THE UK’S MORE FLEXIBLE LABOUR MARKETS SAVE JOBS IN A DOWNTURN

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 cross-sectional 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).