Media Briefings

The UK’s More Flexible Labour Markets Save Jobs In A Downturn

  • Published Date: November 2007


Greater labour market flexibility in the UK has helped to limit increases in
unemployment during economic downturns, according to new research by Dr
Richard Barwell and Dr Mark Schweitzer, published in the November 2007 issue
of The Economic Journal.
The report finds that workers in jobs that are protected from ‘real’ pay cuts are more
likely to lose their jobs. In the 1970s, this kind of wage rigidity was widespread and it
exacerbated the effects of any downswing on unemployment. As the extent of wage
rigidity fell, downswings caused less of an increase in unemployment in the 1990s
than they did in the 1970s.
The study also finds that people’s expectations of inflation – and, in particular, their
uncertainty about future inflation – fell with the greater independence of the Bank of
England in the 1990s. This suggests that confidence in the Bank of England may
have lowered inflation in itself.
The effect of the independence of the Bank of England is consistent with the authors’
further finding: that workers are ‘forward-looking’ when forming their expectations of
inflation, that is, they use information other than previous inflation rates.
As workers do not know what inflation will be over the coming year, they estimate it
when bargaining for their wage. These expectations of future inflation are important
in determining wage demands, and thus in turn the realised rate of inflation: they
become a self-fulfilling prophecy.
The research establishes a number of key features of the UK labour market:
• Protection from ‘real’ pay cuts (where wages grow more slowly than inflation)
has been the most important source of wage rigidity.
• The number of workers protected from such cuts fell between the 1970s and
the 1990s, which reflects the increasing flexibility of the UK labour market.
• Some workers are more likely to be protected from pay cuts than others,
according to their age, their job or whether their wage is covered by a union
agreement.
The study provides a new take on an old question: do wages adjust enough to
shocks? Research published in The Economic Journal in 1901 documented the
extent to which wages do not change from one year to the next, and in some cases,
from one decade to the next.
At least as far back as John Maynard Keynes, macroeconomists have identified that
rigidity in wages is a possible, if not probable, cause of cyclical movements in
unemployment: companies may be more inclined to lay off their workers if they
cannot adjust their wages in response to shocks that affect their productivity.
Economists differentiate between two kinds of wage rigidity. Workers may be
protected from nominal, or absolute cuts in their pay packet. Or they may be
protected from real cuts in their pay, where their wage is pegged against the cost of
living to keep its purchasing power constant.
It is likely that the extent to which individuals are protected from nominal or real pay
cuts will vary, both across the workforce at any moment in time, and through time for
a given worker. This study uses a rich source of data containing information on the
pay of a large number of British workers over several decades to estimate this crosssectional
and time series variation in the incidence of nominal and real wage rigidity.
It is difficult for workers to guarantee an increase in their nominal wage that will
protect them from a real pay cut, because they do not know for sure how much the
cost of living will increase over the coming year.
In practice, workers will have to agree an increase in their nominal pay that matches
their expectation of the rate of increase in the cost of living. The researchers
estimate these expectations of inflation that are implicit in workers' wage demands
and find two key results:
• First, those expectations are more sophisticated than simple adaptive
expectations models suggest: workers don't expect the inflation rate next year
to be the same as it has been this year.
• Second, the distribution of those expectations is far less dispersed in the
1990s, and that is consistent with introduction of the new monetary policy
framework acting as a more powerful anchor on expectations.
The final section of the study investigates the potential business cycle consequences
of wage rigidity. The researchers identify those workers who are more likely to be
protected from cuts in their pay and then investigate whether those workers are more
likely to lose their jobs. The results suggest that they are, providing supporting
evidence of the macroeconomic relationship between wage rigidity and
unemployment at the micro-level.
ENDS
Notes for editors: ‘The Incidence of Nominal and Real Wage Rigidities in Great
Britain, 1978-98’ by Richard Barwell and Mark Schweitzer is published in the
November 2007 issue of The Economic Journal.
Richard Barwell is at the Bank of England. Mark Schweitzer is at the Federal
Reserve Bank of Kansas City.
For further information: contact Mark Schweitzer on +1 303 572 2695 (email:
mark.schweitzer@kc.frb.org); or Romesh Vaitilingam on 07768 661095 (email:
romesh@compuserve.com).