Debunking The Myth of Wage-Price Spirals

I find Andrew Bailey’s regular pleas for wage restraint in the UK extraordinary. As the governor of the Bank of England he holds one of the most privileged positions in the country and earns a salary just shy of £600,000 per year. Meanwhile, the UK economy is experiencing one of the worst cost of living crises in its history with ordinary workers’ wages, adjusted for inflation, well below pre-pandemic levels.

At 7% per annum, wages in the UK are rising sharply; but when accounting for 8.7% inflation, real wages are in negative territory, down by 1.7%. If the average worker in the UK is getting poorer, why then is Andrew Bailey so concerned about a wage-price spiral?
 
We have heard the same lazy message from Irish politicians in recent years too. But there is no sign of a wage-price spiral in Ireland either. Current wage growth this quarter is running at approximately 4.3% with an inflation rate of 6.1%. In real terms, Irish workers are on course to earn 1.8% less than their expected salaries this year.
 
Prior to the pandemic, in 2019 the inflation rate in Ireland was 0.9% and average wage growth was 3.6%. Irish workers gained 2.7% purchasing power that year. But since inflation started rising in 2022 from its lows in 2020, the swing in purchasing power means that most Irish workers are now roughly 5% poorer since the pandemic.
 
Luckily as in most developed economies, headline inflation in Ireland has fallen considerably since its peak 12 months ago. All things being equal, wages are likely to catch up next year as inflation continues to fall.
 
In the US, nominal wage growth since 2020 has averaged approximately 6% per annum. With headline inflation now as low as 3%, wages in the US are growing faster than inflation. This clearly suggests, for now at least, that wages are having much less effect on inflation than a lot of economists previously feared.
 
Historically, wage-price spirals are very rare in developed economies. A study by the IMF earlier this year shows that the largest wage pressures tend to be short-lived lasting just 3 to 4 quarters. During inflationary periods, nominal wages tend to rise fastest at the beginning of the cycle but eventually lose momentum as soon as they catch up with inflation. The IMF finds that in the vast majority of the 100 cases it studied, nominal wage growth stabilises after about 2 years.
 
Interestingly, the report also shows that wage-price spirals were much less prevalent from the 1980s, shortly after the world’s major currencies adopted floating exchange rates in the 1970s. Up to this point, as per the Bretton Woods agreement in 1945, the dollar was backed by gold and world currencies fixed their exchange rates to the dollar.
 
When President Nixon took the dollar off the gold standard in 1971 however, the US dollar lost over 30% of its value and inflation soared to 13% by the end of the decade. Wages which were growing by approximately 6% per annum during the 1960’s rose to 10% per annum in the 1970’s. It might be argued therefore that the more persistent wage-price spiral during that period was strongly correlated with foreign exchange issues which don’t exist in the US today.
 
Bearing in mind America’s huge trade deficits today and the sheer volume of its imports each year, the current strength of the dollar must be a contributing factor explaining the dramatic fall in US inflation from 9% to 3% over the past 12 months.
 
In most developed economies like the US, inflation tends to occur as a result of supply imbalances in energy markets. When oil prices fall, inflation tends to fall shortly after. Having a strong currency re-enforces the downwards pressure on prices.

On the demand side, when labour costs rise too high for too long, businesses cut jobs to stay competitive and wages fall. Similarly, when prices rise too high for too long, consumers cut spending and prices fall.
​
Historically speaking as the IMF paper points out, there are very few cases in developed economies where both wages and prices persistently rise in tandem leading to runaway inflation. In addition to the market forces mentioned above, central banks almost always intervene by raising interest rates to slow the pace of rising prices.  
 
The notable exceptions are Germany in the 1920’s or Argentina in more recent times. The common denominator in both these cases is that Germany and Argentina financed their expenditures by borrowing money in foreign currencies. This exposed their already weak currencies to exchange rate risk. Most developed economies on the other hand have stable currencies given the demand for the goods and services that they export around the world. And by not borrowing in foreign currencies, they insulate their economies from the volatility that often occurs in foreign exchange markets.
 
If, say, the exchange rate between the Argentinian Peso and the US dollar depreciates, more Pesos are needed to pay off dollar debts. Argentina risks going bankrupt unless it can find more money to pay its bills.
 
Why would the exchange rate weaken? If interest rates rise in the US for instance, investors flock to the dollar to pick up higher yielding assets such as US government bonds. This strengthens the dollar causing the Peso/Dollar exchange rate to fall. As more and more dollars leave Argentina, the Peso weakens further. This pushes up the price of imports and causes more inflation.
 
At this stage the central bank has a number of options. It can try to borrow more dollars, default on its debt or print more of its domestic currency to close its deficits. In the vast majority of cases, central banks in poorer countries print money because it’s the least painful option in the short run. Borrowing from foreign investors becomes too expensive and defaulting involves major restructuring of the economy. With their backs against the wall, the printing of money by central banks acts as a quick fix that helps prevent bank runs and ensures essential imports of food, energy and pharmaceuticals are paid for.
 
In the long run of course, as the central bank continues to print money and monetises its debts, an increase in the domestic money supply causes the value of the currency to slide even further. Eventually inflation becomes a self-fulfilling prophecy as people’s expectations of future inflation becomes increasingly unanchored. 
 
Having lost faith in the ability of their central bank to stabilize prices, workers demand higher wages and firms bid up their prices. As firms bid up their prices, workers demand higher wages in response to higher prices. And so the cycle continues. With no end in sight, and as the central bank continues to print money, the result is often hyperinflation. This is what economists fear when they talk about wage-price spirals. In extreme cases like in Argentina and Germany, the end game is usually a collapse of the currency followed by bailouts and a long and painful deleveraging process.
 
With the ‘Brexit-effect’ on exports, rising deficits and stubbornly high inflation, you’d have to wonder given the continued deterioration of the UK economy, if Andrew Bailey fears the worst is yet to come?