Dominic Lawson: There is a simple reason Brown wants to limit wage rises: he can't afford them

How is the Prime Minister allowed to get away with it? Over the past week Gordon Brown has been telling a succession of interviewers – mostly from the BBC – that public sector pay increases should be limited to 2 per cent because anything more would lead to an increase in inflation. On Tuesday, at the monthly prime ministerial press conference, he was especially clear: "The single purpose of this is keeping inflation under control."

None of Mr Brown's interrogators seem willing to put the obvious point to him – that wage increases are not, in themselves, the cause of inflation. The leaders of the public sector unions have been making this point with increasing vehemence, but few in the media seem disposed to listen to them.

As almost all professional economists have recognised for years, the principal cause of inflation is "easy money" – that is, lax control of the money supply. There is no such thing as an "inflationary pay award". Perhaps the most conclusive recent research was produced by Professor Gregory Hess, who, infuriated by a Wall Street Journal headline ("Unions seek big pay gains, sparking inflation worries"), wrote a paper which – after reams of econometric analysis – concluded: "The vast majority of the published evidence suggests that there is little reason to believe that wage inflation causes price inflation. In fact, it is more often found that price inflation causes wage inflation. Wage inflation does a very poor job of predicting price inflation, while money growth does a much better job."

Gordon Brown, of course, understands this very well. He has read the textbooks. Better still, he has had personal instruction on the matter from his good friend Alan Greenspan, the former chairman of the US Federal Reserve. Indeed, Brown's defining act as Chancellor was to see the critical counter-inflationary importance of removing the temptation from Government to "reflate" the economy with easy money whenever it seemed politically expedient: he made the Bank of England independent (just like the Fed). Yesterday, that independent Bank proved the point, by refusing to heed the cries of over-borrowed businesses for an immediate interest rate cut.

Or look at it another way: just how could breaking the 2 per cent barrier on the part of the minority who work in the public sector be held responsible for a rise in inflation – at a time when private sector pay increases are running at close to 4 per cent?

Obviously, if the Government were simply to adopt the Robert Mugabe expedient of printing more banknotes in order to pay higher wages in the state sector, then that would have an inflationary effect – but the British economy is not run along the lines of Zimbabwe's.

If there are "excessive" pay awards, the dismal consequence is not price inflation: it is unemployment. It is not just out of filial loyalty that I recommend Nigel Lawson's political memoir, The View From Number 11, which contains the following: "As a Government we were handicapped in explaining this elementary relationship by decades of propaganda about a supposed wage-price spiral in which the evils of excessive pay were seen almost entirely in terms of inflation, rather than unemployment."

Especially in more difficult times, it is just not possible to pass on each and every increase in wages to consumers through price rises. Ask the chief executive of Marks & Spencer. So companies either lay off workers, or don't take on new labour which they otherwise might have done. Or they simply bypass the British labour market altogether by basing more of their production overseas.

It is true that these sorts of competitive pressures don't exist within the public sector. Yet a trade-off between wages and unemployment still pertains. There is a budget for each of the public services. It can pay for only so many public servants at any given average salary. After that, the money runs out.

Here, in fact, we come to the true, unstated reason for Gordon Brown's eye-wateringly tight public sector pay round. The public finances, despite the Prime Minister's furious protestations to the contrary, are not in good shape. Latterly as Chancellor, he borrowed heavily during the good times – when traditional prudent housekeeping would have demanded that more was put away for the inevitable rainy day. We now have a budget deficit stigmatised as unsustainable by the International Monetary Fund and which Gordon Brown knows must be reduced, not increased still further.

This, alas, could be a recipe for great hardship at a time when the economy already seems poised on the edge of a dramatic slow-down, if not actually a fully-fledged recession. Unfortunately for Mr Brown, however, the Bank of England does not have much room for manoeuvre – the Retail Prices Index now stands at 4.3 per cent (compared with 2.6 per cent when Labour took office in 1997).

Gordon Brown no longer recognises the RPI, having in 2003 changed the official measure of inflation to the Consumer Price Index, which stands at 2.1 per cent. This is the measure he cites to the trade unions, when defending his 2 per cent pay policy. Since the Consumer Price Index fails to include council tax, mortgage interest payments and some other housing costs, we can hardly blame the public sector unions for telling Mr Brown where he can shove his CPI.

Someone who knows Gordon Brown quite well told me that the Prime Minister's dramatic launch of his confrontational three-year public sector pay policy is – however paradoxical it might seem – a result of his recent political setbacks. Mr Brown has decided, so this man argues, that he needs to return to the image that made him respected: that of the "Iron Chancellor". Hence the Prime Minister's new mantra that he is "taking the difficult decisions, not the popular ones".

Yet when Gordon Brown became Chancellor he did not pretend that the very tight public expenditure policies he started with were caused solely by a desire to "bring inflation under control". After all, the Conservatives, in somewhat traumatic fashion, had finally achieved that. He told the truth, which was that the state was over-borrowed, and some of that debt should be repaid.

So why won't he utter the same truth now? The reason is all too obvious: it is one thing to say that you are the "Iron Chancellor" who will reduce the public sector debt which you had inherited. It's much less impressive to say that as Prime Minister you are inflicting economic hardship in order to reduce the debts which as Chancellor you were responsible for incurring. So instead you say that the only reason is to "keep inflation down".

Almost all of the media will believe you. Businessmen will believe you (partly out of ignorance and partly because they think it might help them negotiate lower pay awards with their own workforces). Probably the vicars in their pulpits will believe you. Yet it's not true.

d.lawson@independent.co.uk