The class warriors at the Bank of England

It’s school holidays in London next week, so Free Lunch will take a break — we will be back in two weeks’ time.

Last week I posted a tweet in reaction to a BBC interview in which Bank of England governor Andrew Bailey called for workers not to chase the current inflation with high wage demands. Bailey said that “we do need to see a moderation of wage rises, now that’s painful. I don’t want to in any sense sugar that, it is painful. But we need to see that in order to get through this problem more quickly.”

I wrote: “Genuine question: why does the governor of the Bank of England encourage restraint in wage demands but not call for restraint in businesses’ attempts to protect their profit margins? Intellectual bias, ideology, greater resignation wrt price- than wage-setting, or something else?”

My question clearly hit a nerve — it was my second-most popular tweet ever (which is not saying much, but it’s all relative). And I was hardly alone in pointing out the awkwardness of telling workers to suck it up — while at the same time raising interest rates during what the BoE itself projects to be a historic squeeze on household incomes. By the weekend, the governor had taken flak from all sides, including 10 Downing Street.

Do share your own reactions — but those on Twitter, at least, fell into some clear categories. On the “move on, nothing to see here” end of the spectrum were those who said Bailey’s remark was not so much an intended message as a response to the interviewer’s question, which did indeed ask about wages only. But I do not think this is right, since the governor emphasised this message at the central bank’s press conference earlier in the day, and chose to repeat it in at least one follow-up interview. He meant to call for wage moderation.

A larger group, at the other end of the spectrum, thought the answer was obviously ideology. Their replies circled around the theme that of course a banker (even a public sector banker) paid about £500,000 a year would want to put workers in their place.

But that is too facile, too. The BoE is duty-bound to fight inflation, and I would say Bailey’s view on how inflation could take off is standard among economists. While he declined to identify a “wage-price spiral”, the worry he expressed was that when the price of imported energy and goods goes up — a terms-of-trade shock in the technical jargon — that will reduce average living standards. If workers then try to make up for the imported inflation that eats into their wages with higher wage settlements, and businesses pass on their higher wage costs in the form of higher prices, inflation can become entrenched in the domestic economy even after the terms-of-trade shock wanes.

But there is something incomplete in this analysis, which is what my tweet was getting at. The wage-price spiral depends on not one but two mechanisms: wage demands trying to catch up with price rises and price increases to pass on rising wage costs. Calling for wage moderation can only be read as an attempt — or perhaps a wish — to weaken the first mechanism. But what about the second?

Theoretically, you can prevent a wage-price spiral by disabling either of its two links: workers’ attempt to protect (or increase) their real wage, or businesses attempt to protect (or increase) their profit margin or real return. In other words, you could prevent a terms-of-trade shock from creating domestic inflation by forcing business owners to take the hit from higher imported input prices (and wage rises enough to cover the related consumer inflation) in a compressed profit margin. And in fact yesterday the BoE’s chief economist Huw Pill made sure to mention real profit margins alongside real wages.

An instinctive focus on wage demands and neglect of profit margins echoes the eurozone’s obsession with “unit labour costs” (the wage costs per unit of output produced) a decade ago. Then, the perceived imperative was to boost “competitiveness”, but nobody ever looked at whether “unit capital costs” (which can be defined in an equivalent way) should or could be squeezed instead.

So why does Bailey, and many with him, only focus on the wage-setting side of the vicious circle, and not on the price-setting side? He could, in principle, have said something like: “I know this will be painful for businesses, especially after the pandemic, but we do need to see a moderation in their price rises. I don’t want to in any sense sugar that, it is painful. But we need to see that in order to get through this problem more quickly.”

In terms of the theoretical model, assumptions about how wages are determined have no lesser status than assumptions about how prices are set. That is to say, there is no theoretical reason to “take as given” how companies set their prices (to maintain their prices, say) but think how wage negotiations play out is amenable to a central bank’s attempt to influence expectations, which is presumably what Bailey was trying to do. This is true even if that management of expectations amounts to a threat: moderate your wage demands or we’ll raise rates even more! In theory, after all, he could have threatened businesses instead: let your profits be squeezed rather than raise prices, or we’ll increase your borrowing costs!

A better answer would be empirical: that a central bank’s words are more likely to influence wage-setting than price-setting. But this is surely not demonstrably true. Indeed, it may not be true at all: it is a particularly odd belief in an economy such as the UK’s, which has little co-ordinated wage bargaining compared with the rest of Europe.

So could it be that trying to browbeat workers rather than managers into moderation is not necessarily thought to be easier, but less harmful if it succeeds? A lower profit margin could, in theory, discourage investment, and a person could logically believe that less investment is worse than lower real wages. And this puts the question in the correct light: the crux of the matter is really distributional. Who bears the cost, in terms of their real income, of a negative terms-of-trade shock — wage earners or business owners?

I find the investment worry hard to credit. Over the past four decades, the labour share of national income has gone down in most rich economies, and the capital share has gone up (they have been fairly constant in the UK, however) — but investment rates have largely fallen rather than risen. So would investment really fall if labour manages to boost its share somewhat? In any case, a central bank that is really worried about investment can counter squeezed profit margins by lowering borrowing costs — in other words, the opposite of what the BoE now aims to do.

My best guess is simply that there is a blind spot in most economic policymakers’ mental model of the economy. It is so ingrained to ask how wage demands affect inflation that it is easy to miss the equivalent question about margin and profit protection. This is, I suppose, ideological in the sense that it unwittingly frames the problem so that the plausible answer favours the interests of one economic class. But economic class is a concept that has been largely exiled from mainstream economic debate for a long time. As I wrote last year, that is changing. The reactions to Bailey’s remarks — which would have been unexceptional not long ago — show that economic policymakers can no longer ignore once-outmoded questions of class conflict.

Other readables

• My colleague Gavin Jackson (whose new book on money you should read) draws lessons for the monetary system from Sumerian cattle farming.

• Euro bond markets are getting carried away in their reaction to the European Central Bank’s messaging.

• The IMF gives an update on the most advanced projects around the world for central bank digital currencies in a new report.

Numbers news

• The European Commission has released its latest economic forecasts, downgrading its projection for 2022 growth in the EU to 4 per cent.

​Letter in response to this article:​

​Curb profit margins not workers’ wages / From Professor Louis Brennan, Trinity Business School, Trinity College Dublin, Ireland