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Dragging us all down

Matthew Whittaker

Date: 21. September 2012 / Category: Labour market

This post originally appeared on Public Finance

Unemployment is one of a number of factors keeping a lid on pay levels in both the public and private sectors

With so little to cheer in the British economy in recent years, the steady fall in unemployment since the turn of the year has been seized on as a sign that broader recovery may be around the corner. Yet in truth, the prospects for living standards in the country remain gloomy. And even if growth does return, new research from the Resolution Foundation predicts that unemployment will need to fall by over one million before Britain’s workers can look forward to any meaningful increase in pay.

It’s a fairly obvious point that pay rises depend in part on the underlying level of unemployment: the more people there are ready to step into work, the less scope employees have to push for higher wages. Of course the connection is not quite so straightforward in practice, and pay trends are affected by many more factors than unemployment alone, but data drawn over time and across countries points to a clear relationship.

The new study What a Drag, written by leading labour market economists Paul Gregg and Steve Machin, suggests that this relationship may have intensified over the last decade. Wages have certainly performed less well during the current downturn than in the recessions on the 1980s and 1990s. Where previously median pay just about kept pace with inflation, even as output fell and unemployment rose, this time round it has fallen by more than 4 per cent.

Of course, this disappointing performance stems in part from the public sector pay freeze announced in Budget 2010. And, while painful, wage restraint more generally is likely to have played its part in the surprising resilience of employment since the start of the crisis in 2008 (despite topping 2.5 million, unemployment remains low relative to the size of economic contraction). However, the report finds that wage trends were altering earlier in the 2000s, long before the onset of recession.

It considers two periods: 1986-2002 (when median wages generally increased above inflation) and 2003-2010 (when pay first flat-lined and then fell). The authors find that wage rises did indeed become more sensitive to changes in unemployment in the latter period, and to a significant degree: while a doubling of unemployment was found to depress median pay by 7 per cent in the earlier period, the impact rose to 12 per cent from 2003.

This means that the actual increase in unemployment observed between 2005 and 2011, from 4.6 per cent to 8.3 per cent, led to a reduction of £2,100 in the annual earnings of workers on median pay. Such a rise in unemployment would have reduced those earnings by only £1,300 in previous years. The increased sensitivity of wages to unemployment is therefore costing typical workers £800 a year.

Why is this happening? There’s no definitive answer and it’s difficult to pin down the precise date at which the relationship changed, but the weakening of labour market institutions – such as the falling coverage of trade unions – may well have played a part. As may the success of active welfare policies which have made the unemployed better able to compete for jobs.

Whatever the causes, the findings have several implications for policymakers trying to plot a course to economic recovery. First, wages are unlikely to outpace inflation (among low and middle earners at least) until unemployment falls significantly – probably below the levels recorded during the ‘good’ years prior to 2008. Secondly, the Bank of England should find itself able to keep interest rates lower for longer as growth returns, without fear of wage-driven inflation.

Finally, and perhaps most importantly, if the government wishes to boost the wages of ordinary workers it must focus not just on policies that influence pay directly, but also on driving down unemployment. The shift in the relationship between wages and unemployment mean that getting people back into work matters not just for those directly affected; it is an essential pre-condition to securing sustainable wage growth.