Danny Gabay: They've curbed inflation. They've curbed rates. So why should we curb immigrants?

The British public tends to take a dim view of self-congratulation, and an even dimmer view of politicians who try to convince them that they have never been better off. But, economically, it's true that we have rarely had it so good. Whereas once upon a time the UK economy would lurch from boom to bust with metronomic regularity, it is now enjoying the longest sustained expansion in its modern history. Whereas inflation was once a national pastime, we now have lower inflation than the Continent or America. And in place of strife, the UK has more of its population in work than just about anywhere outside Scandinavia.

The British public tends to take a dim view of self-congratulation, and an even dimmer view of politicians who try to convince them that they have never been better off. But, economically, it's true that we have rarely had it so good. Whereas once upon a time the UK economy would lurch from boom to bust with metronomic regularity, it is now enjoying the longest sustained expansion in its modern history. Whereas inflation was once a national pastime, we now have lower inflation than the Continent or America. And in place of strife, the UK has more of its population in work than just about anywhere outside Scandinavia.

But according to the polls, we are far from ecstatic. It may just be British reserve that's keeping the champagne on ice. It could equally be that memories remain fresh of the last time we thought we'd cracked it, and things ended in housing arrears. But this modesty would surprise many outside the UK, who seem far more impressed.

Some of them are so admiring that they have decided to come to Britain to look for work. Net immigration has risen sharply since 1998 (see the first chart), and over the past two years alone, more than a million migrants have entered the UK. The outflow from Britain has also risen, but it has not kept pace with the inflow. This has not gone unnoticed. Other polls show immigration is likely to be a key battleground in the general election.

Many view the rise in immigration as a threat to the economy, but the opposite could be closer to the truth. Not only might higher immigration be a symptom of the UK's economic success, it might have contributed significantly to it.

The performance of the labour market is central to this story, and in particular the UK's apparent ability to generate ever more jobs without igniting wage inflation. Economists like to talk about speed limits. Simplifying the argument enormously, it is believed that there is a natural rate of unemployment and attempts to reduce it below that level will only induce higher inflation.

The second chart shows the relationship between the unemployment rate (based on the international definition) and a measure of the cost of employing the average British worker. This measure takes into account both the wages of this typical worker and his productivity. The scales on the chart for the real unit wage cost have been inverted so the lower the green line, the higher are the wage pressures.

The first thing to notice is that unemployment is incredibly low. What should also be obvious from the chart is that at similar levels of unemployment in the past, wage pressures would have built up rapidly. But so far during the current cycle, wage inflation has really been the dog that failed to bark.

There are many plausible explanations for this improved performance, ranging from the deregulation of the late 1980s, to the adoption of an inflation target and the eventual granting of independence to the Bank of England, which helped by anchoring inflation expectations.

But there have been two other more subtle but equally important changes which have played a part in this story. The first is the succession of labour market reforms introduced by the Labour Government. Together with the sustained increase in funding for the public services, programmes like Welfare to Work and the minimum wage have encouraged previously retired or disaffected workers back to work.

Between 1993 and 1997, some 1.6 million people left the unemployment register, but only 1.1 million new jobs were actually created. By contrast, since May 1997 only 800,000 have been taken off the register but some two million new jobs have been created. So the proportion of the workforce actually in work has risen. More of us who are able to work are doing so than ever before.

By encouraging an increase in the supply of labour, the Government has been able to raise employment without triggering wage inflation problems. But has it also had some outside help?

A closer examination of the second chart suggests that despite the many positive factors noted above, wage pressures were beginning to build during 1998. Skills shortages were widespread and it seemed the UK labour market had reached its speed limit. That was one of the key factors behind the rise in interest rates to 7.5 per cent. But these fears proved unfounded. Despite further modest falls in unemployment, wage pressures subsided, and so did interest rates.

The missing link could well be the influx of young, willing and able immigrants who arrived just in time to save us from higher interest rates. According to the official data, the more than two million migrants who have arrived in Britain since 1997 have almost entirely been of working age - while those leaving this country have tended to be over 50.

That will help with the pensions problem, but our interest here is the effect on wage growth. We have tried to estimate the size of this impact. Based on a simple model, we calculate that given the drop in unemployment, the increase in immigration could have reduced the level of average earnings by as much as 7.5 per cent since 1998.

Some may see this as a negative, as it implies the average wage would be higher today had we not allowed so many new entrants into the UK, But it would almost certainly have also meant much higher interest rates, higher unemployment and far less spectacular gains in house prices.

Whether or not the Bank of England decides it needs to raise rates once or twice more in this cycle will in large part depend on its view of the likely inflation threat posed by the labour market. So far, earnings have remained well contained. But a reduction in net immigration, if not matched by a reduction in demand for staff, would surely lead to higher inflation and higher rates.

So the next time you hear a politician, of whatever persuasion, telling you that they plan to curb immigration in order to preserve your wealth, think carefully about they are saying.

Danny Gabay is a partner in Fathom Financial Consulting. danny.gabay@fathom-consulting.com

All politicians need rules but chancellors get to rewrite them

Economists, like judges, generally agree that politicians need rules. This is particularly true of finance ministers, who, left to their own devices, tend to believe their own hype and end up deep in debt. The Continent has the Growth and Stability Pact, here we have Gordon Brown's medium-term fiscal rules.

These British rules state that the government may only borrow to finance capital expenditure over the economic cycle; and it may never owe more than 40 per cent of the country's wealth.

The first of these rules, the "golden one, is what concerns us here. In plain English, this rule says that as long the government can show its tax receipts will match its current spending on things like running the civil service and public sector wages over the course of the economic cycle, then it can borrow as much as it deems fit to finance expenditure on the future - i.e. on more and better schools, hospitals and roads.

Adherence to this rule, therefore, in effect determines the amount available to the Treasury to spend on public services or to give back to the public in the form of tax cuts.

Until last week, many observers were convinced that the Chancellor was set to break this golden rule, forcing him either to abandon it, raise taxes or cut spending. None of these options would be palatable to Mr Brown. The first would leave British fiscal policy rudderless, the second and third would at best be unhelpful to his next door neighbour's case for a third term.

But last week the Office for National Statistics, the government body, decided to reclassify roughly £500m a year of expenditure on road repair and maintenance as investment, rather than current expenditure. As this goes back to 1998, it, gives the Chancellor around an extra £3bn to play with, which is handy just ahead of an election-time Budget.

There is no suggestion that the ONS was leaned on to make these changes, but the Opposition is understandably crying foul. But then that is why this rule is golden - all of it parts are moveable. Government agencies decide how long the economic cycle lasts and what constitutes capital as opposed to current spending. Not so much a case of moving the goalposts, as of not telling your opponents what game they're going to be playing.