The struggle to boost real wages

As is almost always the case, living standards look set to be a key issue in the general election, and we are now heading into April, which is the key month for wages.

As the Bank of England has noted, around 40% of all annual pay settlements will be decided in the next four or five weeks. If 2015 is going to be the year that pay really starts to rise, then we should have some strong clues soon.

Now it's important to remember that there is a big difference between "wages" and "living standards". Wages are the biggest driver of household incomes, but the tax and benefit system (and other sources of income like bank interest or private pensions) also play a role.

But given the importance of wages in determining overall household incomes, there are good reasons to focus on them. Whilst real wages are picking up at the moment, the big driver of that has been falling inflation rather than nominal wage growth. With inflation forecast to gradually rise in the coming years back towards 2%, real wage growth will require a pickup in cash earnings.

The big squeeze in UK living standards after the 2008 crash has been driven by a historically large squeeze in real wages (wages taking into account inflation). This was all set out in a new report from the Centre for Economic Performance (CEP) yesterday, which emphasised that falling real wages have driven living standards down for working households, whilst the income of pensioner households has actually risen since 2008.

Looking at the data, there are two stories that can be told - both of which contain important elements of truth - that offer more encouragement.

The first is that the real wage squeeze has been accompanied by rising employment. That's especially important if discussing average (meaning in this case "mean") wage levels.

Imagine an economy with ten workers, nine of whom earn £25,000 a year and the last of whom is unemployed. The average wage is £25,000. Now imagine that the nine in work get a pay rise of 2% and the unemployed worker finds a job on £15,000 a year.

The average wage would now be £24,450, a fall of 2.2% from £25,000. But is that a meaningful number? All ten workers are clearly better off, and what has driven the fall in the average is not a fall for any individual, but a change in the composition of the sample. That sort of compositional change has played a role in the UK's wage data in recent years. In particular, a big fall in youth employment (young people tend to earn less) dragging down the average. But compositional change doesn't explain the extent of the fall.

The second argument is that the fall in real wages is just a counterpart of the weakness in productivity. If productivity growth is weak then firms can't increase real wages without hitting their own profit margins. On the other hand, if workers are becoming more productive - i.e. producing more per hour worked - then hourly wages can be increased without impacting firms' bottom lines.

UK productivity is forecast to pick up in the future and it may be that if productivity growth returns then so will decent wage growth. That said, UK productivity has been forecast to pick for quite some time without actually happening.

Whilst it is no doubt true that in the medium to long term there is a very close relationship between productivity growth and wage growth, that might not be the full picture.

An important collection of essays published today by the Resolution Foundation - a think tank focused on living standards - argues that before the wage squeeze of 2008 onwards, there was a wage 'slowdown' from 2002 until 2007.

The various authors in the collection emphasise the need for strong GDP growth, rising productivity and a supportive tax and benefit system as preconditions for stronger wage growth, but note that "recent experience here and abroad suggests that establishing a benign economic backdrop, though crucial, might not suffice".

It is against this backdrop that the Centre for Economic Performance concluded yesterday that "no party has a coherent policy on what can be done substantively to improve the real wage position of UK workers". All of the talk of increasing the minimum wage and incentivising the (higher and non-statutory) living wage may well support the incomes of lower earners, but will have little impact on those in the middle of the earnings distribution. Given the importance of wages to living standards, and the importance of living standards to the election - that is a fairly damning indictment.

Politicians, though, are not the only policymakers who will help determine the path to real wage growth. Much of macroeconomic policy over the past two decades has been outsourced from finance ministries, like the Treasury, to central banks such as the Bank of England.

Last year, Paul McCulley, then chief economist at one the world's largest fund management firms - PIMCO - asked the crucial question: "How does a nation's productivity growth become real wage growth for ordinary citizens, in the context of low inflation and moderate long-term interest rates?"

His answer was straight forward: "A prolonged economic boom", and he argued that would require central banks to allow wages - and possibly inflation - to grow, before raising interest rates.

The idea that central banks should allow wage growth to run ahead of productivity, and build up inflationary pressure before raising rates, is far from uncontroversial in macroeconomics. But it does remind us that the course of real wage growth for middle earners in the next half decade is as much in the Bank of England's hands as anyone else's.