THE ECONOMY & THE CITY
Inflationary Gap or Gaffe?
By NICHOLAS DAVENPORT ITAVING been fearful that the budget drama might end in tragedy—the Chancellor over- taxing, over-deflating and pushing private enter- prise into a furious recession—I was delighted to read Mr. Callaghan's Cardiff speech a week ago in which he seemed to be reassuring us all that his budget would not after all be drastic- ally deflationary. The Government's programme, he said, aimed at balancing our overseas pay- ments not this year but 'within a reasonable period of time' and he was sure that the country was united in not wanting to go back to 'the straitjacket of the 1961 [deflationary] policies with all the unfairness and hardship that resulted from creating unemployment in the desperate hope that somehow the unemployed would go and work in the export industries.' For many years I tried to expose the shortcomings and in- humanities of Treasury attempts to close 'an inflationary gap' through monetary deflation. These policies were always badly timed. Both Mr. Thorneycroft and Mr. Selwyn Lloyd applied deflation when the economy was already turning down towards recession, the first even when there was a balance of payments surplus. I would go so far as to maintain that such policies are now completely out of date and unfitted for a modern economy that is intelligently planned and partially controlled from the centre. Yet Mr. Callaghan is now being pressed to repeat the folly—notably by the National Institute of Eco- nomic and Social Research.
An 'inflationary gap' is simply an excess of monetary demand over the amount of physical resources--materials and labour—available in the economy. It is usually caused by incomes rising faster than output and is often at its worst when wages have risen sharply ahead of the productivity of labour. Salaries, including directors' fees and salaries of Members of Parliament, ministers, and the whole Whitehall Establishment, account for just over 25 per cent of the national income against 42 per cent for wages. Hourly wage-rates were rising last year at a rate of about 51. per cent and will be going up this year, according to the National Institute, at the rate of 61 per cent. Some big rises were granted at the end of last year and new wage claims are now being put in to meet the recent sharp rise in prices. A large number of hours reductions have been negotiated or are likely to be negotiated to take effect before the middle of 1966. A cut in hours, the National Institute points out, usually raises wage costs more than the equivalent rise in wage rates and, of course, the wage-drift goes on— through the much-exploited system of overtime-- so that the rise in average wage earnings per week always exceeds the rise in weekly wage rates. There is no denying that we have here the elements of a thorough wage-cost inflation.
The National Institute generally works out the exact inflationary gap which has to be closed and tells the Government how to do it. On this occasion it is unusually diffident. Most deflation- ists argue that in view of the 41- per cent (minimum) rise in government spending, the 61 per cent (minimum) rise in wage earnings, the expected 3 per cent rise in exports and 51 per cent in investment (fer the first nine months) there will be ark excess of demand over output--
on the assumption that output will show very little further rise from the last quarter of 1964. But the National Institute differs from this assessment. It allows for a bigger rise in output— namely some 31 per cent—and thinks that growth will slow down only in the first half of 1966. Nevertheless it estimates that the rise in total demand will be more than the rise in output. In other words, it postulates an inflationary gap and, believing that the Government will want to im- prove the balance of payments in 1966 by at least £300 million, it suggests that it should increase taxation in the budget (over the increase already ordered) by an amount sufficient to reduce final demand (at factor cost) by £200 million. (It generously allows for the fact that the Treasury should be able to reduce government expen- diture abroad by about £50 million and private investment overseas by the same amount.)
The Economist does not agree. It is uncon- vinced, as I am, that an increase in the burden of taxation is the right recipe.
I strongly advise Mr. Callaghan not to follow this lead. If he puts income tax up another 6d. to 8s. 9d. (each 6d. loads the taxpayer with £120 million) or if he raises surtax he will strike at the incentives of the managerial class whose energies Mr. George Brown is trying to enlist in the export drive. If he uses the regulator and puts up purchase tax he will add another £150 million to the consumer cost of living and in- vite another rush of wage claims. The result will be a decline in output, a rise in costs and a flop in exports. Apart from adding further to the grievous tax burdens on tobacco and drink there is only one way to damp down con- sumer demand without raising costs. That is by doubling or trebling the deposits required on h.p. trading. To restrain the home trade in con- sumer durables in this manner might free some resources for the export trade. Finally, if pressure in the labour market still persists the Government should impose the building controls I have been advocating--the easiest controls to administer and the most effective.
To go back now to harsh monetary and fiscal measures of deflation would be to put back the clock. We are trying to modernise Britain and right our balance of payments in a scientific way, not the old-fashioned banking way. We have enough labour and resources to achieve our targets—a 4 per cent growth rate and a 5 per cent rise in exports. But our labour is being hoarded in industries which need to be brought down to scale and our resources are not being properly developed and exploited. Mr. George Brown's department is drawing up a national economic plan which will seek to deploy our labour and resources in a more efficient and economic way. With incredible energy Mr. Brown is also trying to stop the wage-cost in- flation by setting up a wages and prices com- mission to supervise and administer the national incomes policy. It may not work, but it is the only way in which this besetting problem can be tackled. It would be a crime to jeopardise his chances of success by asking Mr. Callaghan to parade in the budget clothes of Mr. Selwyn Lloyd and plunge the whole private sector into
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