This year will see what the Resolution Foundation calls a “cost of living crunch”. But why? Everybody says it is because real incomes will be squeezed by rising prices, especially of essential items such as gas and food. Everybody is wrong.
One fact tells us this. If rising prices cause real incomes to fall, we should have seen the latter slump during the 1970s, a decade when inflation averaged 12.6 per cent a year. But they didn’t. In fact, real household disposable incomes rose 3.4 per cent a year then. That’s almost twice as fast as they’ve risen in the past 10 years, a period of low inflation.
This tells us that inflation alone does not squeeze real incomes. And if real incomes could withstand oil prices rising by a factor of 10 in the 1970s, why are they so vulnerable to a rise in gas prices today?
The answer lies in power and politics. Two things protected household incomes in the 1970s. One was that workers had the bargaining power to get pay rises to more than cover the rising cost of living, so wages rose faster than prices in the decade. The share of wages in GDP rose at the expense of profits, especially in the first half of the decade. The 1970s saw a crisis for shareholders, not for workers.
Also, government borrowing increased, helping to support incomes. And because the real value of that debt was eroded by inflation, this meant there was, in effect, a transfer of real resources from gilt-owners to ordinary households.
Today, of course, things are very different. Workers don’t have the bargaining power to get inflation-busting pay rises. In the last 12 months average weekly earnings have risen by 4.2 per cent and median monthly pay by 5.3 per cent. On both measures pay is falling in real terms.
And this year will see government borrowing fall. The Office for Budget Responsibility envisages cyclically-adjusted net borrowing falling from 8.3 per cent of GDP in 2021-22 to 3.9 per cent in 2022-23. In effect, state support for real incomes is being withdrawn.
Real incomes, then, are under pressure not simply because of rising prices, but because – unlike in the 1970s – millions of households lack the economic or political power to get higher real incomes.
Which is why share prices have risen during the current inflation scare. Shareholders believe that the pain of higher gas and oil prices will fall on workers rather than companies – unlike in the 1970s.
This belief, though, might be mistaken. If falling real incomes lead to a retrenchment in consumer spending (and December’s retail sales data suggest they could), economic activity will fall short of expectations – with nasty effects on the earnings of domestically-oriented companies and perhaps on investors’ appetite for risk.
My point here is one which has been made for decades by various economists in different contexts. It is that money – which is the unit in which we measure prices – can deceive us. As Adam Smith wrote, “real riches” consist not in our money but in our “power of purchasing or consuming”. Muddling the two is what we call money illusion. One particular form of this is the failure to appreciate that monetary transactions such as the exchange of money for goods or labour are in fact relations between people. And they are sometimes relations in which bargaining power is unequal.