The pay message is not getting through

`It is fantasy politics to believe that somehow the money for public sector pay could be found if City fat cats could be penalised'

THE PEOPLE whose job it is to run the economy - Gordon Brown and the MPC nine - must be starting to feel as though they are banging their head against a brick wall.

Virtually every day the Chancellor issues some exhortation to keep pay deals low, stressing that the future stability of the economy rests on our shoulders. The Bank of England's experts have made it plain as pie that too-rapid earnings growth is what triggered the latest rise in interest rates, and will trigger the next one if we don't watch out.

Is the message getting through? The answer has to be a resounding no. For the typical worker, the chain of events is not that higher pay settlements lead to higher interest rates, but precisely the opposite: that higher mortgage rates lead to higher pay claims. Even supposedly sophisticated City analysts criticise the MPC for increasing headline inflation and consequently earnings growth by taking action that increases the cost of mortgages.

However, to run the risk of sounding boring about this, Britain's policy makers are not mad, bad and dangerous. They have a point in harping on about pay at a time when, however patchy it is, the economy is indeed closer to overheating than it has been in 10 years. Two things dear to the heart of most of us depend on wage deals remaining "responsible". They are the amount we pay to buy our homes and the quality of our health and education services.

Start with interest rates. The jobs market is at the heart of the question as to how fast the Bank of England can allow the economy to expand. If it steps on the brakes too little or too late, output hits the inflation buffers and we return to the classic British economic problem of high and rising inflation.

Not only does inflation make the economy less efficient and account in part for lower levels of productivity in the UK, it is also very unpopular with voters. Governments that see inflation rise during their term typically lose the subsequent election. Inflation is a fraud on anybody with savings, and on people on low and fixed incomes - in other words, most of the population.

The catch is that those inflation buffers are reached at an uncomfortably high level of unemployment. Economic expansion over the course of the cycle can reduce unemployment so far but no further, leaving a high residual or "structural" element of joblessness. As yesterday's figures suggest, even a jobless rate as high as 6.4 per cent (on the superior survey-based definition - it is 4.8 per cent on the claimant count) seems incompatible with a stable level of earnings growth.

Not only is this far higher than the 5 per cent or so the US economy seems able to achieve now for its "non-accelerating inflation rate of unemployment", or NAIRU; it also does not include the many people who have simply given up the struggle of looking for work and withdrawn from the labour force. The Employment Policy Institute estimates there could be as many as 1.4 million discouraged workers, compared to the 1.8 million counted as unemployed by the survey.

Among some economists and certainly many union leaders, the notion that structural unemployment is so high - or even exists at all - is controversial. For example, in the US the firebrand former Labor Secretary, Robert Reich, has criticised the Federal Reserve for not allowing growth to accelerate further from its 5 per cent annual rate in order to trim the numbers out of work - and the US has 4.3 per cent unemployment. Certainly in the UK there are critics of the Bank who challenge the notion that the economy has already reached that structural bottom line.

In a paper presented at a recent conference, John Philpott, director of the EPI, ran through the arguments in defence of the Bank. The independent think-tank puts Britain's NAIRU at somewhere around 7 per cent and applauds the Bank's pragmatism in allowing unemployment to fall as far as it has before tightening monetary policy again. As he noted, we do not have a tight jobs market in the sense that it is a sellers' market - relatively few of us can be confident that if we lose our job we will stroll into another on equally good terms. But we have reached the limit of the economy's ability to grow and create jobs without triggering inflation.

He argued that we need a strategy for "making pay work" as well as "making work pay". It is a mistake to believe that the flexible labour market, with weaker unions, does not create a going rate of settlements. Unions, he said, justify higher claims for their members by pointing to fat cat pay - a hard argument to overturn, morally speaking, even if it doesn't amount to a hill of beans in terms of the impact on the economy.

Employers, meanwhile, tend to match what their competitors are paying and justify it by saying it is fine for wage growth to match productivity growth. At the level of an individual company this is just about excusable, although it implies that none of the productivity gain goes to profits and investment. At the level of the economy it is dreadful. Productivity gains are not entirely the result of the sweat of workers' brows. Investment in new technologies, management and developments external to the company such as more competitive markets also contribute.

As Mr Philpott put it: "The fashion for linking pay to productivity is therefore a classic case of business short-termism - not good for consumers, harmful to competitiveness and damaging to long-term performance." Instead, earnings growth should be limited to long-run productivity growth across the economy plus the inflation target - in other words, something under 4.5 per cent.

One can sympathise with the Chancellor being unwilling to spell this out more forcefully than his vague exhortations to be prudent and responsible. After all, not only is he already unpopular with the unions over public sector pay and the minimum wage, but he can also see how much criticism the Bank of England has come in for.

But Mr Brown has a more urgent reason for desiring slower growth in earnings. Public spending control depends on being able to keep public sector pay growth low. If private sector earnings take off still further, the public sector will find it harder and harder to retain and attract staff, and discontent will spread. He, as much as anyone, wants a high-quality health and education service. He can't deliver it if the pay gap widens.

It is fantasy politics to believe that somehow the money for public sector pay could be found if City fat cats could be penalised. Even the London partners of Goldman Sachs are not wealthy enough to fund a 5 per cent rise across the public sector.

Of course, if those of us in the private sector are willing to earmark an income tax increase of, say, 3p in the pound out of our expanding pay packets to boost teachers' and nurses' pay, that is another matter. But, oddly enough, it is not an option the critics of the Chancellor and the MPC have been canvassing.

d.coyle@independent.co.uk