his colleagues, there was no future for people in "the fascist regime" (although why Mr Rotten chose to place Jim Callaghan on a pedestal alongside Hitler and Mussolini is anybody's guess).

Our memories play tricks. At my friend's party, there wasn't too much spitting or swearing, I didn't see many dancers performing the pogo, and, as far as I can recall, guests weren't wearing too many safety pins. Nostalgia for the 1970s, then, is based on a particular view of what happened at the time.

In economic terms, the 1970s was the decade of stagflation, a period in which the rules of the economic game were turned upside-down. It was the decade when economists discovered it was possible to have a combination of high inflation and rising unemployment. The Keynesian demand management consensus of earlier decades began to fall apart. In the attempt to reduce unemployment, policymakers found inflation rising further and further.

This, though, is merely a description of events. What really went wrong? One conventional view is that, in the UK, the 1970s were a decade of excessive union power. Industrial relations rapidly deteriorated and union leaders, following their own, undemocratic, political agendas, held the country to ransom. For those on the right, this is an attractive narrative. The subsequent collapse in union membership – thanks to the efforts of Margaret Thatcher – has rid us, once and for all, of the stagflation menace.

There is, of course, some truth in this story. It is not, though, the whole truth. The rebelliousness of unions in the early 1970s was, in part, a response to hopeless macroeconomic policies which led the Heath government to impose a prices and incomes policy. The unions may have had their own agendas, but they were helped along by a government which had a very poor grasp of economic reality.

The chart places the experiences of the 1970s in context. It shows, first of all, that inflation was a global problem: prices were rising rapidly on both sides of the Atlantic. To suggest, then, that the National Union of Mineworkers was Britain's inflationary scourge doesn't really ring true. All major industrialised countries had their inflation difficulties whether or not their unions were militant.

The source of 1970s inflation, I would argue, was a combination of factors in the late 1960s. First, the Americans wanted to fund the Vietnam War, and were happy to print dollars to do so. Second, in the process of printing dollars, the Americans undermined the prevailing monetary framework, which, for most countries, was the Bretton Woods exchange rate system. Third, governments lost the support of the people, with anti-war sit-ins, race protests and, in Paris, student riots all adding to a sense of deep popular unease.

By the end of 1971, the Bretton Woods exchange rate system was more or less in tatters, with the Smithsonian Agreement merely a last-ditch attempt to maintain the old order. The dollar's value against gold was no longer secure. Other countries were no longer sure that a dollar peg was any longer in their own national interests. They went their separate ways.

Freed from the exchange rate constraint, the UK decided to go for growth. The Chancellor of the Exchequer at the time instigated what is now known as the Barber boom. This was a monumental mistake, leading to an extraordinary surge in growth which, some foolishly believed, would somehow create its own additional capacity.

It wasn't until the end of 1973, after the Yom Kippur War, that the world received its first major oil shock as a result of the Arab oil embargo, long after inflation had started to head upwards. The quadrupling of oil prices, if you'll pardon the pun, merely added fuel to the fire.

Thereafter, things went from bad to worse. In 1976, Denis Healey famously had to come back from Heathrow airport to deal with a deteriorating domestic crisis. Shortly afterwards, and with the help of an IMF bailout, the Labour government, now led by Callaghan rather than Harold Wilson, decided to flirt with monetary targeting.

Then, as 1978 drew to a close, Britain had to endure the winter of discontent.

The year 1979 brought a series of new challenges. The Iranian revolution, signalling both a further doubling of oil prices and the emergence of Islamic fundamentalism, sent shockwaves through the world. Paul Volcker, the new chairman of the Federal Reserve, showed he was prepared to throw the US economy into recession to deal with inflation. In the UK, Margaret Thatcher got the keys to No 10.

The lesson from all of this is not so much that we can feel cheerful in the knowledge that union power is a thing of the past. These days, with Facebook and assorted chatrooms, you don't need a union to organise a protest. Instead, we discovered in the 1970s that economies simply don't work well with an absence of monetary discipline.

Inflation is evil primarily because of its apparently arbitrary creation of winners and losers. In these circumstances, it's not difficult to see why the previously unco-ordinated have an interest in organised protest. That truck drivers managed last week to achieve a pay increase over two years of around 14 per cent surely proves the point.

The question, therefore, is whether the monetary systems now in place are more robust than those which dominated the economic landscape in the late 1960s and early 1970s. In a large part of the world – the emerging markets – they're not. Some emerging economies, of course, pay lip-service to inflation targeting, but the commitment is typically not really there. For the rest of us, inflation targeting is only now facing its first true test. As raw materials prices rise, will we really stand idly back as wages and profits are squeezed in order to meet existing inflation targets? Or, instead, will those targets eventually die a death?

As yet, we don't know. I find it worrying, though, that Alistair Darling, the Chancellor of the Exchequer, has implored workers to accept moderate pay increases.

In last week's Mansion House speech, he said "... continued restraint on pay is required from both the public and private sector ... to return now to inflationary pay settlements would undermine rather than raise people's living standards with a damaging circle of wage increases eroded by steadily rising prices. We must never return to those days."

All of this is true, but doesn't necessarily help. People pushed for inflationary wage increases in the 1970s not because they desired higher inflation but because they weren't sure of their real spending power in an inflationary world. In the early 1970s, the loss of confidence in price stability was a huge contributory factor behind the emergence of far greater wage pressures.

It is, therefore, vital that the Bank of England now preserves that confidence because, without it, we'll end up singing along to the Sex Pistols' greatest moment. Altogether now: "I am an antichrist..."

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com