Expert View: Why oil price rises have lost the power to hurt us

Four years on from the 2001 recession, the US economy still appears to be motoring strongly. But euroland, though later into the recession, has failed to mount a sustained recovery. Consumer and business confidence are still relatively weak and output growth remains sluggish. The consensus forecast is that growth will be slower in 2005 than in 2004. A modest pick-up in 2006 is expected, but this is unlikely to do much to reduce persistent high levels of unemployment in the eurozone.

The good news, rarely mentioned, is that inflation is not a problem. That, if you think about it, is quite remarkable. Oil prices are close to their all-time peak and have been high all year. Earlier oil price hikes had a dramatic effect on inflation. In the 1974-75 oil crisis, consumer price inflation soared above 20 per cent in the UK and Italy (and Japan). In 1979-80 the peaks in the UK, France and Italy averaged over 15 per cent.

One of the most striking features of these previous hikes was how much better the crisis was handled in Germany than elsewhere. The Germans suffered from the same inflationary pressures but the peaks in 1974 and in 1978-79 were a mere 6 per cent. The US economy also performed better than most European countries (and Japan), with inflation peaking at around 10 per cent in both episodes.

At that time, only Germany and the US had independent central banks. Their interest rate policy was not in the hands of politicians. It was run by an institution whose first priority was to preserve the value of the currency, not to get re-elected.

The lesson was not lost. In the course of the 1990s, the UK, France and Japan all decided to make their central banks independent. Subsequently, the creation of the European Central Bank applied the same principles to the entire eurozone. This has more than doubled the share of world output in countries with independent central banks, with a benign effect on world inflation.

However, central bank independence is not the whole story. In the 1970s the effect of oil price increases was transmitted through a relatively large and highly unionised manufacturing sector. When prices rose, industrial wages quickly followed, engendering a further round of price increases. The wage price spiral is today conspicuous by its absence. Why?

There are many reasons. From a UK perspective the most obvious change since the 1970s has been the reduction in the power and influence of the trade unions, especially in the public sector. Changes in the law have played a role, too, as has privatisation, and the continuing long-term decline in the manufacturing sector. Similar forces are at work in the eurozone. Manufacturing is now the province of the newly industrialised countries in the Far East, notably China. In those countries there is still a large, untapped pool of labour, which keeps constant downward pressure on wages. The oil price hikes of the 21st century have not led to a wage price spiral in China. Low Chinese prices help to keep world inflation down.

But there may be another cause, closer to home. The collapse of Communism has opened Western economies to competition from Eastern Europe, where wage costs are a small fraction of those in the West. So our capital goes there (Western manufacturing processes are increasingly being outsourced to the East), while their labour comes over here (the Polish ironing lady, the Estonian barista).

A supply of cheap labour from Eastern Europe, and cheap manufactured goods from the Far East, has helped the independent central banks to keep a lid on inflation. Despite the cost pressures from the higher oil price, a credible monetary policy has helped to keep wages down. If the side effect is sluggish economic growth, as the latest forecasts suggest, those who remember the horrors of the 1970s may well judge that a price worth paying.

Bill Robinson is director of economics at PricewaterhouseCoopers