Running an economy on falling real pay is not sustainable

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Unemployment in the UK is the lowest since 1975. Employment both in absolute terms and as a percentage of the people of working age, is the highest ever. Yet wages lag behind inflation. What’s up?

The problem is that there are lots of things going on and it is very difficult to know what importance to ascribe to each. There is certainly a puzzle, so let’s start with that.

First, the strong rise in employment is itself a surprise. If the economy is really slowing, as the official GDP figures say, you would not expect employment to be rising at a rate of 700,000 a year. Yet it is: 175,000 more jobs, mostly full-time, in the three months to May. Maybe the damage to business confidence from the botched election call will undermine further hiring, but there is little evidence yet.

Next, if the labour market is really tight, and companies are reporting skill shortages, why isn’t pay rising faster? The number of jobs on offer is increasing faster than the size of the workforce, so you would expect companies to bid up wages. There is anecdotal evidence that they are paying more for new employees, but wage increases in general are running at around only 2 per cent.

There is a further twist. Why is productivity not rising? According to Office for National Statistics data, the past 10 years have seen the slowest increase in productivity since the early years of the industrial revolution – the late 1700s. Yet this has been the decade of the iPhone, of Amazon, Airbnb, apps, Uber, Facebook, Google… the list goes on. Surely these advances in existing services and emergence of utterly new ones must have had some impact on the efficiency of the economy?

The key point here is that this is not just a British phenomenon. There is a similar pattern in the US. As a headline on Bloomberg put it yesterday: “Yellen Heads to Congress Wondering Why Job Market Hot, Wages Not.”

I suspect part of the explanation lies in the changing nature of work. Both the UK and US are overwhelmingly service economies, which use a lot of part-timers. They also use more self-employed, who choose (or are forced to choose) flexibility over pay. There has been substantial growth in people working beyond normal retirement age, who are likely to favour pleasant working conditions over absolute levels of earnings. And in Britain there has been an influx of young working people from the rest of the EU, for whom UK wages are higher than those available at home.

But this does not feel like a complete explanation. There has, I think, been a social change too. People would rather have a job (or be self-employed) than risk losing it (or the self-employment contract) by bidding up their pay. That may be partly a hang-over from the last recession, which reminded everyone of the reality of the business cycle. Firms tried to share the work out rather than lay people off, with the result that unemployment rose much less than forecast. It may be partly because of the debt load people carry. Better to keep your not-very-well-paid job and meet the credit-card payments each month, than risk moving to another better-paid one that might not work out.

Two other factors may be at work. One is pressure from offshoring and outsourcing. Many middle-skill jobs, particularly in IT, can be carried out more or less anywhere in the world, and while there has been more push-back recently to offshoring, I suspect it still exerts a downward pressure on wages. As for outsourcing, it is such a huge issue that it is hard to generalise, but moving a business to a supplier with lower overheads may also mean moving to one with lower wages.

The other factor is technology. There are various estimates of the proportion of jobs that might be replaced by automation over the next 10 years, but the most recent one I have seen put 45 per cent of jobs at risk. (Journalists, by the way, are vulnerable – you could be reading something written by a robot.) If a job might disappear altogether, current wage rates are likely to be squeezed.

None of this provides a complete answer. It may be that the level of unemployment consistent with inflation not increasing is lower than previously thought. If so, that is great in the sense that the economy can go on growing and people entering the labour market can go on getting jobs without the whole thing being choked off by a rise in inflation. But running an economy on falling real pay is not sustainable. We need inflation to come back down PDQ, and we need people to start feeling a bit richer.