GUEST POST: Stewart Lansley is the author of ‘Rich Britain’ and two pamphlets in the TUC ToUChstone series: ‘Do the Super-Rich Matter?‘ and ‘Life in the Middle‘. His latest book, written with Mark Hollingsworth, is ‘Londongrad: From Russia With Cash‘, the story of how the London-based oligarchs built vast personal fortunes from Russia’s historic wealth, and spent them in Britain. A real life case study of the rise of the world’s super-rich, Britain’s remarkable compliance in the transfer of wealth from Russia and the consequences it has wrought.

This guest post marks the launch of his new TUC pamphlet.

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Rising personal debt, global imbalances, excessive bank leveraging and reckless financial risk-taking all played a key part in the current economic meltdown. But there is another factor that has been largely ignored — the role of wages which I explore in the first Touchstone Extra -Unfair to Middling:  How Middle Income Britain’s Shrinking Wages Fuelled the Crash and Threaten Recovery, which is published today.

In the 25 years from 1945, the share of the nation’s output going to wages held steady at close to 60% before rising to nearly 65% in 1975. Since that high point, the wage share has been in inexorable decline. Today it stands at a mere 53%. An even steeper fall has occurred in the United States, while continental Europe has experienced a shallower fall.

Although living standards in the UK have nearly doubled over the last 30 years, some groups of workers, especially those just above the minimum wage, from fork-lift truck and bus drivers to bakers and low-skilled factory workers have enjoyed little increase in real earnings over the period. Most middle and low income workers have enjoyed only small rises in real wages. It is only top executives and financiers and the best paid professionals — medics, accountants, lawyers and engineers — who have enjoyed wage rises in excess of wider rises in prosperity.

The overall decline has been driven by the erosion of employment rights, a reduced demand for unskilled labour and the transfer of jobs triggered by globalisation. These factors have greatly boosted the bargaining power of employers.

As a result wages have been falling behind productivity growth. Over the last three decades economic potential has been growing by 1.9% per year while real wages have been rising by only 1.6% a year. Since 2000 the gap has widened with real wages rising by around half the productivity gains.

These trends have had a profound impact on the economy. In the 1970s, Britain’s problems — its inflationary spiral, low investment and weak productivity growth — were exacerbated by the ‘profits squeeze’ of the time. Yet this squeeze turned out to be temporary, the product of an exceptional set of circumstances including the oil price shock. Today the imbalance of the 1970s has been reversed. The ‘profits squeeze’ has been replaced by a ‘wage squeeze’. As wage increases have slowed, investment returns and profit levels have soared.

Moreover, unlike the short lived profits squeeze of the 1970s, today’s wage squeeze is a proving much more enduring. In the process, Britain has, over the last three decades, been steadily transformed from a relatively high wage, low debt, equal society to a low wage, high debt and much more unequal society.

This new imbalance is a key factor in the current financial turbulence. Why? First, because of the negative effect of low real wage growth on spending power. To maintain living standards, families became increasingly indebted. While households borrowed an average of 45% of their income in 1980, they borrowed 157% — more than three times as much — in 2007.

Secondly, because of impact of the swelling profits’ pool. Some of the extra profits funded higher levels of business investment. But much of it flowed elsewhere. Higher profits were used to justify record dividend payments and the explosion of corporate, executive and financial remuneration. With rates of return on financial engineering exceeding those on manufacturing investment, funding for long term success gave way to short-term, fast-buck deal-making with money moving around at speed chasing the quickest return.

Record returns encouraged the wealthy to borrow more not to finance consumption but to take speculative bets on assets where rates of return exceeded the cost of borrowing — at historic lows from the millennium. Money poured into hedge funds, private equity, takeovers and commercial and domestic property.

Bank lending ratios soared. Business values rose. The financial services sector mushroomed in size while the manufacturing base shrank.

Little of this financial merry-go-round strengthened Britain’s economic base or helped create sustainable businesses and jobs. Most of it simply encouraged financial speculation aimed at building even larger personal fortunes. The shift to profits was the most important factor driving the remarkable personal wealth boom of the last two decades, a boom which concentrated wealth in fewer and fewer hands. In turn this concentration fuelled the asset boom.

As money poured into commercial property, housing, art and commodities, asset prices soared. At the height of the housing boom, for example, top end house prices increased much more sharply than on average. According to Savills, prices for prime central London properties costing over £5 million grew by 50% in the year to March 2007, six times faster than for houses in general.

The ‘wage squeeze’ has not merely contributed to economic turmoil, it is now hampering recovery. Wage freezes and cuts — from British Airways to Honda — are increasingly common. So where is the demand necessary to create a sustainable recovery to come from?

In the short term the stimulus provided by public spending and the Bank of England  needs to continue. But the trend of an ever shrinking wage pool needs to be reversed. To avoid a return to the credit fuelled boom of the past, policy needs to shift from a preoccupation with the City and the chasing of ever rising profits. Policy makers need to accept the evidence that declining wages and the soaring earnings gap has contributed to economic instability. Building a more sustainable and less volatile economy depends on improving the lot of low and middle earners.

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Disclosure: I am an adviser to the TUC and an author of a ToUChstone pamphlet