Lots of people have responded on this. A couple of notes

  1. Its quite clear how one could get into a bit of trouble if nominal wages declined relative to nominally sticky debt. You still have to say something about the other factors of production and the terms of international trade but its certainly conceivable that you can get stuck in a trap
  2. This same argument is harder to see through with falling real wages driven by an increasing price level.
  3. Key in this is what is happening to income shares at the margin. If real wages are falling against rising prices this suggest that income shares are shifting. Demanders are bidding up the price of goods yet the per unit revenue is not flowing through to labor. It must be flowing through to some other factor. The question then is why does this factor not increase in supply and thereby drive up the marginal product of labor.

If this is driven by say oil then the answer in most countries is (on first blush) obvious. One cannot simply increase the supply of oil as it depends on having access to geological deposits. Thus as the price of oil is bid up there is no immediate reaction to increase the supply of oil and thus increase the marginal product of labor.

However, suppose the answer is that the margin is going to factory owners. Now we have a quandary. Why do factory owners not respond by increasing output rather than simply letting demanders bid up the price?

Now, I do not really have a good sense for what is going on in the UK, but I am skeptical of the notion that there is a massive supply shock. It could be but I need more. Just asserting this feels empty. One should be able to see most supply shocks and so if the supply shock is not obvious a story should be in order.

My first, guess – and it is a almost a pure guess – is that what is happening is related to trade and finance. .

Here is one scenario:

There was huge borrowing by British households to finance a construction boom which was driven in turn by a land price bubble. The land price bubble collapsed which collapsed the construction boom. British households now have to repay their debts.

To do so they have to move from construction into something that their creditors want to buy. Say manufactured goods. If their creditors are overseas this will require that the British Pound decline rapidly in value.

However, suppose at the same time there is an enormous increase in international demand for British Sovereign debt as a result of instability in the Eurozone. This buying of British sovereign debt props up the Pound and keeps it from falling.

Now, British households have no way to repay foreigners. That gives us the sustained depression in the British economy. They need to repay debt, but they cannot repay it because the Pound will not adjust.

Yet, now we must ask where the inflation is coming from. I know people will be tempted to say “The Bank of England” but there is no immaculate inflation. It is not as if the Bank of England simply decides to print money and magically the Consumer Price Index rises.

The prices of individual goods and services must be rising. They must be responding to the microeconomic forces of supply and demand that they face. This implies that supply is falling or demand is rising for some set of goods. Which are these?

This will help tell us why it looks like there is some sort of supply side shock to the UK. If it is rents then it is possible that this really is a “supply shock” of sorts, as is happening in the US.

I am loath to use that term for what it connotes but if the growth of the housing stock is constrained by falling land prices then we have a Keynesian depression in capital markets that is leading to a supply shock in the final goods market.  The capital markets cannot clear because of sticky prices and collateral concerns and so there is a shortage of capital and so we can have rising prices (rents) at the same time as high unemployment.

Now, maybe it is rents in the UK or maybe it is something else. Maybe the UK economy is really oil dependent? I don’t know. However, to get at what is going on we need to know which prices are rising.