Asset management

10 February 2014

Economist Insights The employment enigma

Despite UK GDP performing poorly, employment growth in the UK has held up pretty well since the recent recession. Output fell but people kept their jobs: creating both a productivity puzzle and an employment enigma. Has there been a shift in the labour supply? Or could the enigma be caused by GDP data which may be revised upwards? Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

In the US, the big question in the labour market is whether the drop in the number of people participating in the labour force is cyclical or structural. In the UK, the big question is why so many people have a job. Despite the terrible performance of GDP, employment growth in the UK has held up pretty well and the unemployment rate is nowhere near as high as would have been expected. The price of keeping people in jobs while output falls is that the amount that each person is producing actually declines; you might say that people are getting worse at their jobs. Why this should be happening is perplexing economists so much that it has been dubbed the productivity puzzle. The recent recession has definitely seen the worst performance for UK GDP (see chart 1), but it has seen the second best performance for UK employment. The more traditional recessions of the 1980s and 1990s saw big job layoffs, and output recovered faster than employment. So productivity actually rose during those recoveries because fewer people were producing more. The mid 1970s recession was very shallow, but still saw the same pattern. So output is behaving in keeping with the past, albeit the pattern is more severe and prolonged, but it is employment that looks unusual. The productivity puzzle could just as easily be thought of as an employment enigma. One explanation put forward for the employment enigma is that firms are hoarding labour. Firms might want to keep hold of workers if they have invested a lot of time into training them, or if they are worried about a shortage of skilled replacements once demand picks up again. However, the training argument is only likely to apply to a small number of

jobs, and there is nothing in the business surveys to suggest any fear of filling vacancies. The data on flows of jobs in and out of the labour market pretty much rule out labour hoarding as an explanation.
Chart 1: Over-employed UK real GDP (left) and employment (right), rebased to 100 at start of recession, months following peaking 115 110 105 100 95 90 0 3 6 9 12 15 18 21 0 3 6 9 12 15 18 21 Months after start of recession 1980-81 1990-91 2008-09

1974-75

Source: ONS, UBS Global Asset Management

A simpler, and more convincing, explanation is that the supply of labour actually increased in response to the recession. A good sign of this is that the participation rate actually rose in the UK, the opposite of the US. Households saw the value of their savings and other assets fall. Those with lots of debts, of which there were far more this cycle,

realised that they were better off keeping hold of a job even if the wages were bad so as to avoid defaulting on their debts. It is rare for nominal wages to fall, but the high inflation the UK experienced (partly from a weaker currency and increases to VAT) allowed real wages to fall. Economic theory tells us that real wages should move in line with productivity growth you pay people more when they produce more. In the 1990s and 2000s this held up well; real wages rose broadly in line with productivity (chart 2). Since 2008 productivity has fallen but real wages have fallen further. Cheaper labour goes some way to offset the lower productivity, stopping unit labour costs from accelerating.
Chart 2: An enigma wrapped around a puzzle Average annual growth in UK productivity, real wages, inflation and unit labour costs (%) 6 5 4 3 2 1 0 -1 -2 1993-1999 Productivity 2000-2007 Real Wages 2008-2013 Unit labour costs

Forward quandary The employment enigma has been a headache for the Bank of England (BOE). It used the unemployment rate as the basis for forward guidance because it thought that output would have to rise faster than employment. If firms had a lot of labour already, then an increase in aggregate demand would be met out of the spare capacity that generates and hence the unemployment rate would only improve slowly. As the recession ended, firms have responded to higher aggregate demand by hiring more workers. This is puzzling because it just keeps productivity low. Firms would be better off making existing employees work longer or harder in other words, more productively. Instead firms seem to be hiring more workers unproductively, which pushes the unemployment rate down to the BOE threshold. The BOE has been forced to rethink its forward guidance. The core challenge for the BOE is whether the weak productivity is cyclical or structural. If it is cyclical, then the BOE should expect a rebound in productivity as output rises faster than employment. In this scenario the unemployment rate will fall more gradually but the pickup in productivity will support an acceleration in wages. This would in turn support a sustainable recovery without generating inflationary pressures. The BOE would then be in no rush to increase rates even if growth is well above potential. Conversely, if there has been a structural decline in productivity then the unemployment rate could continue to decline and even fall below its full employment level. This could potentially generate wage pressures, as skills shortages increase, leading to a pick-up in inflation. In that case the BOE would be forced to intervene even if the recovery remained disappointing. As long as real wages remain weaker than productivity, the BOE has very little to worry about from inflation. However, the complexity and uncertainty surrounding the employment enigma will force the BOE to focus on a wider range of indicators to determine its strategy just like it used to. Paradoxically, the unusualness of the productivity paradox and employment enigma may force the BOE to go back to business as usual, rather than just linking decisions to a single economic indicator.

Ination

Source: ONS, UBS Global Asset Management

If there has been a shift in labour supply it may be cyclical, but there are possible structural explanations as well. The financial crisis and the boom years that preceded it may have led to a mis-allocation of resources that encouraged firms to substitute capital for labour. The crisis could also have led to losses of jobs in high productivity sectors like finance and insurance. There is one last explanation that should be considered seriously the problem might not actually exist (or at least, might not be as large). It may turn out that the puzzle is not employment (which is easy to measure), but actually GDP (which is hard to measure). The average revision to annual UK GDP between 1993 and 2007 has been almost a whole percentage point upwards (2008 has been the exception with a big downward revision so far). This would not be the first time that data revisions wipe out a past puzzle the whole US deflation scare of the early 2000s turned out to be an illusion created by the data. In fact, quite a number of puzzles about the UK economy, such as low bankruptcies, would also be solved by GDP being revised up.

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