The 'solution' to jobs puzzle: Falling wages

  • 12 June 2013
  • From the section Business
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Office workers

Economists have been scratching their heads to explain why employment has expanded fairly consistently since 2010, while Britain's national output has struggled to grow much at all.

But it turns out we might have solved the "jobs puzzle" a long time ago, if we had looked a bit more closely at what we were all being paid.

Today's jobs figures showed that employment had risen by 432,000 in the year to April. That's a 1.5% increase - roughly three times faster than the increase in GDP over the same period.

If you follow the numbers back to 2010, the story is even more stunning. There has now been a 6.8% (nearly 1.6 million) increase in private sector employment since the first quarter of 2010. In that same three-year period our economy has grown by less than 2.5%.

Some of you will be bored with my going on about this "jobs puzzle". Can't we just be grateful, you might say, that employment has been one bright spot in this miserable period, and leave it at that?

But, sadly, it matters quite a lot why private businesses are employing so many more people, now, to make the same amount of stuff.

Why? Because the other side to that stunning figure about employment is that our productivity - output per head - is now about 10% below where it would be, if the relationship between jobs and output had been behaving normally.

If that fall in productivity is permanent, that would mean our long-term economic potential has been cut permanently as well. It would also mean there's not much scope for the Bank of England or the Chancellor to try to speed up the recovery to get back the output we've lost - any efforts to do that would just generate higher inflation.

I know, you've heard all this before. Here's the newsflash, from an important new paper from the Centre for Economic Performance at LSE: it says the fall in productivity is probably not permanent, and it is certainly not due to workers all suddenly becoming 10% worse at doing their jobs.

Instead, Joao Paulo Pessoa and John Van Reenen say the productivity puzzle can be almost entirely explained by workers pricing themselves into jobs, at a time when companies have found it relatively more expensive to buy equipment for those workers to use - and the usual channels for getting credit to businesses in different parts of the economy have been seriously bunged up.

It's worth reading the paper itself, or at least the summary. It's pretty accessible. But the key point is that economists may have been working too hard to explain the puzzle, looking to elaborate explanations involving the financial crisis, when a large part of the story was pretty simple: companies have hired more people than usual because they have been a lot cheaper than usual, and also a lot cheaper than the alternative.

In the five years before the start of the recession in 2008, average weekly earnings rose 10%, after inflation. In the past five years they have fallen by nearly 8%. That has not happened in past recessions. The paper says that goes a long way to explaining why employment has looked very different in this period as well.

It's not just that wages have fallen in absolute terms. They have also fallen relative to the cost of capital.

This is where the fancy explanations relating to the financial crisis come back into play a bit. The idea is that the hit to the financial system means that companies are paying more to the bank to borrow and invest in machinery, etc. That provides them with another reason to employ relatively more people than before, to work with a given amount of capital.

I have already told you about a related explanation of the jobs puzzle - from Ben Broadbent on the Monetary Policy Committee. He suggested we might be seeing the effects of a dual economy, when it comes to credit, with some loss-making ('zombie") companies kept in business by banks under pressure not to pull the plug, and other, growing companies unable to get credit and, in effect, hiring workers instead.

This fits in fairly well with the LSE story. But they say the single most important factor in all this is the fall in wages.

Of course, this is not really news. I and others writing about this have often mentioned the role that falling real wages might have played in protecting jobs. What's new about the LSE paper is that they have put it all together to show just how important the falling relative cost of labour has been.

If this paper is right, we can indeed take comfort in the fact that employment has been so strong - and we don't necessarily have to worry that our productivity as a nation has been permanently hit.

That would be good news indeed. And the millions of us who have suffered a hefty real pay cut in the past five years can take quite a lot of the credit.