Economic View: Retail therapy, rest in peace

Things are getting cooler. For the first time in nearly a decade, real post-tax wages in the private sector are rising more slowly than prices. The Christmas trading conditions were at best mixed - dreadful at Marks & Spencer, though excellent at Dixons. And the climb in interest rates has only just begun and the rises in council tax have yet to bite.

So we are in a period of transition, the tail-end of a surge in living standards that has run since the mid-1990s. You can see a measure of this, the rise in real earnings, in the first graph (above). It shows money wages depreciated by the tax and price index - inflation-adjusted for changes in taxation.

As you can see, private sector incomes have now dipped below the waterline, though the surge in public sector pay seems to have pulled overall pay back above it. Taxation is transferring wealth from one part of the economy to the other as well as squeezing pay overall.

But we are still spending more, thanks to our willingness to borrow. Indeed household spending was still rising at more than 3 per cent a year last year, one percentage point higher than the growth of the economy as a whole. There are, however, some signs that people wish to rebuild their savings (savings rates are nosing up) and the middle graph projects an actual fall in consumption in the second half of this year. This judgement comes from Roger Bootle, in the new economic review for Deloitte. It is based on the assumption that house prices will start to fall towards the end of this year - a view many other forecasters do not accept. For example, Merrill Lynch thinks house prices will rise by 8 per cent this year and the risks if anything are on the upside - ie they may rise more.

Still, there can be no doubt real incomes were squeezed last year and that rising interest rates will mean that servicing debt will take a higher proportion of people's incomes. As a result, consumption will rise more slowly than the output of the economy as a whole, the first time that this will have happened since 1995.

So the economy picks up pace, but we will feel poorer? Looks pretty much like that, though there may be some pick-up in real incomes next year. But we may still feel squeezed because of the huge shift that is taking place in relative prices. Services, particularly those controlled by the public sector, are becoming more expensive, and goods are becoming cheaper.

The most obvious increase is the rise in council tax - one that the Government has threatened to cap. In a world of near-zero inflation, a projected average increase of 12 per cent does seem bizarre, for council costs cannot have risen by as large an amount as that.

But there also are rises in railway fares, the London Tube and so on. These are offset by a decline in the price of goods, as shown in the third graph, which went negative in 1999 and have remained so ever since. In some areas of spending, the fall is quite remarkable.

Footwear and clothing has been going down in price every year since 1992. No wonder Marks & Spencer is in trouble with its clothing division. Whatever its failings in fashion, it would always be hard to earn a living in an industry where prices keep falling, unless these declines were the result of technical advance, as in electronics.

In political terms, this is very tricky, and not just because the squeeze on living standards is taking place uncomfortably close to an election. This shift in relative costs means there is a built-in bias for taxes to rise unless and until the public services sector can start to achieve the same sort of productivity gains as the private goods sector. Thus cars are becoming ever cheaper but train fares ever more expensive. There is an extreme example of this twist in air and train fares between London and Paris.

The train, which is now almost a public industry, gets a subsidy from taxpayers for its track and in all probability the tunnel debt. It will get an even larger subsidy when the final stage of the high-speed link is opened. By contrast, the airlines pay a poll tax on every person they carry. But it is still cheaper for most people to take the plane.

Of course the poor performance of the public sector is partly the fault of the Government. But actually this shift in relative costs and prices would be a problem for any government, whether left, right or centre and whether the consumer was paying through higher access fees or higher general taxation.

This leads to a further question: why is this a problem now as opposed to five years ago? The answer comes in two parts. One is that it was possible for a while to squeeze public sector pay. You can see that in the first graph during the 1997 to 1999 period, or indeed in the squeeze that the universities have suffered, with real income per student falling by nearly half over the last decade. But you cannot squeeze for ever, as the universities have found.

The other is that consumption took a steadily increasing proportion of GDP: household spending is now nearly 66 per cent of GDP, against less than 61 per cent in 1996. It does not need to come down again for us to feel squeezed. All it needs to do is to stop rising for us to recognise that the long boom is over.

In a way this is no bad thing. It is unreasonable to expect to boost living standards by more than 3 per cent a year when the economy is growing at only 2 per cent. In Germany, where the economy has been shrinking, they are lucky if they increase living standards by 1 per cent a year. But do not expect people to be delighted to abandon retail therapy: spending money is more fun than paying off debt.