Why the squeeze in living standards is very welcome

Austerity isn't all bad news (Picture: Howard McWilliam)

OK, so the headline was written to provoke, but from a macro-economic point of view, there is a sense in which the Institute for Fiscal Studies' finding of the longest slump in household finances on record is actually a quite positive development.

How come? It can surely never be a good thing for living standards to be falling in the way they are. Of course not, but if the relatively high level that living standards reaching in the run up to the crisis was unsustainable, then the present adjustment, painful though it undoubtedly is for many households, was both inevitable and necessary, the latter because it helps to make the UK a competitive economy once more.

This is how it works. If the cost of the things we buy – fuel, food, commodities, imported goods, and so on – is going up, then one way or another we will be forced to pay for it with a corresponding fall in real wages. This can happen in two ways, through inflation or through cuts in nominal wages. In the UK, the Bank of England has chosen the former route; in the eurozone, policymakers are enforcing the latter approach on uncompetitive periphery nations.

The Bank of England could have stopped the inflationary impact on living standards, but only by driving up unemployment to such a degree that workers would be prepared to accept no wage increases or even outright cuts in nominal earnings in order to stay in employment. The choice was between higher inflation, or a deeper rececession. The point is arguable, but the Bank's approach would seem to be the least worst from a social perspective. Certainly, it looks preferable to the depression economics being applied to the eurozone periphery.

In time, this external devaluation ought to make the UK more competitive again, so that companies choose to locate their production in the UK rather than overseas. So far, there's not much sign of this happening, but it takes time for businesses to absorb these relative shifts in competitiveness.

In any case, relative labour costs are improving quite markedly right now when compared with much of Europe and even some emerging markets. If the UK does the right things on supply side reform, ten years from now, it could actually be a model economy once more.