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Explanation for Britain's economic puzzle
Samuel Brittan The Financial Times 26/10/12

The late Wynne Godley was one of the most thoughtful of UK Treasury forecasters, and later went on to become a Cambridge professor. One of his characteristics was a tendency to find a puzzle in each set of economic data - something that did not make sense on the basis of past relationships.

There is now a conundrum that would have made his day: the productivity puzzle. Despite David Cameron's incredibly silly optimistic response to a much predicted Olympics-based short-term variation in quarterly estimates, UK gross domestic product is still 3 per cent below its 2008 peak. Yet there has been virtually no change in employment. As a matter of arithmetic this has involved stagnation in productivity, defined as output per person. This contrasts with previous recessionary periods in which productivity had risen substantially by this stage. On the basis of past relationships, productivity would have been almost 15 per cent higher. It is little comfort to find similar phenomena in other European countries.

The real puzzle is why employment has held up comparatively well. On the basis of past relationships, there might have been an unemployment rate of 3.5m instead of 2.5m; the Cameron government would have been out on its ear and the search would be on for a truly national government, if only anybody suitable could have been found to lead it.

But to return to the numbers. The Office for National Statistics has just published a preliminary analysis of the conundrum and a modest part of what has happened can be explained by a fall in working hours. But this still leaves the greater part of the discrepancy with previous periods to explain. The ONS concludes there are several factors at work.

This is a typical statistician's finding, which left me with the urge to seek a single, more general factor. I may have found it in the chart comparing average weekly earnings with the consumer price index. For most of this century, earnings rose faster than prices. But since 2008, the pattern has been reversed and, with the solitary exception of one quarter, prices have been in the lead. In other words, falling real wages have priced workers into jobs, or least enabled them to stay in employment.

This kind of hypothesis drives some people into a frenzy. When Nigel Lawson, a former chancellor, broached this possibility in the 1980s all hell broke loose. To show that it was not just a personal or political hobby horse, in the end he published a paper on the relationship between employment and wages with the unusual authorship, "Review by Treasury Officials".

To establish the link on the present occasion would require more investigation. Real wages from the point of view of the employer are not the same as from that of the employee. Import prices, to take one example, play a different role in the two series. Moreover a full investigation would require an international perspective. Yet the behaviour of UK profit margins which have held up better than in similar periods in the past gives a clue that we are on the right lines.

If there is anything in my hypothesis, it is natural to ask what has caused this moderation in wage behaviour. The firmest evidence comes from the long decline in the percentage of employees who are union members, from 39 per cent in 1989 to 29 per cent in 2000 and 26 per cent in 2011. This has been a long process with delayed effects, but I doubt it is the only reason. The atmosphere among workers seems to be more nervous than in previous recessions - partly because this one has been more prolonged and its causes more mysterious. This may have made workers keener to keep their jobs than to chance their luck and push for pay rises, even when wages have risen less than prices.

Picking on the role of real wages does not in the least absolve the government of responsibility for the long stagnation of real GDP, which has still to regain its 2007 level. Fiscal policy, driven by an obsession with the budget deficit, has held back economic growth, while wage moderation has limited the effects on jobs. To make this point there is no need to trace sluggish growth to specific acts of fiscal retrenchment. Previous governments would have taken action to maintain demand, at least in nominal terms.

Because of population growth, GDP per head has fallen more than GDP since the 2008 peak. Moreover an ONS index entitled Real Household Actual Income per Head, which includes free or subsidised goods such as healthcare, has fallen by about 13 per cent. It is small consolation that the UK is still about 13 per cent above the EU average.

The Institute for Economic Affairs once coined the slogan: "Low pay is better than no pay." If ever nominal demand starts to expand at a more normal rate - whether due to a spontaneous outbreak of animal spirits, a change of chancellor or whatever - the choice between the two should become less painful.


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