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Blame feeble productivity growth for stagnant living standards

In the financial year that ends on April 5, real household median incomes in the UK will at last regain the levels of 2007-08. So forecasts the Institute for Fiscal Studies. Does this mean the UK's "standard of living" debate should be over? No: it is very much alive, not just with respect to the past but also with respect to the future.

The striking feature of the IFS analysis is the weakness of recovery. Real median incomes are estimated to have fallen by 4 per cent between 2009-10 and 2011-12. This is not exceptional: they fell by 7.3 per cent between 1973 and 1977 and 5.7 per cent between 1980 and 1982. But real median incomes are forecast to rise only 1.8 per cent in the three years after 2011-12, against 13.2 per cent and 9.2 per cent in the three years after the troughs of the 1970s and early 1980s. The recovery in living standards has been very weak this time. This, not the severity of the post-crisis decline, largely explains the stagnation.

It is important to understand what the numbers used by the IFS mean. They show household incomes after tax and benefits. But they exclude publicly provided services, such as health and education. This is an important qualification, since the latter also affect standards of living, properly measured.

The overall picture of a dismally slow recovery is quite clear. The fact that consumption per head of non-durable goods was 3.8 per cent lower in the third quarter of 2014 than in the first quarter of 2008 underlines this reality. At the same point after the recession of the early 1980s, such consumption was 14.4 per cent higher. Voters are grumpy for understandable reasons. Such a long period of stagnant living standards is not to be found within living memory.

Also important is the distributional impact of both the crisis itself and its aftermath. After one takes account of changes in real earnings, in taxes and benefits, and the prices of food and energy, the impact appears to have been quite similar across the income distribution. This is not true for the age distribution, however. Those of working age, particularly young adults aged 22-30, were worse hit; while those over 60 did relatively well. This is partly because the government protected the elderly; and partly because this group is less dependent on wages and salaries, which were directly hit by the crisis.

These details are complex. But the overall picture is not. In the third quarter of last year - despite the vaunted recovery of the UK economy - real gross domestic product per head was the same as in the third quarter of 2006 and 1.8 per cent lower than in the first quarter of 2008 (the pre-crisis peak). This has given the UK something very close to a lost decade. Why such a poor recovery should be a matter of congratulation is hard to comprehend. Is it that the eurozone has fared still worse?

It is noteworthy, given this, that the median real standard of living in fact rose in the first two years after 2007-08 and then fell by just 4 per cent between 2009-10 and 2011-12, even though the peak-to-trough fall in quarterly real GDP per head was 7 per cent. The most important cushion, initially, of living standards was increased government borrowing. This was unquestionably the right policy. At a time of severe crisis, the government was correct to let its balance sheet take the strain. But once a government starts to close its deficit, as the coalition chose to do after 2010, measured standards of living are likely to lag behind GDP per head, though the extent to which this will turn out to be the case depends on precisely how (and also how far) it closes the deficit. Choices here are still to be made.

The main cause of the slow recovery in standards of living, then, has been the feeble recovery in GDP per head. Given the robust employment performance, this weakness is, in turn, directly related to the feeble productivity performance. In the third quarter of 2014, output per filled job in the UK economy was still 1 per cent lower than in the first quarter of 2008. Output per hour was actually 1.8 per cent lower. An important question is how far the reaction of a flexible labour market to policy-induced weakness in demand explains this dramatically poor productivity outcome.

What happens to living standards in the next parliament will then partly depend on how fiscal tightening is imposed and also how far it goes. But it will depend above all on whether a strong and sustained rise in productivity is in the offing. If it is, both fiscal fears and concerns about stagnant living standards will melt away. If it is not, the difficulties of today will become permanent. Without productivity growth, the desire for higher real incomes will turn into a zero-sum game. Politics will become nasty. This is the biggest issue. All else is secondary.

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