Another year in which earnings rise less than prices could hit the recovery and David Cameron's re-election hopes
Pay always matters. It will matter even more than usual in 2014 when it will determine not just the fate of the UK's economic recovery but conceivably the result of the next election as well.
Rising real wages will underpin solid growth in consumer spending, trigger a long-overdue pick-up in investment and give George Osborne a narrative for the Conservatives' election campaign in 2015.
By contrast, another year in which earnings rise less rapidly than prices will make a sustainable recovery much less likely and dent David Cameron's re-election hopes.
The year ends with fears that the UK has the wrong sort of growth. The latest balance of payments figures revealed the biggest quarterly deficit since the Lawson boom of the late 1980s, a time of previous excess demand in the economy. There are concerns – entirely justified by the UK's recent history – that another consumer and housing-led recovery will lead inexorably to the same outcome. After three boom-busts in the housing market since the early 1970s, it's easy to see why a 40% jump in mortgage approvals during 2013 has raised eyebrows.
In truth, it is too early to predict how this recovery will turn out. The first point to note is that nearly all recoveries in the west rely on consumption in their early stages.
In China, where investment accounts for around half of national output, it is possible for the state to prime the pump of recovery. In mature, developed economies, investment tends to account for 10-20% of gross domestic product and consumption around two-thirds of GDP. Mathematically, it is harder to get an economy growing without a rise in consumption.
What tends to happen is that rising consumption encourages companies to invest. The increase in demand for goods and services means firms need more productive capacity, so they move to bigger premises and buy new kit. Crucially, though, they only do so if they think the increase in consumption is for real. If they suspect that the boost from household spending is temporary, companies make do.
So, the fact that UK growth during 2013 was dominated by consumption is unexceptional. Nor is it a surprise that the housing market played a big part in the story, given that residential property sector is a sizeable industry in Britain.
At the start of 2013, it was hard to see why consumer spending would bounce back. The economy had flatlined for two years and confidence was low. Inflation had comfortably outstripped earnings during 2012, making it hard for families to make ends meet.
Three factors combined to change the picture: cheap money, the Bank of England's funding for lending scheme (FLS), and rising consumer confidence. Threadneedle Street cut its official rate to 0.5% in early 2009 but it took a long time for the monetary stimulus to have an impact.
It only really did so when FLS was announced in the summer of 2012. This was a deal under which the commercial banks could borrow more cheaply from the Bank of England provided they passed on the benefits to their customers.
The idea was that households and business borrowers would benefit: loans would become more readily available and the interest rates charged on them would be lower. Lending to businesses was disappointing, but the impact on the mortgage market was rapid and significant.
Consumer psychology is difficult to fathom. Those who kept their jobs throughout the deep slump of 2008-09 and the flatlining of 2011-12 may have felt by early 2013 that they were no longer at great risk of being made redundant. It is also likely, though, that the pickup in the housing market boosted confidence, not least because rising house prices generated the sense that life was returning to normal. Consumers may simply have been looking for an excuse to feel less miserable after years of gloom.
Whatever the reason, there was a steady and marked improvement in confidence, which began in late 2012 and continued through the spring and summer. Rising optimism led to higher spending, and this led to higher growth.
The increase in consumer spending did not come about through increments in living standards. Indeed, when consumer demand was especially strong in the middle of 2013 inflation was running at 3% while average earnings were growing by 1%.
What occurred was that consumers ran down their savings to fund higher spending. Again, this is not unusual. Households get more cautious in troubled times and they save more just to be on the safe side. When they perceive that life has become less difficult, they save less.
But, unless consumers are willing to save less and less and borrow more and more, there is only so long this process can continue. Eventually, spending growth has to be the result of rising incomes rather than falling savings. All of which brings us back to the present. Consumer confidence has edged lower in the past three months, reversing part of the gain seen earlier in the year. High street spending in October and November was weaker than the City had been expecting.
Again, this is wholly predictable. Consumers no longer felt comfortable about running down their savings and so they spent a bit less. They may have had a bit of a splurge at Christmas but will then retrench in the new year when the credit card bills roll in.
After a year in which the consumer has been the driving force behind the expansion of the economy, 2014 should be the year when investment kicks in. Many of the objective conditions for an increase in business spending are in place: companies are cash rich, profitability is good, interest rates are set to stay low, and ageing capital stock needs replacing.
The one factor not in place is the most important one of all: an increase in real wages. If companies believe that consumers will carry on spending, they are much more likely to take the plunge on new investment projects. If they think consumer spending will stall, they will keep their plans on hold.
In those circumstances, the recovery in the UK will prove unsustainable. It will depend on a sugar rush from rising house prices stimulating further falls in consumer spending. The lack of new investment will mean that inflationary pressures build up and the trade deficit will continue to widen.
Companies have got used to having the upper hand in wage negotiations but now need to grasp a simple message: rising real incomes equals rising consumption equals rising investment equals a far higher chance, even given the structural flaws in the economy, of a sustainable recovery.
Give Britain a pay rise.