Hamish McRae: Adapt now, or our children will suffer

Economic View

It is possible that the 20-somethings now entering the workforce in Britain will become the first generation for a couple of centuries that end up, on average, poorer than their parents?

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It is a deeply troubling thought, for while the combination of two world wars, the inter-war depression and the 1970s inflation meant many individuals are worse off than their parents, this has not been true for society as a whole. Harold Macmillan's misquote – that most people had never had it so good – has until recently still applied.

But now we are seeing something of a return to the gloom of the late Seventies, when commentators wrote of the UK facing not just relative decline but absolute decline. We have had five years of stagnation in living standards. Home ownership is falling. Productivity is falling. And now the Bank of England thinks that the country's GDP will not be back to its previous peak until 2015.

Of course we are not alone. If the UK faces a lean seven years, Japan has experienced two decades with very little growth. In the US, there has been growth but it has been unevenly shared, for the median income of working people is now no higher than it was in the 1980s. Across southern Europe people are having to confront a more savage squeeze on their living standards than they have ever experienced in peacetime.

There is, of course, a sharp contrast between this sense of decline in the West with the self-confidence of the emerging world. But that in a way makes matters worse for us. We can and should celebrate the way that millions of people are being lifted out of poverty every year in China and India – and recently in Africa too. But this success does rather rub our nose in our failure.

You could say that the emerging world's progress is the result of their application of technologies developed in the West – everything from production-line manufacturing in China to mobile telephony in Africa. But unless we can continue to innovate, to keep increasing our productivity, our own living standards will stagnate.

So are we condemned to stagnation? I think the answer to that is almost certainly not, but it is hard to separate the many different strands of evidence. The first difficulty is to distinguish between the cyclical and the structural. It has been a pig of a cycle and you would expect, as we all clamber up out of the dip, that living standards must inevitably be lower than they would be had we cantered on. As you can see from the main graph, the UK and US have had a different experience. In the US published GDP is back above its previous peak but employment is well below it; we have done the opposite, with higher employment but lower GDP.

So their productivity has improved but ours has declined. But, it is surely socially less destructive to keep as many people who want to work in jobs, particularly given the US's weaker welfare protection. At the moment our countries seem have a different choice of priorities but it may turn out that as demand rises we will converge again, with the US increasing employment and the UK productivity. The worry is that even in the US there seems to be a longer-term slide in the rate of increase in productivity, as the small graph suggests.

There is another reason why living standards have been held back. It is that consumption was artificially boosted during the boom by excessive borrowing and while individuals on both sides of the Atlantic have made a good start at rebuilding savings, our governments have barely begun to cut the deficits, let alone start to pay off debt. That too will hold back living standards for several more years.

But all this is cyclical. The issue that matters more than anything else, is whether there has been some structural change, some damage to the great engine that has increased wealth incrementally, year after year, since the Industrial Revolution.

The answer to that depends on your analysis of the forces that drove such growth. On the one hand the extent to which it was the exploitation of finite natural resources; and on the other the extent it was the result of human ingenuity.

You can see both drivers at work now. China is fuelling its economic boom by scooping up natural resources from wherever it can get them, as well as applying Western technology. But within the West we are still innovating, finding ways of doing things more effectively. Look at the way modern cars don't break down as they used to 30 years ago and deliver double the miles to the gallon, or the way we book our own flights on the internet, enabling airlines to achieve much higher load factors than they could before.

The problem is that human ingenuity is struggling to increase living standards against a several strong headwinds, some of which we cannot do much about. For example we cannot do anything about ageing societies. That is another welcome development, for who would want a country where lifespans were falling? But most developed countries have been bad at adapting to this shift. A smaller workforce relative to the numbers of young people and the retired inevitably reduces overall living standards.

Nor have we been good at matching skills to jobs. We cannot know what skills will be needed in, say, 10 years' time, so we have to teach people to be ready and be eager to retrain. Even now, a recent GE Capital study of medium-sized firms showed the managers felt the biggest thing that held them back was not shortage of cash but shortage of skilled people.

The point here is we could be doing better. But the relentless drive to do more with fewer resources evident in manufacturing has not yet spread to many service industries and to the public sector. Until we realise that, our children may not have as high living standards as we enjoy.

A big week for home and European economic announcements

There are three bits of economic news coming up this week that will deserve notice.

The first comes on Tuesday, when the eurozone finance ministers will have to decide if Greece gets its next tranche of money. If they don't hand it over in the next couple of weeks, Greece may well not be able to pay its civil servants or pensioners next month. So they will eventually do so. But they may not agree yet because the IMF does not accept the eurozone figures for the sustainability of Greek debt and therefore is unwilling to sign off its role in the financing. Indeed, legally it probably cannot do so.

The central message here is that Greece will eventually get not just this chunk of money but also subsequent disbursements. Expect that to give a short-term boost to the euro, even though nothing is changed in the medium-term.

The next event is on Wednesday when the Chancellor (and the rest of us) get the October public accounts. That will tell us all how far adrift the Treasury is in hitting its deficit reduction target for this financial year and, if you are cynical, the extent to which the Chancellor will try to massage the figures to give the impression he is still on track.

He cannot do much, given that he has the Office for Budget Responsibility looking over his shoulder, so this is essential input for the OBR's report, out on 5 December with the Autumn Statement. Bank of England minutes will also be published on Wednesday.

Then on Thursday, the focus will shift to Brussels and the EU budget. The thing to realise about this is that this is politics, not economics. The numbers are huge in absolute terms but small in terms of national finances.

The difference between what will be seen as a good or a bad deal for the UK is in the hundreds of millions, whereas we are borrowing a billion every three days. But politics matter and the interest for us will be the way in which this pushes the UK further towards the door marked exit.