Why Britain is in desperate need of a payrise

Why Britain is in desperate need of a payrise

Britain’s stellar success at the Rio Olympics has done wonders to sooth the looming depression that engulfed my left-wing liberal student bubble in the aftermath of the Brexit vote. ‘I don’t want to talk about it’ has been muttered among friends too weary of the emotion that comes with any discussion of what we considered to be Britain’s Armageddon. Yet this complete societal collapse has failed to materialise, with initial economic reports showing a mixed picture. British consumers are more concerned about the weather than they are about Brexit, while employment is up and a weak pound has boosted tourism.

Nonetheless pundits are quick to tout the surprise result, along with the rise of Donald Trump and Marianne Le Pen, as the consequence of years of economic malaise. This was more than a protest against the career opportunities that never come knocking and the affordable homes that never get built. It was a protest against the economic model that has been in place for the past three decades. This is a model where large chunks of the economy are stymied by low skills, low wages and low productivity. Where business have a tendency to meet rising demand by employing cheap labour rather than investing in modern equipment.

Many people can’t point to exactly where and how, but there’s the feeling that something isn’t right. This has unfortunately manifested itself as a focus on immigrants or “dangerous” types, but what they have really come to distrust is the system of economics and politics. Brian Bell and Stephan Machin, undertaking research commissioned by the Financial Times, found compelling evidence that worsening economic conditions has resulted in moving voting patterns away from the dominant political parties. The report highlighted the case of Castle Point in Essex. Real median wages have dropped by 13 per cent in the years 1997-2016 and Ukip took 31 per cent of the vote share in 2015. The study cited anger at “uncontrolled” immigration as a main driver of Ukip support, yet in Castle Point immigrants account for only 4 per cent of the population.

These Ukip voters are drawn to the understandable but incorrect conclusion that since immigration increases the total number of people in work or looking for employment, UK workers must have been harmed by the increased competition for jobs. This is known as the ‘lump of labour fallacy’. In reality there would be harm only if the total number of jobs is fixed and only where immigrants compete for a particular job. But since immigrants also consume local services and goods, this increases demand and so raises job prospects of those who produce those goods and services. The image (CEP chart -Figure 4) shows how just uncorrelated the unemployment rate and net migration rate are.

Yet as noted above, it has been wage growth, or lack of it, that has seemed to drive this bigotry. That even if immigration doesn’t increase unemployment, surely an increase in the supply of worker’s must drive wages down? Economic theory tells us that it isn’t that simple. The impact on wages of existing workers depends on the extent to which migrant skills are complements or substitutes to the skills of existing workers. The greater the substitute the greater the impact on wages, while complimentary skills boost everyone’s pay. Interestingly a paper by the European Economic Association found that the main impact of increased immigration is on the wages of migrants already in the UK. This might go some way to explaining the disproportionately high number of UK migrants who wanted to leave the EU.

Nevertheless it is important to recognise that quoting empirical studies can never give the full picture. Migrants often go to areas that are experiencing economic growth and strong labour demand, and are therefore both a cause and effect of changes to wages and employment, leading to what econometricians call ‘reverse causality’. International immigration can further dissipate its own employment effect by causing the internal movement of local labour to other areas.

Despite these challenges research still points to the minimal aggregate effect of immigration wages and employment, with compositional reports conducted by the Centre for Economic Performance and the Migration Observatory  showing how increased immigration raises wages over the long term. Blaming immigrants is short-sighted and an act of misdirection. However, that doesn’t mean the perception of deep unfairness in our economy is incorrect.

Worldwide, an anti-establishment revolt has been raging since the crisis. This feeling of anger and frustration has most recently been directed at the European Union, and unsurprisingly, is strongest in areas of Britain that have seen wages stagnate in recent years. Between 1997 and 2015, the median wage in the UK overall rose from £269 per week to £426 per week. But prices rose 43 per cent over the same period, leaving a real gain of just 15 per cent, or less than 1 per cent a year. This average masks the fact that 62 out of 370 local authorities actually saw median wages fall in the period, with some witnessing double- digit declines.

Wage growth is typically thought to be driven by three main factors: productivity, inflation expectations and labour market slack (that is, the level of hours worked relative to potential labour supply). In the long run, an individual’s real wage should track their productivity — the value of what they produce over a given period measured in real terms. Nominal wages also need to take account of inflation to preserve spending power. As wages are typically set in advance, this means factoring in inflation expectations when setting wages. Finally, in the short run at least, if unemployment is high then workers are more likely to accept lower wages because their alternative options, such as searching for a job elsewhere, are worse.

By contrast, from 2008–12, wage growth averaged less than 2%. Some of this fall can be explained by the sharp fall in productivity growth. But even accounting for this, wage growth was weak during the crisis and the immediate recovery. This is likely due to the high level of labour market slack, reflected in the rise in unemployment, reducing the pressure on employers to raise wages to retain and attract staff. Economic theory expects a rise in wage growth as workers regained bargaining power due to declining slack in the labour market, but pay growth remained weak even though unemployment began to fall rapidly in 2013. Wage growth remained below its pre-crisis average in 2015 despite unemployment falling back towards its pre-crisis rate of 5%.

Across the Atlantic it is more of the same. American unemployment is, by historical standards, low. Yet real wages in America remained largely stagnant between 2010 and 2015. This is in part explained by America’s unemployment-insurance scheme drastically reducing the term over which someone can claim benefits. In economic parlance worker’s ‘reservation wage’, the pay rate needed to bring them into employment, fell rapidly. This is reflected in the large proportion of job’s created in 2014 coming from low-wage, low productivity sectors. Most concerning is the number of workers who are ‘part time for economic reasons’-those who would rather work full time but are unable to do so. The Federal Reserve Bank of Chicago conducted research that showed how this group of workers still exert a strong effect on wage growth.

David Blanchflow and Stephan Machin, in a paper for the Centre of Economic Policy, present a foreboding comparison of the US and UK’s labour market. In 2013, US median real weekly earnings were about the same as in 1979. Across the chart below the typical US work has fared terribly, facing decades of stagnant wages. This is of concern, as the American labour market went through a number of neo-liberal changes much earlier than the UK. These included greater ‘flexibility’ and a significant reduction in union bargaining power over wages.  

So why have wages across the western world performed so poorly even as unemployment has fallen? Blanchflower and Machin cite weak productivity growth and rising inequality in the years following the recession as cause for this rise of the working poor. There has been a ‘decoupling’ of median wages from what little productivity growth there is. That is, since a growing share of the value created from productivity growth is absorbed by higher salaries for top earners, average wage figures rise far above that which the typical worker actually earns. 

What are known as ‘compositional effects’ in labour economics have further acted as a drag on measures of productivity and wage growth since the financial crisis. Compositional effects are the changes in the average wage due to a change in the mix of characteristics of those in employment (Figure 1-Bank of England Report.)

The CEP chart above shows how unemployment in the UK is almost at pre-recession levels. But any small difference in employment masks substantial churn in the labour market. The changes in aggregate employment are the product of much larger flows into and out of employment as well as the movement of people between different jobs. Demographic shifts have played their part, with a higher level of graduates, women and part-time employees entering the workforce. Initially these composition effects account for a large proportion of the UK’s pre-crisis wage growth.

During the recession and subsequent recovery these effects began to turn negative. Flows into and between jobs went primarily into lower-skilled, lower paid industries. If this slowdown in productivity had been short term and cyclical then the United Kingdom would be able to return to trend growth quickly without resulting in excessive inflation. 8 years on from the crisis, productivity shows no signs of improving, and hence neither does wage growth.

The failure of wage growth to pick up as much as might have been expected following the fall in unemployment in recent years indicate a fundamental change the UK’s labour market structure. The Financial Times quote John Philpott, director of the Jobs Economist consultancy calling for a rethink in the Bank of England’s definition of a ‘tight labour market’-that is the level ofunemployment below which wages start to rise significantly.

Globalisation brought with it the promise of prosperity for all. A fundamental proposition in economics holds that when individuals are free to engage in trade, the size of the economic pie increases enough that the winners could, in theory, compensate the losers, leaving everyone better off.  In practice, the compensation tends to remain hypothetical, where there are those who argue that globalisation is now like the weather, something we can moan about but not alter. This is a false comparison. The global market economy was created by a set of political decisions in the past and it can be shaped by political decisions taken in the future. Yet to design sound policies it is vital to understand why wages have stopped rising, what the implications of a flat-wage world would be, and the likely impact of pay-propelling policies.

Economics is still only just getting to grips with these questions. But the message from Brexit and similar movements is clear: many working and middle-class voters, who feel left behind by globalisation, are far angrier than establishment leaders realised. Political instability stems from economic insecurity.  One has to wonder how, in a democracy, the political establishment could have done so little to address the concerns of so many citizens. They have shown they can no longer be dismissed; leaders must figure out how to address their concerns, or face political ruin.


Daniel Sharp, President