Inflation is only a symptom

The vast majority of economic discussion focuses on the wrong indicators. It obsesses over the relatively marginal and misses the truly important.
Take the huge outpouring on the latest inflation figures compared with next to nothing devoted to news on labour productivity. The first is of secondary significance while the latter is a crucial measure of economic health. This is a clear case of muddled priorities.

When it was announced that Britain’s inflation rate fell to 2% in the year to December the story got widespread coverage in the mass media. Yet there are several reasons why the excitement was overdone.

For a start the rate was only slightly down on the previous month’s 2.1%. Indeed inflation had hovered around the same level for several months.

In any case any measure of inflation can only be a rough estimate. Strictly speaking it was consumer prices index inflation that fell to 2% in December. In the same month another measure, the retail prices index, rose from 2.6% to 2.7%. This is not the place to debate which is the better measure. The point here is that measuring inflation is inexact.

However, the key reason for not attaching too much importance to inflation is that it is an outcome, rather than a cause, of more fundamental economic forces. Blaming changes in prices for economic problems is like blaming the associated spots for causing measles or chickenpox. Medical scientists understand that viruses are the cause of such symptoms. Economics, in contrast, is stuck in the Dark Ages with its superficial approach.

This does not mean that inflation cannot have a substantial impact. High inflation can rapidly erode real incomes and savings. It is simply that economic discussion often confuses the symptoms with the underlying cause.

Admittedly some argue that the 2% level is of symbolic importance because it is the Bank of England’s target level. But that simply begs the question of why one of Britain’s most important economic institutions is itself so focused on inflation.

In contrast, labour productivity is a key indicator of economic vitality. As the Office for National Statistics says it “is the main determinant of national living standards”.

Yet when the Conference Board, a respected American think tank, recently published a substantial study of global productivity trends it got little coverage. The discussion seemed to be confined to specialist financial sources such as the Bloomberg, the Financial Times and Reuters.

Admittedly there is a debate to be had about how best to measure productivity. It can be expressed as the amount of output for every job, every worker or every hour worked.

But the principle should be clear. The best measure of economic strength is the amount an economy can get out relative to the amount of effort its labour force puts in. This truth was recognised as far back as 1776 in Adam Smith’s classic study on The Wealth of Nations.

It also follows that dynamic economies tend to enjoy rapid productivity growth. Conversely sluggish economies usually suffer slow growth or even contraction.

In that context it is telling that output per hour in Britain is still significantly below its peak level in the first quarter of 2008. That is in contrast to previous recessions where productivity has usually rebounded rapidly.

There can be no sensible economics discussion as long as it fails to grapple with underlying trends.

This comment was first published today on Fundweb.