How Europe can follow America's lead

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The Independent Online
The extent that European markets dance to Wall Street's tune is ridiculous. On Friday, government securities prices in the UK and the main Continental markets surged, following a sharp rise in their United States equivalents. But why did US bond prices rise? Because employment in the US rose by "only" 193,000 in July instead of the 215,000 the markets expected and because average hourly earnings fell by 0.2 per cent instead of rising by the same amount, the markets concluded that US interest rates will not go up next month as had previously been expected. Result: joy on the bond market.

Ridiculous, but interesting. It is, of course, interesting for people who are concerned with financial markets because it shows once again the strength of the links between markets around the world. Economic policies may vary and national economies may be at different stages of the business cycle, and the markets factor these in. But despite that, they frequently move in unison, and when they do, the lead invariably comes from the US.

But it is interesting at another level for people here: if the US is really able to sustain a long, low-inflation recovery, with unemployment coming down to below 5.5 per cent without that showing through in a surge in wages, maybe it will be possible to sustain the present expansion here, and eventually drive UK unemployment down to those levels too.

There was, between 1986 and the beginning of last year, a neat "fit" between the level of unemployment in the US and short-term interest rates, as the graph on the left from Merrill Lynch shows. Interest rates were pushed up from 1986 to 1989 (with a brief interruption in October 1987 after the stockmarket crash), to lean against the inflationary pressures associated with falling unemployment. Then, as unemployment mounted, rates were eased - held down to just over 3 per cent from mid 1992 right through 1993 - and the sustained fall in unemployment got under way.

Now look at the last 18 months. Unemployment has stayed around 5.5 per cent but interest rates have actually eased. This has been possible because there is really very little sign of inflation. Or rather there is very little sign of inflation in the current price of goods and services, the normal items that go into the consumer price index, which is still up only 2.8 per cent year-on-year. There has been plenty of inflation in asset prices, particularly on Wall Street, and that carries other dangers. But by conventional standards the US inflationary climate has remained adequately benign. Employment has continued to rise solidly, but wage pressures remain minimal.

Why is this? I don't think we really know. Low wage pressure may have something to do with the social insecurity discussed by my colleague Yvette Cooper below, but that would only affect a small minority of the workforce at the bottom end of the wage range. Large-scale immigration will also hold down wages in some regions, particularly along the Mexican border, but will not be felt nationally. There seems to be little wage pressure at the middle and upper-middle pay levels, though at the very top, US pay is clearly a law unto itself. Nor does the entry of new low-wage economies into the international trading arena explain the downward pressure on US wages, for this competition is only felt in a handful of internationally- traded goods, and not in the vast range of service industries.

Perhaps the real explanation lies in the climate of competition in manufacturing and services: the willingness of companies to move to a different part of the country which might offer lower wage (and other) costs and the willingness of workers to chase jobs. Economists talk of the flexibility of the US labour market as explaining the ability of the US to get its unemployment down to such low levels, but just as important is the other side of the relationship: the flexibility of the corporate sector. And of course it is much easier for service companies to up sticks and move than it is for manufacturers. Moving a few computers is easier than moving an industrial plant.

If this is right, then there is a tantalising implication for the UK. Of the large European economies, the UK is closest to the US in a number of ways: obviously the flexibility of its labour market, but also its openness to foreign investment and high proportion of service industry jobs. Maybe it will be possible to sustain the present fall in unemployment so that it comes down to the 5 per cent region of the US. Is the "natural" rate of unemployment in the UK - the rate which can be sustained without inflationary pressures - about the 7 per cent which most economists seem to think, or is it significantly lower?

This is one of those enormously important economic questions to which it is impossible to give a satisfactory answer. The only way to find out is to allow the expansion to continue and see what happens. But, of course, rising inflation awaits if growth is pushed too far or too fast. The "too-fast" danger may well be upon us this winter, to judge by the evidence of both the consumer and the house price boomlet now taking place. If the coming growth spurt gets out of hand and starts to result in rising inflation in the price of goods and services, it will be brought to a halt by the sadly familiar mechanism of a rise in interest rates.

In the US there is something else that might halt growth: a fall in share prices. Wall Street valuations are exceptionally high, and a large proportion of the wealth of US consumers is now in their stock-market holdings. This rise in wealth has encouraged a splurge in consumer borrowing. Even at present low interest rates, servicing this consumer debt is costing Americans nearly 14 per cent of their disposable income, as the graph on the right shows. So the continued US growth rather depends on US consumers being able to sustain these debt levels, and as and when interest rates rise, they will be pushed to do so. The London-based investment advisory boutique, Smithers and Co, which drew attention to this debt level, thinks that the pricking of the US asset price bubble carries grave dangers for the US economy.

We do not have any such bubble here. House prices are rising fast but remain close to the bottom of their post-war range in relation to earnings. Share prices are not such a large part of individuals' wealth as in the US and in any case the London market is much less overvalued than its US counterpart. So here the concern is not asset prices but current prices. But as the evidence of Friday reminds us, what happens to US interest rates will be of profound importance in shaping our own.

Looking ahead, my concern here would not be about the length of this growth phase; rather it is about its pace. Providing the Chancellor does not do something silly like stoking up the consumer boom by trying to cut interest rates yet again - and he may already have made a serious error with the last cut in rates - it is possible that growth can run on a little ahead of the rate of growth of capacity. We could allow unemployment to trickle down, month-by-month, so that in perhaps 18 months' time it would be down in the 6.5 per cent region and still falling. Providing the fall is gradual enough it is possible that this could be achieved without whipping up inflationary pressures. And if this could be done it would change the whole nature of the debate about unemployment in Europe.