June 2000
 
1 BACKGROUND

This commentary has been prepared as an independent second opinion on the Report on Inflation commissioned from Mr Michael Parr by the Finance and Economics Committee.  The comments contained in this paper consist of a synthesis of the views of three economists with knowledge of the island.  The authors of this paper have neither sought, nor been offered, remuneration for their views.

The Report on Inflation consists of a somewhat pedestrian analysis, which, whilst providing States members with the textbook basics, pays insufficient attention to the specific issues that affect price formation in Jersey. The Report contains nothing that has not been said previously to States members, and some matters that we feel the Report might usefully have addressed were not.  For example the Report does not address fiscal policy and the various fiscal subsidies that stimulate demand, nor does it explore at any depth the “crowding-out” effect of a dynamic leading sector such as financial services.  The Report also pays insufficient attention to an issue that is absolutely central to the island’s future, namely whether or not to apply controls over the island’s continued population growth.

Any attempt to understand why Jersey’s economy has for many years been prone to inflation rates that significantly exceed those in the UK, must begin with recognition of the political nature of the island’s inflationary problem.  The problem stems from the deliberate policy of the States, acting through its Finance & Economics Committee, of maintaining high rates of growth in order to serve the interests of the island’s disproportionately influential business sector. We are not, therefore, optimistic that the current debate will lead to the implementation of effective counter-inflationary measures.  Past experience suggests that many States members do not understand the nature of inflation or its causes and, faced with the intense lobbying from pressure groups within the business community, would not be prepared to endure the political unpopularity that would inevitably arise from a sustained counter-inflation programme.  They will instead opt for populist, easy-win measures such as targeting public sector pay increases, and avoid the more important issues of reducing excess demand in the island’s economy and tackling imperfect market conditions (ie cartels, oligopolies and monopolies) on the supply side.

1.1 Methodology Issues

The methodology used in the compilation of the Jersey retail prices index (RPI) is similar to that used for its UK equivalent.  The index received a clean bill of health from the UK Office of National Statistics in the early 1990s, and improvements agreed by the Joint Advisory Council and implemented by the Chief Adviser’s Office have created a modern index suited to the needs of a small island economy.

On the specific issue of sample sizes raised by Mr Parr, we can advise that tests undertaken between 1992 and 1995 indicated that increases to the range and sources of the items sampled for the RPI basket had nil or minimal impact on the index results at that time.  The conclusion drawn from those tests was that the majority of small retail outlets were price-takers rather than price-makers, and that there was little – if any – genuine price competition between the larger retailers and between service providers.

Whilst sharing Mr Parr’s desire for more statistical data, we recognise the resource implications of collecting additional data sets, and note that statistical data-sets on the micro-scale of Jersey can be unreliable indicators unless considerable resource is expended upon producing them regularly and frequently.  This particularly applies to trade data, which is not collected by Jersey Customs, and which would be inordinately expensive to prepare. We therefore conclude that it is preferable to concentrate the limited available resources on preparing a few indicators to very high standard.

1.2 The Jersey / UK differential

The divergence between the rates of inflation in Jersey and the UK considerably pre-dates the period referred to in the Report on Inflation.  The divergence is not a new phenomenon.  We therefore do not share Mr Parr’s view (page 10, paragraph 40) that the “Jersey RPI has, at least superficially, tracked that of the UK reasonably close over time.”  Obviously there is a relationship between price changes in the UK and Jersey, but the latter’s index has consistently and over a long period shown a significantly faster rate of growth than the UK index.  This differential is evident from the figures below relating to the period 1990 to 1996, which demonstrate that the Jersey index rose at a rate 36 per cent faster than the equivalent price change in the UK over that period  (see table 1 below).  Clearly there are specific, local features in the island’s economy that cause the prices of goods and services – particularly the latter – to rise at a faster rate than those of its principal trading partner.
 
  Table 1 : Jersey / UK index movements – 1990 to 1996

      Jersey RPI UK RPI

  1990  100.0  100.0
  1991  109.1  108.2
  1992  116.5  112.5
  1993  122.5  114.7
  1994  126.1  117.3
  1995  130.0  121.4
  1996  133.7  124.7
  source : States of Jersey Statistical Review (1997)
 
 

2 DEMAND-PULL NOT COST-PUSH

Previous analyses of the Jersey / UK inflation rate differential have demonstrated that the effects of cost-push pressures are relatively minimal, and that the differential arises from local demand-pull factors compounded by the absence of price competition.  This is most clearly seen in the services sector, which almost by definition includes a high content of local supply.   Analyses conducted in Jersey and in Guernsey during the early and mid-1990s showed that the price of locally supplied services consistently rose at a faster rate than that for goods imported from the UK and France.

The sustained increase in consumer demand in Jersey arises from a variety of factors, including –

? population growth and associated demographic factors;
? rising real incomes;
? high employment levels and general job security;
? the increased proportion of the total labour force engaged in high paid financial services related activities; and
? ready access to low cost credit.

Attitudes also play an important role in the determination of prices.  Unsatisfactory as it might seem, there appears to be little price consciousness on the part of many Jersey shoppers, who appear to place issues of convenience (eg access to parking, range of brands stocked, speed of service) ahead of price issues.

2.1 Population Growth

Population growth has been a major stimulus to demand over the past half-century.  Since 1950 the island’s population has grown by approximately 32,000 persons (60 per cent) - an annual average of about 650 persons.  The increase over the past decade is estimated at about 6,000 (7 per cent).    This rise in the resident population has been accompanied by an even faster rate of growth in the number of households on the island, which has further increased the degree of demand pressure on the housing market.  The discrepancy between the growth rates of resident population and household numbers is explained by the long-term trend towards smaller household sizes (for example the number of single person households doubled between 1971 and 1996).  Demographic factors play an important part in stimulating the growth of demand, and will continue to do so unless the States takes firm action to slow the rate of immigration.
 

2.2 Rising earnings, job security and the ‘culture of contentment’

The majority of the economically active population has enjoyed a sustained increase in real earnings (ie earnings growth adjusted for price inflation).   Over the period 1990 to 1999 real earnings increased by an annual average of 1.6 per cent, but this figure disguises substantial differences between the main sectors of the economy.  Earnings grew fastest amongst employees in the trust and company administration companies, but rose at below average rates amongst hotel and restaurant employees, and in the public sector.  The average earnings figures understate the true rate of growth of earnings in the financial services sector because it does not include the year end bonuses payable to bank employees and others employed in the finance sector.  These bonuses represent a significant proportion of the total value of the remuneration package, and (anecdotally) appear to have risen in value in recent years.

Unemployment is not an issue in Jersey.  Such unemployment as has occurred, for example during the early 1990s, was entirely frictional in nature (ie people moving from one job to the next with a brief gap of less than three months in-between) and demand for labour has consistently exceeded supply for many decades.  We regard this as a sign of policy failure arising from a political unwillingness to address the widespread inefficiency of labour use in many sectors.  This issue is considered at greater length in the section below on imperfect competition, but it is important that States members understand that any short-termist move to liberalise the supply of labour in response to pressures from the business community will inevitably place increased pressure upon the island’s limited resource, particularly housing, and thereby stimulate further long-term inflationary pressures.

Rising affluence and job security have led to a significant change in attitudes.  A large proportion of the island’s workforce is not really troubled by inflation.  Earnings growth has enabled a constant rise in most people’s standard of living; property values have increased owner’s levels of perceived wealth; and employment prospects are virtually without risk.  What were once the consumption patterns of the better-off have become the norm rather than the exception, and improvements in material well-being have stimulated an apparently boundless appetite for self-gratification and convenience.   The American economist JK Galbraith described this change in social attitudes as follows –

“In past times, the economically and socially fortunate were, as we know, a small minority – characteristically a dominant and ruling class.  They are now a majority . . . They will be called the Contented Majority, the Contented Electoral Majority, or more spaciously, the Culture of Contentment.”

In such conditions, price consciousness takes second place to issues of convenience and affordability (a function of earnings and credit availability).  The minority that has not benefited from this rising affluence remains highly price conscious, but has no power to influence prices, and their situation deteriorates progressively as inflation erodes the value of their earnings.
 

3 Imperfect Competition and the Absence of Anti-Trust Legislation

The lack of price competition in sectors ranging from retail distribution through to the printed media and advertising has exacerbated the impact of supply / demand imbalances.  The absence of effective price competition restricts the opportunity for Jersey consumers to benefit from lower prices and price deflation to the same extent as consumers in the UK.

We doubt that there is sufficient support amongst States members to mount an effective legislative campaign against the cartels, oligopolies and monopolies that prevail in many sectors of the island’s economy.  It is also unlikely that there is sufficient anti-trust experience and capacity within the island’s civil service and judiciary to undertake the massive task of unpicking these restrictive practices.  Such a task would require considerable input from external sources, and would therefore be an expensive and contentious process. States members are exposed to extensive lobbying by trade organisations such as the Chamber of Commerce and the Jersey Hospitality Association and it is the latter organisations that set the agenda in the local media.  It would consequently be a politically daunting challenge for individual members to take on.

Imperfect market conditions apply to most sectors of the island’s economy.   In some cases monopoly conditions are almost inevitable, for example where there is insufficient demand to support more than one supplier, eg water distribution.  In such situations there is a need for robust regulation to prevent abuse of monopoly conditions.  Such regulation has never been applied in Jersey, and if it were applied it would probably require the break-up of the vertically integrated monopolies that control virtually every stage of the production, marketing and distribution of key products.  A number of businesses illustrate the type of vertical integration that would generally be regarded as inhibitive of competition -

? The Jersey Electricity Company has an unregulated monopoly over electricity production and distribution, and has a large market share in the electrical installation, electrical repairs, and electrical goods distribution markets;
? The Jersey Gas Company has an unregulated monopoly over gas production, distribution, installations.

? The Guiton Group has monopoly control over local news production, advertising, printing, newsprint / magazine wholesale and retail distribution;

? Ronez Limited has a monopoly in the import, production and distribution of cement, aggregates, road making materials and related contracting services, and the production of cement products.

Other markets are dominated by oligopolies and cartels that avoid price competition, eg grocery distribution, fuel oil and bottled gas distribution, building materials, motor spirits, soft drinks and alcoholic beverages, and which are not subject to any form of legislative control.

Imperfect market conditions are a major problem for the island.  Lack of competition prevents downwards pressure on prices, and encourages inefficiencies of resource use and poor service standards.  The example of the motor spirit cartel operated by the Jersey Motor Trades Federation has previously been used to illustrate how imperfect markets lead to the inefficient use (ie over–use) of resources.  But a similar argument can also be applied to many other sectors in which the lack of robust competition has prevented the shake-out of inefficient businesses that has occurred elsewhere.  Some might regard this facility to sustain inefficient and poorly managed businesses that would not survive in a larger economy as an attractive feature of the island, but there is an important flip-side.  The majority of these inefficient businesses create little in the way of profit and are relatively resource intensive.  They use space and labour (frequently low or semi-skilled migrant labour) that could be used more efficiently in other ways.  In short, the lack of effective price competition has adverse implications in respect of prices and the demands placed upon the island’s scarce resources.
 

4 Fiscal Stimuli to Domestic Demand

The island’s fiscal policy contributes significantly to price inflation by subsidising demand for housing and consumer goods.  High and rising levels of consumer spending power combined with low tax levels and indirect subsidies in the form of tax relief on the cost of loans inevitably fuel inflation, particularly in a non-competitive and supply constrained economy.

The housing market illustrates the long-term price effects of consumer subsidies.   Subsidisation of owner-occupation has been the main plank of the island’s housing policy for several decades.  The subsidies come in a variety of forms -

? unlimited tax relief on mortgage interest payments;
? low interest charges on States loans;
? low cost loans to bank employees (untaxed as income
in kind by the Income Tax Department);
? sales of starter homes at below market price.

Inevitably the value of this considerable volume of subsidy has been capitalised into rising land values and construction prices, thereby having an impact upon both the owner-occupied and rental markets.  The inescapable outcome of decades of housing subsidy is that housing has become less, rather than more, affordable, leading to increased dependency on the part of many tenants and owner-occupiers on subsidy of one type or another.  In other words the States have pursued a confused and utterly self-defeating housing policy for decades.  The extent of confusion about the causes of inflation was revealed in the mid- 1990s when Deputy Len Norman, the then President of the Housing Committee, (wrongly) told States members that Deputy Alan Breckon’s proposition to cap mortgage interest tax relief would “contribute to a rise in the cost of living”.     In part this confusion persists because so many States members have failed to distinguish between the ‘cost of living’ (a measure of the amount of money required to sustain a defined basket of expenditure) and ‘the rate of inflation’ (the rate of price change over time).

The States of Jersey has no control over monetary policy therefore the only means of controlling demand lie with fiscal measures and with the Regulation of Undertakings and Development Law.  However, the island’s current fiscal policies do nothing to mitigate the inflationary effect of high levels of consumer demand.  In fact they achieve the opposite effect.   Given the microscopic scale of the island’s economy it would make sense to dampen consumer demand through fiscal measures, and preferably remove excessive spending power entirely.  This is not by any means as radical a measure as some might think.   There are several examples of small, hydrocarbon exporting states that have adopted policies to safeguard their economies from excessive consumer expenditure by withdrawing a significant proportion of their oil based revenues for investment in externally managed funds (cf the Alberta Heritage Fund, the Norwegian Petroleum Fund).  Other states have taken this process a stage further by donating a proportion of their revenues to external beneficiaries (cf the Kuwaiti Fund for Arab Economic Development).   The use of fiscal measures to mitigate the economic impacts of excessive local demand may well be an anathema to the majority of States members and the public, but the unpalatable fact is that the only real cure for demand-pull inflation is to take steps to reduce demand.
 

5 Prestige Projects and Persistent Over-heating

The continued and high levels of investment in capital goods – principally private sector office blocks and prestige public sector construction projects such as the airport, marina, and the Waterfront development programme – have contributed to the high level of inflation.   The one period in recent years when the level of over-heating in the construction sector reduced considerably, ie between 1990 and 1993, offered the States an opportunity to rectify the demand / supply imbalances in the labour and housing markets.  Instead the Finance & Economics Committee responded to the supposed “crisis” at that time (ie a rise in registered unemployment from about half of one per cent to about two per cent, and a fall in nominal GDP growth rates from 14 per cent to 3.5 per cent between 1990 and 1992) by licensing new businesses and advancing capital expenditures on prestige projects.  This was the wrong response to what was potentially a benign situation.  The demand that F & E injected into the island’s economy inevitably refuelled both price inflation and population growth, and an opportunity to calm the island’s long-term over-heating was lost.

We agree with Mr Parr’s comment (page 13, para. 58) that the States needs to learn to distinguish between expenditure that is financially affordable and expenditure that is economically desirable in the wider macroeconomic context.  This does not rule out all public sector capital projects, but it does place greater emphasis upon selecting the appropriate timing for capital expenditure, and upon identifying States projects that achieve distinct strategic goals, eg urban regeneration or improved delivery of core services such as health and education.  Public sector expenditure on prestige projects such as the marina or airport makes no sense.  Had these projects been necessary or viable at the outset they would have been attractive to private investors.
 

6 The Cuckoo in the Nest

The strong inflationary pressures that have manifested in the island’s economy for decades are indicative of long-term structural adjustments within the economy.   The rapid growth of the financial service sector has provided a large proportion of the resident population with high levels of net disposable income and job security.  As a consequence purchase decisions are based more upon the issue of affordability than upon the actual price.  This particularly applies to the housing sector, where lending multiples of six (even seven) to one are available to salary earners.  The long-term effect of inflation is that traditional low cost, low value-added activities such as tourism, the pre-existing light manufacturing activity, and to a lesser extent agriculture, have inevitably been “crowded-out” by the financial services sector.  Mr Parr comments (p 17) in his report that the Jersey / UK inflation differential “will certainly be storing up more problems for the future associated with loss of competitiveness (which) in turn may have led to a possible over-dependence on the financial sector . .”   We are less hedged in our views.  In our opinion the island is already over-dependent upon financial services (and has been for many years), and the other sectors are already uncompetitive (and have been for many years).

The States of Jersey has avoided discussion of the “crowding-out” issue.  Maybe this is because States members either do not understand the issue, or prefer to avoid its unpalatable implications. The oft-repeated strategic commitment to the maintenance of a balanced and diversified economy is a hollow mantra that means nothing in the context of an economy that is dominated by, and dependent upon, financial services, and which is neither balanced nor diversified, and has not been for many years.
 

7 Inflation Targeting

Inflation targets were considered in the 1990s, but were not properly pursued then and won’t work now unless radical measures are taken to reduce demand pressures.  States members may huff and puff about their intentions to control inflation, but they do not (thankfully) have control over monetary policy and they have thus far shown no inclination to use fiscal and regulatory measures to dampen demand.  The issue of inflation targeting therefore is largely an irrelevance designed to give politicians a stick to hit public sector workers with during annual pay negotiations.   The public sector has been used as an example for wages policy for many years.  This cheap political populism plays well to saloon bar journalists and the Chamber of Commerce gallery, but has inevitably led to a drain of talent and experience from the civil service.  If States members want to display their machismo by setting targets for wage negotiations why not use the finance sector as a guide for inflation targeting?  As lead economic sector the banks and accounting houses set the pace in the economy.  Let the bankers, lawyers and accountants show the way by pulling their belts in a few notches.
 

8 Population Growth

We are greatly concerned about the political pressure to reduce the scope of, or entirely abolish, the Regulation of Undertakings and Development Law.  We are aware that a number of influential States members see no virtue in restraining the island’s population growth, but do not have sufficient courage in their convictions to test them with the electorate.  The Regulation of Undertakings and Development Law is the most direct means available to the Finance and Economics Committee to dampen the growth of demand for labour.  The fact that this Committee has in the past avoided applying this law in a sustained and coherent fashion does not negate its potential usefulness as an effective mechanism for tackling demand pressures in a supply constrained labour market.

Rising demand for labour has been the principal cause of the island’s population growth in recent decades, and population growth has been amongst the major stimuli of demand pressures, particularly in the housing sector.   Liberalisation of the controls over demand for labour would almost certainly increase the rate of population growth and further exacerbate the existing shortages in the housing markets.  Further growth of the labour force will also translate into increased demand for consumer goods and public services.  It should therefore be recognised that population growth creates inflationary pressures, particularly in an economy that is constrained by labour and housing market bottlenecks.  In the past the States has bowed to pressure from the business community by allowing the population level to rise more or less constantly through inwards migration.  This policy has provided a source of cheap (but largely semi- or unskilled) labour, and it has also ensured that demand for high-cost rental accommodation has always exceeded the available supply (thereby pleasing the island’s landlord and property development constituencies).  The concomitant rising population level has provided local retailers with a constantly expanding market for goods and services.  The outcome?   Inflation.  Overcrowding.  Environmental and social pressures.  A disgruntled electorate.  But killings to be made by landlords and property developers and a business community that faces none of the competitive pressures that drive progress elsewhere.

In short, liberalisation of controls over the demand side of the labour market provides an easy route to growth of business turnover and profitability, but will not yield a sustainable solution to the island’s inflation problem.  Jersey’s politicians must therefore make a straightforward choice between the long-term interests of the island and the short-term interests of the politically dominant rentier and business classes.
 

9 Summary

There are no quick fix solutions to Jersey’s inflation problem.  The long-term impact of the Jersey / UK inflation gap has been a loss of competitiveness in key sectors, ie tourism, agriculture and light manufacturing and assembly, and the creation of a situation in which the island is over-dependent upon its role as a tax haven and offshore finance centre.  The island’s demand led inflation arises from a combination of population pressures, high disposable incomes, supply side bottlenecks, lack of effective competition, and a fiscal policy that exacerbates rather than reduces excess demand. The only solutions to this problem lie with taking effective measures to dampen demand and with the introduction of competition into the island’s economy.

These are long-term measures that will generate considerable political resistance from local vested interests.  There are therefore few grounds for optimism about the States of Jersey actually being serious about the ‘war on inflation’.  The politically populist measures proposed to date, eg abolition of import duties on motor spirits; abolition of the controls over demand for labour; and the continued focus upon public sector wage restraint, are counter-productive, self-defeating and indicative of a continued confusion about the causes of inflation. It seems unlikely to us that the island’s decision makers will be sufficiently determined to sponsor genuinely counter-inflationary measures such as the abolition of tax relief on interest payments and other subsidies; tighter controls over demand for labour; and strong measures to tackle anti-competitive practices.
 
 

June 2000