The UKs Productivity and Employment Mystery

THE UK’S PRODUCTIVITY AND EMPLOYMENT MYSTERY

GDP per hour – labour productivity – in the UK remains lower than at the beginning of the recession in 2008. A special session at the Royal Economic Society’s 2013 annual conference held jointly by the Centre for Economic Performance (CEP) and Institute for Fiscal Studies (IFS) investigated the causes of this mystery.

Productivity is usually lacklustre in a recession as many resources are under-used because of low demand. The most recent recession has been more severe than any since the war: with output more than 3% below its pre-crisis level, this is the weakest recovery for over a century. Although we would expect productivity to have taken a big hit, we would also have expected some more recovery by now.

The four studies stress that labour market flexibility is an important part of the solution to the productivity puzzle. In a normal recession, output falls but real wages generally do not. Unemployment rises as firms face high labour costs and weak demand. Many workers; particularly the less skilled cannot find work. The exit of these more marginal workers from jobs means that measured labour productivity falls by much less than it normally would.

The latest recession has also seen the least skilled struggling to find work (Blundell, Crawford and Jin). But a big difference is that real wages have dramatically dropped in this recession, helping employers keep on more workers than in a normal downturn (Wadsworth). Consequently, unemployment has risen by much less than expected. The greater flexibility of real wages is likely to be due to weakened union strength and welfare reforms (Gregg and Machin).

Professor John Van Reenen, director of the CEP says: ‘The good UK jobs performance is the silver lining in the cloud of our low productivity numbers.’

Further details

John Van Reenen at CEP:

Public and private sector investment have collapsed in the UK. The banking crisis has increased the cost of capital despite a fall in the Bank of England’s interest rates, especially for small and medium-sized enterprises. Low demand and high uncertainty have also held back investment. In addition to falls in the quantity of capital, there is some fall in the quality of capital as banks are reluctant to close down underperforming firms (so-called ‘zombie firms’).

Van Reenen argues that low wages and weak investment mean a big fall in the amount of effective capital per worker and this accounts for most of the fall in labour productivity. This means that there is not a large fall in efficiency (total factor productivity) in this recession compared to earlier severe downturns.

The argument of ‘supply side pessimists’ that demand expansion through expansionary monetary or fiscal policy will be self-defeating is therefore wrong. Significant expansions in public investment, for example, will not lead to higher inflation.

Richard Blundell, Claire Crawford and Wenchao Jin from the IFS:

This research investigates to what extent changes in wages may have contributed to the fall in productivity over the last five years. The average wage has fallen by 3.5% relative to Retail Price Index since April 2008, which is in sharp contrast to continued real wage growth during and following the early 1980s and early 1990s recessions.

Moreover, this has not occurred as a result of firms choosing to fire expensive workers and hire cheaper ones: if anything, the composition of the workforce has shifted towards more productive workers (as it usually does during recessions).

It instead appears to have occurred because existing workers have accepted lower real wages. In fact, we see an unprecedented proportion (about 70%) of existing employees experiencing real wage cuts since 2009, compared to at most 50% during some years in the early 80s.

It is not entirely clear why this might be. One reason may be that the pool of potential workers available in this recession is larger than in previous recessions: for example, changes to welfare policy – such as the addition of job search conditions to benefit claims for lone parents when their youngest child reaches a certain age – and the substantial reductions in wealth that occurred as a result of the recent financial crisis both appear to have increased the proportion of the affected groups who are available for work.

Another reason might be that the reduced power of labour market institutions (for example, trade unions) may have enabled firms to impose such changes on their workers. What is clear is that wages and productivity have fallen in tandem during the recent recession; thus, while we cannot claim to have solved the ‘productivity puzzle’, it is clear that understanding what has happened to real wages is likely to help shed light on what has happened to productivity, and vice versa.

Paul Gregg at Bath University:

The recent economic performance of the UK economy has been highly unusual, with a protracted period of poor growth but a steady recovery in employment. At the same time, real wages have fallen by some 10% since 2009, the largest and most sustained decline in modern economic history. But real wage growth had already slowed substantially before the recent recession, from 2003, even when the UK enjoyed the lowest unemployment levels seen for 30 years.

This research documents the nature of real wage changes across the wage distribution over the last three decades, showing that the recent period of stagnant real wage growth represents a distinct break of trend that pre-dates the onset of recession. It explores whether unemployment has become a stronger moderating influence on real wage growth since the trend break and document, using aggregate economy-wide data and regional panel data, that the sensitivity of real wages to unemployment changes have become stronger in the period from 2003 onwards.

The magnitudes suggest that a doubling of unemployment from 4 to 8% (roughly what happened since the recession) would lower real wages by 12% in the current labour market but this would have only been 6% in previous periods. Furthermore, this is against a backdrop of an underlying stagnation of real wages even without unemployment rising, whereas previously wages were growing at just over 1% per annum.

The implications are profound. First, the cost of Britain’s recent poor growth record is falling on workers in the form of lower wages rather than high unemployment this time around, as compared to the recessions in the 1980s and 90s.

Second the higher sensitivity of wages to the unemployment rise seen has driven real median wages down by over £1000 more than would have been the case previously.

Third, the economy has lost the capability to see rising real wages except in periods of significant falls in unemployment. Even with low but stable unemployment wages are set to stagnate. Hence there is no underlying wage pressure to worry the Monetary Policy Committee at the Bank of England and interest rates are thus likely to remain low, by historical standards, even when low unemployment returns.

ENDS

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