The British economy is expanding again at a respectable pace. George Osborne, the Chancellor, has sustained much criticism for policies of tight austerity to restore the public finances even while Britain was in recession. He is at least able to claim that the UK has the fastest-growing economy in the G8; ahead of his Autumn Statement he promised a “responsible recovery.” Living standards, however, are stubbornly not rising. This dichotomy is increasingly crowding out other subjects in economic debate. Ed Miliband, the Labour leader, insists that the party is “fighting for all the people of our country now facing the worst cost-of-living crisis in their lifetimes.” If Labour manages to frame the election argument so that it is about disposable incomes rather than output growth and the deficit, it will have a politically potent theme. Yet stagnation in incomes and wages is an issue on which little serious political thinking has been done because it defies easy ideological rationalisation. It isn’t an issue specific to the management of the economy by the coalition government. It’s a phenomenon that stretches back many years. Labour denounces wage stagnation and income inequality, but it is not the sole repository of that call. The appeal of populist movements on both wings of politics, but especially on the right (the Tea Party movement in the United States is an example), lies in large measure in the impression that households on middle incomes are losing out. While wage and income stagnation ostensibly offers an opportunity for Labour, it is at least as likely to encourage populist campaigns on the right that are driven by protectionism and hostility to immigration. (Labour’s own defensive and increasingly illiberal rhetoric on immigration suggests that this point is not lost on the party leadership.) There is a sensible and progressive argument, founded on economic efficiency as well as equity, for more direct government intervention to raise median living standards. Unfortunately, as is still not adequately recognised by Ed Miliband and his colleagues, the state of the public finances—a legacy of Labour’s mismanagement under Gordon Brown—makes this extremely difficult. Since the bitter global recession of 2009, the national economic debate has focused on quarterly GDP figures as a measure of whether—and how confidently—the UK has emerged from this catastrophe. There are many things wrong both with the debate and the measure, and these deficiencies are unfortunately compounded by the media’s thirst for controversy. While politicians have argued about double- or triple-dip recessions, Britain’s economy remains smaller than its pre-crisis peak. If it had merely continued to grow at its long-term average rate since 2007, it would be some 30 per cent bigger than it is now. The political argument, moreover, takes a drearily predictable form. The government declares that its strategy of austerity has laid the foundations for recovery; Labour complains that economic growth is not being felt by households in higher standards of living. Labour is not wrong on this, but the story is more intractable than it intimates. Economists are familiar with the flaws of judging welfare by GDP growth. GDP measures the market value of all goods and services produced in a year. GDP per capita divides this by the mid-year population. At the most basic level, neither measure takes account of broader measures of welfare such as happiness or health. More particularly, GDP per capita isn’t a measure of individual wellbeing. A better measure for this is median household incomes (not the arithmetical average, which can be skewed by outliers at either end of the income distribution). As this measures, by design, the income in the middle of the distribution, it is a reasonable proxy for living standards. Figures from the Office for National Statistics show that UK median household incomes over the past 35 years have generally tracked GDP. For the middle fifth of households, average disposable income in 2010/11 amounted to £24,400. In real terms this is almost 1.8 times the equivalent figure in 1977. The gross income of the middle fifth of non-retired households has increased from £20,300 in 1977 to £37,000 in 2010/11. This is, on the face of it, much better than the experience of the US, where median household incomes have expanded at a consistently slower rate than GDP. The reason for this difference may be related to the very rapid expansion of incomes at the top of the income distribution in the US—more so than in the middle—whereas in the UK the growth rates at the top and the middle have been more similar. But in the UK there are variations around the economic cycle. From the mid-1990s to the middle of the last decade, when the economy was expanding briskly between recessions, growth in median household incomes outstripped GDP. But in the years immediately preceding the economic downturn, it slowed quite sharply. In the five years from the onset of the downturn, it fell by almost 9 per cent in real terms, though this effect was cushioned to some extent by cash benefits and a fall in the proportion of incomes eaten up by taxes. Taking account only of non-retired households, gross incomes of the middle fifth of households fell by slightly over 6 per cent but direct taxes have fallen by substantially more. A progressive tax system can ease the stagnation of incomes up to a point but there are limits that politicians are loath to talk about. The most fundamental is the shift across the advanced industrial societies towards knowledge-based economies. Yet the commitment of the previous Labour government to get at least half of young people into university has had a countervailing effect. Figures from the Department for Business, Innovation and Skills show that the proportion of school-leavers entering higher education in 2011/12 was only just under 50 per cent. Employers are typically seeking graduates even for relatively low-skilled occupations. Yet the corollary of this is that degrees, being plentiful, no longer command such a premium in the marketplace. Two longer-term trends thus appear quite stubborn. First, higher education is not translating into the boost to incomes that graduates may have expected. Part of the reason may be that students in higher education are not in large numbers taking degree courses that are particularly in demand from employers. Second, growing technological demand for labour is also leaving behind semi-skilled and unskilled workers. Meanwhile, the general relationship between disposable incomes and output growth appears quite problematic. Retail sales picked up in 2013 but not because of a rise in disposable incomes. Whereas there has been cumulative real GDP growth of a little over 4 per cent since the recession of 2009, aggregate household disposable income has not recovered—it’s been broadly flat. So no one in particular is feeling better off even though the economy appears at last to be recovering. Now, it is possible for standards of living to increase even as real incomes stagnate. This happens when goods and services improve in quality or decline in price, or both. It wouldn’t be hyperbole to say that the way households live has been revolutionised in the past 20 years by technology—principally consumer electronics and the emergence of the digital age. The extraordinary expansion of capacity and quality has been accompanied by a dramatic fall in absolute prices. This may now present a problem for politicians in that consumers do not regard these advances as compensation for stagnant incomes; rather, they are part of modernity itself. What is more, household incomes are being squeezed by rises in prices for more basic goods and services demand for which does not change when prices do, especially gas and electricity. *** Nobody knows what the political effect of these pressures will be. Labour believes that it has an election-winning theme with a call for an energy price freeze. This would make little economic sense if it doesn’t take account of industry costs but that does indeed appear to be the proposal. Populism is a potent message in these circumstances and the danger is that it might be expressed in peculiarly damaging ways. During the long business expansion between the mid-1990s and the middle of the last decade, a sense of wellbeing was buttressed by the easy availability of consumer credit. As everyone knows, this was a mirage. The risks of lending had not, in fact, been mitigated by new financial instruments and securitisation: they had simply been passed around the financial system. That irresponsibility is not going to be repeated soon, especially given the regulators’ insistence that the banks build up their capital reserves. At some point interest rates will rise and in any event cheap borrowing to finance consumption will not be available. In short, there has recently been a slight easing in credit conditions and households have responded to better economic news by increasing their net borrowing. But this is unsustainable and in any event reflects mainly a breathing space in the very painful process of deleveraging that households have had to engage in since 2008. Economic anxiety about stagnant incomes can’t be dissipated by the same means adopted in the business expansion. Households have too much debt; they aren’t in a position to drive a consumer boom even supposing that this were desirable. There is a strong case, on grounds of efficiency and justice, to reduce inequality, and the least disruptive way of doing that is to raise median household incomes. This might be done by increasing cash benefits. The aggregate value of these benefits, such as tax credits and housing benefit, has roughly doubled for middle-income households over the past 35 years. As a proportion of gross income, cash benefits amount to a little over 10 per cent for the middle fifth of non-retired households. The scope for boosting incomes by increasing these cash benefits is severely limited by budgetary constraints, however. Here’s the main political problem. As living standards stagnate and a direct measure to boost them isn’t available, there will be increasing political pressure to opt for bad solutions. In many respects it’s encouraging that the squeeze on living standards hasn’t so far given a boost to populist parties of the far left and far right (disregarding the exceptional by-election victory of George Galloway in Bradford West, one of just a handful of seats in the UK where he might be a credible candidate). But the temptation for bad policies intended to preserve living standards is constant. It’s observable particularly in the controversy over EU enlargement and the free movement of peoples across national borders. I recently debated with Nigel Farage, leader of Ukip, on the EU and even my debating partner, a Liberal Democrat MP, criticised the previous Labour government for opening Britain’s labour markets to Polish and other eastern European immigrants in 2004. No politician, apparently, is prepared to say that this was a good thing that boosted the economy by opening it up to new skilled workers. It’s widely recognised among labour market economists in Germany that it was a mistake for their country not to adopt the same policy—the skilled migrants generally came to the UK. It makes eminent economic sense to boost demand and mitigate the stagnation of real incomes by encouraging more skilled immigration. The experience of eastern European immigration since 2004 has been twofold: far more people came than the Labour government expected, and I don’t deny that concentrations of new immigrants in particular localities can put a strain on services. But the economic effect was overwhelmingly positive. New immigrants, being generally of working age, contribute more to the Exchequer than they take out. This issue is one respect in which policies to mitigate the central economic problem in political debate dismayingly aren’t attractive to politicians. Other ways of addressing wage and income stagnation may be costly and won’t be immediately effective, but can be justified as investment rather than current expenditure. There is a strong case for state investment in improving literacy and numeracy for young people entering the workforce with low skills, and for providing lifelong learning and education. There is also a stubborn market failure in that if companies invest in training they risk losing their more skilled workers to competitors. The only short-term course will have to be largely costless regulatory changes. What needs to be avoided are populist measures that are held out as a palliative but which will damage living standards. Trade protection is an extreme example, but not a fanciful one. There is also a broader risk that the case for increasing median incomes and narrowing extremes of inequality is confused with a more thoroughgoing aversion to enterprise. Not all inequality is bad. Income inequality is in some respects a signalling device. It indicates to young workers where they should improve their own skills and allows a smoother allocation of capital. The problem comes when inequalities in income are not obviously justified by workers’ differing marginal contributions. The single greatest cost of banks’ behaviour during the boom years may not even be in huge sums of taxpayers’ bailout money; it may instead be in spreading the notion that high rewards are unrelated to effort and ability. Finally, there needs to be a recognition of intergenerational equity. Younger workers face the prospect of supporting retirees who, in number, will come to swamp them. That needs to be addressed progressively by a steady rise in retirement age and slowing the rate of increase in pensioner benefits. The rest of this decade will be a risky and disruptive time for the British economy. The problem of income stagnation and inequality does not look imminently resolvable. Median incomes are being squeezed over the long term; incomes at the lower end might be brought up progressively by investment in skills and some form of subsidy. But it is difficult to envisage cash benefits to middle income households rising significantly. Direct interventions are justifiable and necessary, but only where they are, in effect, capital investments to enhance people’s earning power. The risk is that politicians will instead intervene to protect markets and keep out skilled workers from overseas. Unfortunately, that course appears to be gaining popularity across the political divide.
