Are the monetarists back in control - and out of control?

Just what is going on with the economy? The manufacturing sector is technically in recession. The claimant count rose marginally last month whilst the trend rate of employment growth has eased off rather alarmingly. Earnings appear to be rising at an unhealthy rate and Gordon Brown says that, if this carries on, all bets are off. Sterling is still overvalued even though the hawks at the Banks of England are hiking up interest rates.

Wage inflation is the Government's alibi for its welfare-to-work strategy failing. Read Gordon Brown's words from his Budget speech this year: "Welfare to Work reforms must be complemented by responsibility across the economy...but if wage bargaining proceeds in the same short-termist way as in the past, then growth this year could slow to 2 per cent." Already, the Government's best backstage brains are being tasked to find out how the New Deal can be insulated from any economic down-turn.

Everyone who remembers the last 2 recessions will recognise a dismal pattern: an over-valued currency, interest rate rises, inflation growing. Ominously, this pattern looks like repeating itself. But the spectre of recession is hanging needlessly over the economy.

Economic downturn and the consequential growth of unemployment is not caused by one single factor. In the background are long term structural changes like the effect of technological advance or the results of social inequality - the trend towards fewer people doing more work.. But recession is usually triggered by a combination of poor international competitiveness, mistakes by Government, and the effect of external shocks.

Structural problems are worsened by unexpected events or the effect of political interventions. For example the re-unification of Germany in 1990 placed huge stresses on the public expenditure and capital formation capacity of the former West German economy. The combination of Germany's fiscal and monetary prudence and its central role driving the western European economy caused recession throughout the Continent. Similarly, a world recession was precipitated in 1974 by the oil exporting countries of the OPEC who raised the price of oil by 400%. With Japan now officially in recession, the equivalent shock of 1998 could be the globally destabilising effect of melt-down in the Asian economies.

Despite this, a recession is not inevitable. What is alarming, however, is the actions of Government and the Bank of England. Both the Bank and Treasury are over-reading the significance of wages data. This is wearisomely familiar territory for use. After years of arguing that "unemployment figures" didn't measure unemployment, we've now concluded that average wage data doesn't really reflect true changes in the levels of earnings growth.

This is partly a result of big bonuses in the financial services sector where average earnings have risen by just over 10%. It is also caused by profit related payments working their way into the 1st quarter's data. These payments are irregular or caused by newly cyclical behaviour. So they cannot be adjusted for by any of the traditional tools of statistical seasonal smoothing.

There is also a significant effect caused by changes in the labour market too. More people are working full-time and many are working more over-time. So it is an arithmetic truism that average earnings will increase.

Worse still, the earnings survey itself is unreliable. The data is drawn from a sample which is getting rather old and unrepresentative. Although the Office for National Statistics has started to fix this problem, the fresher figures will not come through for a few months.

None of these features are an indication that wage settlements are getting out of hand. Indeed labour productivity continues to increase whilst unit wage costs have grown at a slower rate than average earnings. So companies are paying extra because they can afford it. There is not much the Government or the Bank can do to stop people working harder and earning more.

Potentially, this growth in spare cash could be inflationary as income flows lead to greater personal consumption which cannot be met from the domestic economy. But the basic and simplistic premise that wage rises are directly leading to retail price inflation is not justified.

And this message is important because the theoreticians on the Bank's now infamous Monetary Policy Committee (MPC) are jacking up interest rates. Bizarrely, the MPC thinks it is choking off inflation yet the Committee's decisions are actually worsening the inflation outlook. Apart from some food items which have recently risen for unseasonal reasons (bad weather), many retail prices are falling.

However, the headline inflation rate, which includes the cost of housing, has started to rise mainly because mortgage costs have risen. Why? Because the Bank's zealots have increased interest rates.

If the UK is to avoid a recession, the Bank and Treasury need to re-think their economics and drop the orthodoxy.