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The long-term squeeze

Everybody knows this year will see a squeeze on real incomes in part because of soaring gas and electricity bills. What’s not so appreciated, however, is that the squeeze might not be wholly temporary, because there are long-term pressures on real incomes.

My chart gives some context here, showing wages relative to some components of the CPI.

It shows that since January 2000 weekly earnings have risen 21 per cent faster than the CPI index, meaning that a weekly wage now buys one-fifth more goods and services than it did at the start of the century. All these gains, however, came before the financial crisis, although real wages have increased since their 2014 low-point. The pattern is much the same for food and (surprisingly) rent.

Even over 20 years, however, wages have fallen relative to many items. A week’s wages now buys 40 per cent less gas and electricity than it did in 2000 – and this is before next month’s price rises. It also buys fewer services in general such as haircuts, holidays and restaurant meals: these comprise half of the CPI.

There is, though, one respect in which real wages have soared. They now buy almost twice as many non-energy, non-food goods as they did in 2000: such goods include TVs, clothes, furniture and electronic items such as smart phones many of which could not be bought for any price in 2000. They also include new cars, prices of which have risen 48.4 per cent since 2000 compared with a wage rise of 77.4 per cent.

Which brings us to our first reason to fear for future living standards. The fall in the relative (and absolute) price of many goods was in part a one-off event – an increased supply of cheap goods from China. But this is now fading away: in the ten years to January 2010 wages rose 5.2 per cent a year relative to non-food non-energy goods, but in the 12 years since they have risen only 1.4 per cent a year.

While the fall in goods’ relative prices was partly one-off, however, the rising relative price of services is not. It is part of a long-term trend, described by the late William Baumol in 1967. Imagine, he said, you want to put on a performance of a Schubert string quartet or Henry IV Part Two (his examples). You need as many people as in Schubert’s or Shakespeare’s time. The productivity of actors and musicians (at least in live performances) has not changed for centuries whereas that of farmers or industrial workers has soared. This could merely cause the pay of actors and musicians to fall relative to other workers. But there’s a limit to how far this can happen; they would leave for other jobs if wages fell too far. Instead, the cost of performances relative to other things rises over time.

What’s true of actors and musicians is true of service sector workers generally. Hairdressers, waiters and bar staff cannot serve many more customers than they did years ago, and anybody who has had the misfortune to employ one knows that lawyers are not much more productive than they were at the time of Jarndyce vs Jarndyce. And so the cost of such services rises over time, roughly in line with wages, so workers are no better off. That’s Baumol’s cost disease.

It’s not just in the private sector that we see this. It’s also exists in the public sector because putting knowledge into children’s heads, caring for the elderly, treating patients or nicking villains are jobs that don’t easily admit of efficiency gains. Allied to an ageing population increasing demand for health and social care, such rising costs point to increases in public spending over time. The OBR foresees this rising from 41 per cent of GDP in 2022-23 to 45.4 per cent by 2050. That means a rising tax burden, which would eat into wages.

There’s another danger, pointed out back in 1815 by David Ricardo. As the economy and population groew, he said, farmers would have to cultivate less and less fertile land to meet demand for food. That, he said, meant that food prices would rise over time, squeezing real incomes. It also meant that owners of the best land could charge higher rents and prices, thus transferring income from renters to themselves.

Ricardo’s theory was wrong for food. But it perhaps does apply to other products of the land: oil prices and commodity prices generally have risen faster than wages so far this century. And it also applies to prime property, which is why young people even on good wages have no hope of buying a house in London. Two apparently different pressures on living standards thus fit the pattern identified two centuries ago.

But why hasn’t Ricardo’s theory been true for food? It’s because farmers became more efficient at producing it, outweighing the need to use less fertile land.

Which brings us to another threat to living standards – that economy-wide efficiency gains have stalled. In the last 15 years GDP per worker-hour has grown just 0.5 per cent per year, compared to 2.2 per cent a year in the previous 30 years – a time which encompasses two recessions and the winter of discontent.

Exactly why productivity growth has slowed is a separate story with many elements. Whatever the cause, though, the effect is the same: efficiency gains are too small to offset the rising relative costs of services, higher taxes, higher energy bills and the fading benefit of cheap imports. And so a squeeze on real incomes is a long-term danger.

This prospect isn’t wholly disastrous for equities. One reason for the slowdown in productivity growth is a decline in the rate of creative destruction, which means incumbent companies face less competition.

But on the other hand, stagnant living standards are an environment in which appetite for risk won’t increase much. Worse still, economic stagnation breeds political instability, as we saw in the 1930s, 1970s and since the financial crisis. Whilst such instability has been resolved happily for investors in the past, we’ve no guarantee it will be in future.