Features
William Ham Bevan 9 Nov 2018 12:47pm

Why are pay levels lapsing?

With employment levels booming, pay levels have failed to keep pace with inflation across the industrialised world. William Ham Bevan asks, what’s behind the stagnation – and is there light at the end of the tunnel?

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Caption: Image: Mark Henley/Panos

It has been painted as the greatest riddle of modern economics. For decades, wisdom has held that when unemployment drops, pay levels should rise (and alongside them, inflation) as businesses are forced to compete for personnel. Yet since the financial crisis of 2008, even in industrialised economies where unemployment has fallen to levels last seen 40 years ago, wages have risen sluggishly, if at all.

It’s certainly the case that in the UK, real wages – taking inflation into account – have yet to climb back to pre-crisis levels. In April, the TUC branded the expected 17-year wage decline “the worst in 200 years”. In the UK, the domestic picture has been analysed in more measured terms by the Resolution Foundation, the think tank best-known for its annual Low Pay Britain report. In August, it reported that average weekly earnings were still £13 less in real terms than a decade earlier; and it has found that public sector jobs have been worst affected by the squeeze.

The most recent ONS labour-market statistics offered slight encouragement, with pay rates at least heading in the right direction. In the three months to July 2018, total pay including bonuses rose to 2.6% – or 0.2% in real wages, after inflation is taken into account – from 2.4% over the three months to June. Nevertheless, this is still comfortably below pre-crisis pay levels, and the uptick in pay is within the bounds of oscillations that have been seen since the recovery began.

Stephen Clarke, a senior economic analyst at the Resolution Foundation think tank, said: “While Britain continues to enjoy near-record employment levels, the key benefit of historically low unemployment – stronger pay growth for those already in work – is only slowly materialising.” “It is a major social issue,” says Iain Wright, director of corporate and regional engagement for ICAEW.

“In the aftermath of the financial crisis and the recession, I thought we’d see unemployment of perhaps 4 or 5 million. That hasn’t happened, and that’s a good thing. But the downside has been little or no wage growth. We’ve seen an increase in in-work poverty. People are working hard in low-paid jobs and still can’t pay the bills – and there’s something profoundly wrong with that.”

A new normality?

As well as seeming to go against conventional insight into the way employment and pay levels are related, wage stagnation has shown little sign of the self-correction expected by many commentators at the start of the economic recovery. Geraint Johnes is professor of economics at Lancaster University and an associate of the Work Foundation specialising in labour economics. He says: “Economists have traditionally said that everything always bounces back to 2%. So if you had a period where productivity was below that level, it would bounce back up; and because real wages and output are determined by productivity, they’d also bounce back.

What we see now is a 10-year period where that bounce has just not happened. Something structural has clearly happened in the economy, and our expectations have to be modified by that.” Many analyses rely on the concept of “slack”: when applied to the labour market, the amount of unemployment and underemployment, where people are working fewer hours than desired.

Clarke says: “Are we in a ‘new normal’ where even with very low levels of slack in the market, we can at best expect nominal wage growth of around 2.5 to 3%, or will we get back above 3%? I don’t think there are any real signs of the latter. All the forecasts have us ticking along at around 2.5% from now until 2022.” Some would further argue that the standards by which labour markets are considered “slack” or “tight” are themselves ripe for reappraisal.

Independent labour-market analyst John Philpott, a former director of the Employment Policy Institute, says: “Although people talk of a tight labour market, we have an employment level that’s still above the rate that generates wage inflation. Thirty years ago, that point was around 10%. Now, because of a combination of structural changes including deregulation, it’s probably closer to 3%. We’re still some way away from that. And even if we keep unemployment falling and see upward pressure on nominal wages, what happens to real wages will obviously depend on whether we hit our inflation targets.”

So how did we get here? In the UK, the economy has been subject to a series of adverse shocks over the past 10 years. After the recession, severe austerity measures – considered by some economists to have set back economic recovery – have been followed by uncertainty over the effects of leaving the European Union.

However, economists are united on the root cause of wage depression. In common with many developed economies, Britain is enduring a long struggle with low productivity. Three issues are particularly pertinent, according to Professor Johnes: a lack of innovation, a shortage of business investment and a mismatch in the labour market. It’s not difficult to find markers to suggest that businesses have been reluctant to innovate over the past 15 years.

“Look at patents,” says Johnes. “Toward the end of the 20th century and the beginning of the 21st, we had a big peak in patents in industries such as IT and pharmaceuticals. That spurt of innovative activity seems to have dried up. These sectors have still seen heavy investment in research and development, but the gains and returns on investment have fallen.”

In the UK, the second issue – lack of capital investment – is most commonly linked to Brexit, and the reluctance of businesses to spend until the nature of the settlement between Britain and the EU is known. Johnes points out that it’s a more stubborn problem, and investment levels have remained depressed since the recession. The third factor is arguably the most complex. “After the Thatcher reforms, we have a very much more flexible labour market,” he says. “When a big recession hits, unemployment doesn’t go up as much as it used to. People are very willing to change jobs, maybe to ones they’re less suited to, or that don’t make full use of their abilities. And so we end up with a heightened level of mismatch in the market, with people not using their skills fully.”

Consequences

On an individual level, the most notable consequence of wage stagnation has been a squeeze on living standards. According to Jonathan Cribb, a senior research economist at the Institute for Fiscal Studies, real average household income has grown by a comparatively anaemic 1.6% per year since 2011-12, when recovery began after the financial crisis.

By comparison, the average for the 40 years prior to the recession was 2%. Cribb says low wage growth is the key factor. “The household income figure takes into account not only how much people are paid, but how many people are in work, how much tax people are paying, and how much in benefits and other forms of income they’re getting.

When you look at the resources coming into the household, they’re 6% higher than before the crisis. But if you just look at people’s pay packets, they’re around 3% lower.” The consequences can be seen in a wide range of indicators, from house sales to the weekly shopping trip. “There has been a clear response to the fact that living standards are not increasing,” says Johnes.

“We’ve seen a shift to the budget end of the grocery market, with companies like Aldi and Lidl doing very well. People are also putting off buying durable goods, or making them last longer.” Wright agrees. “If you’re confident that you’re going to remain employed and have wage increases over the rate of inflation, you’ll start to invest on a household level. You may buy a bigger house or a car, or invest your spending money in other ways. But when wage increases are not happening, you don’t have this confidence.

“The structure of our economy – and this is also true of most westernised post-industrial economies – is very reliant on consumer confidence to drive it forward. It’s not necessarily based on export performance; it’s as much about this internal consumption by individuals. When that falters, the whole economy splutters.”

The effect on savings, too, has been profound; and as the wages slump goes on, individuals are becoming less inclined to put money aside. “One of the things that has been very striking in the recent past is that savings have fallen off a cliff,” says Johnes. “If you look at the ratio of savings to income, in 2015 Q3 it was 10%. The latest data we have suggests a figure of 4.1% – so they have really collapsed.”

The exact nature of the link between pay levels and interest rates – and the reasoning behind August’s hike in the Bank of England base rate – is more controversial. Clarke says: “The Bank of England has argued that there are signs of nominal pay growth picking up, and that’s partly behind their reason for raising rates; though if you read between the lines, what they’re really saying is that they think the current level of wage growth is probably all that the UK economy can handle before inflation starts rising.”

A meaner, leaner future

Unpredictability on both a world and domestic level – represented by oil-market fluctuations and Brexit manoeuvrings respectively – makes economic prediction a risky science. But there’s near unanimity that a further period of wage depression is not only likely, but could have grave effects on the nation’s social fabric. “I’m quite pessimistic,” says Wright. “I take my lead from organisations like the OBR, whose latest economic and fiscal forecast actually shows wage growth going into reverse from 2020.

We’ll have had a period of about 15 to 20 years with absolutely no wage growth at all. That’s unprecedented in the modern era. People want to think that if they work hard, their standard of living goes up.” One ray of light is that however much the parameters may have shifted, drawing closer to full employment may finally achieve a mitigating effect. “It may be that we’re approaching a point where low unemployment really will start feeding through into pay,” says Clarke.

“As economists, we all thought that the long-run rate of unemployment was about 4.4% or 4.3%, which is what we were at in the mid 2000s. It has dropped well below that now, at around 4%, and could even drop lower. “Now, it may be that 3.8% is the new sweet spot, when we start really seeing unemployment feeding through into pay. I think there’s very little slack left, and you can imagine a world where we reach 3.8% and start to see an impact on wages.

“However, some economists put the figure as low as 3%, or close to it, when there’s an upward pressure on pay. It could be that some of the shifts we’ve seen – such as more selfemployment and casualisation – mean we are able to sustain the lower level of unemployment without generating pay pressure. And we may have another inflation shock, or find that productivity fails to pick up at all.” There is the possibility, too, that even if it occurs, any employment- related wage inflation could be meagre.

Philpott says: “Any growth in real wages simply as a result of unemployment falling will be modest by historical standards. We can’t escape the fact that the underlying problem is flatlining productivity. If we could get back to what used to be normal productivity growth, we could see real wage growth of around 2% year on year.

“Unfortunately, there’s nothing to suggest we’ll get anything close to that. Something between zero and 1% a year is the best we can hope for. If there is a productivity pick-up, that changes the equation; but that doesn’t seem to be on the horizon – and we’ve still got the uncertainty of Brexit.”

Ultimately, the prospects for improvement all rest in finding ways to close the productivity shortfall. And that, says Wright, is a matter for politicians and business leaders alike. “I don’t think policymakers want to be in the business of managing decline,” he says. “Trying to tackle these big issues is absolutely key.

I think the business community is really up for assisting them, to make sure the economy runs as well as it can and to make sure we can compete in the modern world. “Britain has a huge amount to offer, and I think that it will continue to be a major economic power in the coming decades. But we have to ensure that productivity improves. This isn’t about improving economic statistics or figures; we need to make sure so that everybody’s life improves through increased wage growth and rising living standards.”


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