What is more important: the state of the economy or people’s wages? The answer might determine who wins the election

LISTEN to a Conservative politician for more than one minute and he or she is sure to utter the words “long-term economic plan”. The slogan is projected behind them when they give speeches and plastered across their campaign literature. It has been shoehorned into any number of policy announcements, no matter how uncomfortably. A scheme to give miscreant drivers 10 minutes’ grace before they are slapped with parking tickets, for example, was said to be part of a long-term economic plan. The phrase bores Tories to tears—yet it might win them the election.

Just two and a half years elapsed between the run on Northern Rock bank, which marked the start of Britain’s financial crisis, and the formation of the coalition government in May 2010. In the meantime the economy took a huge hit. From the peak in early 2008 to the trough in 2009, GDP per person fell by 6.9%.

The new government promptly dedicated itself to fixing the resulting hole in the public finances (see article). But the big economic problem was weak demand. Fearing for their jobs, consumers were paying down debt rather than splashing out on new cars or televisions. Businesses were not investing. Unemployment rose to 8.5%—lower than in other wealthy countries, but still painfully high. And many of those in work had too little of it: part-time jobs and self-employment had replaced many full-time jobs. Then, just as things began to look up, the euro crisis crushed Britain’s biggest export market.

By 2013 the IMF was complaining that Britain remained “a long way from a strong and sustainable recovery”. Moody’s, a credit-rating agency, downgraded the country’s debt from AAA to AA1, citing “continuing weakness” in growth. And the Labour Party, which had lost economic credibility during the financial crisis, began to close the gap with the Conservatives on economic competence. Then things began to turn round. The economy grew by 1.6% in 2013. The next year, growth accelerated to 2.8%—faster than any other member of the G7 group of rich countries. On the way Britain created a million net new jobs, taking the employment rate to its highest ever level, 73.3%, and unemployment back down to 5.7%. In January Christine Lagarde, head of the IMF, praised Britain’s leadership as “eloquent and convincing”. The recovery would appear to set the Conservatives on course to win the election. Voters often tell pollsters that they are most concerned about things like immigration and health care, but their behaviour suggests economics trumps such worries: Labour won big victories in the 2000s despite dire ratings on immigration, for example. And the public is crediting the Tories. David Cameron and George Osborne, the chancellor of the exchequer, have a 15- to 20-point lead on economic competence over Ed Miliband, Labour’s leader, and Ed Balls, his economics spokesman. But it is not as simple as that, because Britain’s recovery has been so joyless. Real wages had already been falling for two years when Mr Osborne entered the Treasury. For most of the 2010-15 parliament they continued to decline. This was all the more painful because Britons had become accustomed to steady rises in living standards. From the turn of the millennium to the eve of the crash, real earnings had grown by an average of 2.6% per year. Since then they have fallen by an average of 1.2% a year, putting Britons through the longest period of real wage falls since records began in 1855, according to the Bank of England’s data.

Much of this was caused by imported inflation. The tumble of the pound after the crisis made imports more costly, before energy and food prices soared in 2011-12. In the government’s first two years, inflation was more than a percentage point above its 2% target for 22 of 24 months. Little could be done about this: tighter monetary or fiscal policy would have strangled a weak economy and further pummeled wages.

But pay also stagnated because British workers’ productivity did. Output per hour worked—which determines wages in the long run—plunged during the crisis and remains 2% lower than in 2008. In the rest of the G7, it is 5% higher. Low wages and a ready supply of low-skilled immigrants have encouraged firms to hire people rather than invest in computers and other things that might make them more efficient. A gummed-up banking system probably prevented the most productive firms from expanding, too.

In a sense, the wage squeeze was welcome. It kept unemployment down, thereby spreading the pain of the downturn more widely. Economists usually blame recessions at least partly on the difficulty firms have in cutting wages when demand dries up; that problem was not much on display in Britain. So Labour and the Conservatives go into this election talking across each other. The Conservatives argue that the economy is recovering. Labour says that households are struggling. Both are right. Yet this is something of a puzzle when one considers what has driven Britain’s growth over the past few years. A few years ago it was an article of faith among all the major parties that the economy would have to be sustained by something less gluttonous than consumer spending. There was talk of Britain paying its way in the world through stronger exports, and of a manufacturing revival. That has not happened. Instead, the recovery has been domestic. Since 2013 consumer spending has grown at a healthy annualised rate of 2%. Buoyed by the return of consumer confidence, firms have boosted investment in tandem (see chart).

This seems odd, given how pitifully low wages have been (even if a collapse in the oil price has removed some of the pressure). Despite suffering the stagnant pay that Labour laments, households have driven the recovery that the Tories boast of. Britain’s consumption boom came from two sources. The first was population growth. Thanks to immigration and a baby boom, Britain’s population is 3-4% bigger than in 2010. While GDP is up 8% over the 2010-15 parliament, GDP per person is up only 4.8%. The second was confidence: as workers stopped fearing for their jobs, they started to save less. The household saving ratio fell from 8% in 2012 to 6.4% in 2013 (though it has since picked up a little). Confidence could not have returned without a prop from policy. Unlike its European neighbour, the Bank of England kept its eyes fixed firmly on the horizon during the imported inflation of 2011-12, recognising that turbulence was temporary and keeping monetary policy loose. The bank also recognised that boosting lending required more than just monetary policy. It clubbed together with the Treasury to provide cheap funding for banks. The salvo of stimulus was completed in 2013, when the bank’s new governor, Mark Carney, promised not to consider raising interest rates until unemployment fell below 7%.

Far from rebalancing, Britain has gone on a debt-fuelled binge

Another, classically British, stimulus kicked in at about the same time. House prices went up by 5.5% in 2013 and by another 9.8% in 2014. In crowded London they have risen by 27% in the last two years. This made household finances healthier and may have given consumers the confidence to open their wallets.

The sober-headed will not celebrate that trend. Young people—nicknamed “generation rent”—find it ever harder to buy a home. To address this, in 2013 the coalition launched a scheme—named “help to buy”—to top up some mortgages with government loans and guarantee others. That, of course, probably pushed prices even higher. In his final budget, Mr Osborne announced subsidies for those saving for a first home. That would be likely to create still more demand.

The fundamental problem is too few houses: in the decade to 2014 only 176,000 were built per year on average, when perhaps 240,000 were needed. Antiquated planning regulations constrain supply, especially in the prosperous south-east. Britons are ever more desperate to get on the housing ladder before it is pulled up out of reach. As a result, the Bank of England worries about a debt-fuelled bubble and in 2014 intervened in the mortgage market to curb excessive lending.

Instead of rebalancing, Britain has returned to its old ways: growth has been led by consumers and fuelled by house-price increases. Net trade has in fact made a slightly negative contribution since 2009, as British firms have struggled to export to a Eurozone that is only starting to recover. British consumers, meanwhile, continue to import aplenty. This, together with a drying up of income on Britain’s overseas investments, has pushed the current-account deficit to fully 5.5% of GDP.

A consumer-driven recovery is not necessarily a concern. There is nothing inherently good about exports or inherently bad about consumption. But in the long run, more household spending must be funded by wage rises, not declining saving or a boom in house prices. The next government’s main challenge will to boost productivity rather than demand. That will require careful thought, targeted investment, and an acknowledgment that cutting the budget deficit is not the be-all and end-all of economic policy.