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The persistent myth about the financial crisis and living standards

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It has become commonplace to describe the period since the Great Recession with lots of dramatic words—not only referring to the financial crisis itself, but how the economy and household living standards have stagnated. Growth in average living standards has been described as 'terrible' or 'disastrous', while there has been much talk of a 'cost of living crisis' and a 'squeezed middle'.

There are good reasons to think that household income growth has been very poor since the crisis. Between 2007-08 and 2011-12, real average household income (measured after taxes have been paid and benefits received) in the UK fell by 2.3 per cent, or by £600 per year. Then, as the recovery started, growth was weak at first but then strengthened. Household income rose by 8 per cent in the five years between 2011-12 and 2016-17—in other words it grew at 1.6 per cent per year.

Growth in average living standards of 1.6 per cent per year (remember, this is after accounting for inflation). Is that good or not? It really depends what you compare it to. In the 40 years before the financial crisis, average household income grew by 2 per cent a year. So, comparing to that, growth doesn’t look great. On the other hand, if you compare it to the five years before the recession, when growth averaged only 1.1 per cent per year, the recent trends look a lot better.

And for those of you who think that these don’t sound like big differences—they aren’t in the short term. But in the long run even small differences in growth can cause really big differences in living standards. If average income grows at only 1.1 per cent per year, it will take 63 years for incomes to double. But if growth is 1.6 per cent it only takes 44 years for incomes to double, and at 2 per cent it only takes 35 years. So we will be a lot better off in the long run if growth is only a little bit higher each year. 

So the key point here is that actually, we haven’t just had poor growth in living standards in the decade since the recession. Instead, we’ve had over 15 years of relatively slow growth in living standards and nothing like the rapid growth seen in the late 90s/early 2000s (around 4 per cent per year) or the mid 80s (5 per cent per year). 

Why has this been? Well, in the five years preceding the recession, growth in the pay of people in work was not that strong—certainly weaker than in the late 90s—and there wasn’t much employment growth either, leading to slow income growth. Then came the recession, with falling employment and large falls in employee pay packets after accounting for inflation, and tax rises such as increases in VAT in 2011. Since 2011-12, there has been some modest recovery in employee pay packets and big increases in employment, though cuts to working age benefits have stopped the incomes of poorer households growing as fast as middle income households’. 

However, if we look out to the longer run, there is one factor that is particularly important and that is growth in the pay of those in work. That’s not to say that employment—or tax rises or cuts—are not important: in the short run, they are. But the employment rate cannot grow forever (people still want to undertake further education, or enter retirement), and taxes tend not to rise or fall that much as a share of the economy. But the pay of people in work can continue to grow if that growth is caused by higher productivity (i.e. if workers continue to produce goods and services more efficiently over time). Britain’s productivity performance in recent years has been really poor. Boosting productivity should therefore be near the top of any government’s agenda.

How can we boost productivity? There is no silver bullet, but economists do have a good understanding of things that are important. Good quality infrastructure that prevents delays in people and goods moving around the country. Openness to trade with other countries, which encourages firms to compete with the most productive firms worldwide. An education system that produces workers that are equipped with skills needed in the workforce. And a tax system which gives individuals incentives to work and firms to invest. These are the fundamental issues that should be addressed by a government that wants to see long term increases in living standards.   

Jonathan Cribb is a Senior Research Economist at the IFS. A version of this article first appeared in Prospect Magazine and is reproduced here with permission.