Could we be set for two decades of lost pay growth?

Rarely have questions of household living standards and the shape of the public finances been so interwoven. The Autumn Statement – or, more specifically, the OBR’s Economic and Fiscal Outlook – identified a £25bn shortfall in tax revenues by 2018-19 relative to the projections in place at the time of Budget 2014. This is a direct consequence of the disappointingly weak performance of pay in recent months and the expectation of sluggish recovery to come. The pay squeeze that has gripped British workers for an unprecedented six years is increasingly recognised as a key factor in the persistence of the battle with the deficit.

The OBR’s outlook points to a gradual transition over the coming years, from today’s employment-rich but revenue-light recovery to one in which unemployment plateaus but productivity and wage growth return. Tellingly though, there is no rebound or ‘catch-up’ of lost ground. Having reduced its projections for real-terms wage growth in 2014, 2015 and 2016 relative to its position in March (despite also marking down inflation projections), the OBR does not expect wage growth to surpass its pre-crisis trend level at any point over the forecast horizon.

Even under this grim path of average pay growth, parts of the income distribution may fare worse. Our take on the OBR numbers is that typical (median) pay won’t recover its pre-crisis level before the end of the decade. Median weekly pay stood at £415 in April 2014 and our projections point to a meagre £25 improvement by 2019 measured against CPI: a return to 2003 pay levels. Use RPIJ inflation instead (which includes mortgage interest costs) and the improvement over the next five years stands at just £6. That would leave wages back at where they were in 2000 – nearly two decades of lost pay growth.

These wage figures pose fiscal problems not just for tax revenues, but for sectoral balances too. Given the considerable swing from government deficit to surplus set out by the Coalition over the next five years, there is a simple, mathematical, need for equal and opposite shifts across the other three sectors: households, corporations and the rest of the world. The OBR assessment is that the UK’s trade position will improve slightly and that the corporate sector will edge towards deficit. However, the biggest offsetting swing is set to come from households, with net lending moving from 0.4 per cent of GDP today to an “historically large” 3.1 per cent of GDP in 2019. This is twice the level of the immediate pre-crisis period.

In order to sustain the level of private consumption required to meet current growth forecasts against a backdrop of rapidly falling government consumption and slow wage growth, households are being asked to start borrowing again – in a very significant way. The OBR forecasts that household debt is set to start climbing from its current level of 146 per cent of disposable household income to a new high of 184 per cent by the start of 2020 – well beyond the pre-crisis peak of 170 per cent.

While some of this increase is down to an expectation of rising house prices, a large part is expected to come from unsecured borrowing, such as loans and credit cards. Relative to the Budget projection, the OBR thinks that households will have amassed an additional £41bn in unsecured debt by the start of 2019 – over £1,500 per household on top of its previous forecast – taking the total above £700bn.

Interest rates are expected to remain lower for longer, meaning that servicing such a level of household debt should prove easier than might otherwise be the case. But clearly questions will be raised about the sustainability or otherwise of another dose of debt-fuelled growth.

Perhaps part of the answer to this problem lies in the fact that we’ve been here before. The OBR has consistently projected a return to pre-crisis debt-to-income ratios over the medium term alongside sharp reductions in the public deficit. Yet in practice we haven’t yet seen much re-leveraging of the household sector. Instead, we’ve experienced a slowdown in the pace of deficit reduction. It may be that the same thing happens again, with the plan for public finances set out at the Autumn Statement never seeing the light of day.

The cyclically adjusted current budget (which has been the focus of the Coalition’s deficit reduction plans to date) is set to be £13bn in surplus by the target year of 2017-18. Meanwhile the overall budget (which the Conservatives have said they would want to balance in the next parliament) is projected to be £21bn in surplus by 2019-20. With political targets set to be surpassed, there is clearly room for whoever forms the next government to opt for a slower path of consolidation than the one set out in the Autumn Statement.

That would ease the pressure on public services and on households, and would simultaneously reduce the burden on consumers to underpin growth by flashing their credit cards at ever greater pace.

Based on what each of the three main parties has said to date (not much), our estimate is that the Conservatives could deliver anywhere between £28bn and £48bn of fiscal tightening in the four years from 2016-17 (on top of an expected £8bn of departmental spending cuts in 2015-16, earmarked under Spending Review 2013). At the other end of the spectrum, Labour’s promised focus on a current budget surplus means they might need just £7bn of tightening after 2015-16 (though it might be as high as £28bn depending on how quickly they choose to reach their target). The Liberal Democrats appear to be offering a path that falls somewhere between the other two.

These potential differences in scale are very significant. But it remains the case that whatever level of consolidation each party wants to deliver post-election, there are difficult choices ahead. And the job looks harder still if we factor in promises of tax cuts and extra funding for the NHS.

And then there’s the real kicker. With its projection for productivity growth representing the “most important uncertainty” in its entire report, the OBR has considered what the public finances would look like if today’s disappointing levels were to persist across the next five years. The result? The £21bn projected budget surplus morphs into a £37bn deficit. This is a downside scenario, but it is clearly within the realms of possibility. Boosting productivity and pay will remain at the heart of getting Britain on the right fiscal track.

This post originally appeared on The Economist’s Free Exchange blog