From the productivity puzzle to an employment puzzle and, now, the wage puzzle

With technology becoming ever more pervasive in every aspect of work and life, economists have been puzzled by the lacklustre productivity growth in the last decade or so. In the UK, the productivity puzzle is simply the flipside of an employment puzzle: after the financial crisis, why did businesses keep hiring people, even when demand growth was sluggish? Our report in 2018 provided several explanations, not least the flexibility of increasing output through labour rather than capital.

Now, more than a year into the global COVID-19 pandemic, the labour markets have thrown us another puzzle: how come, with economic activity in the UK still well below its 2019 levels, real wages are going up?

As the chart above (and below) shows, wage growth (left hand panel) in almost every UK sector in the first quarter of 2021 was significantly higher than in the first quarter of 2020, and also much higher than average rates we have seen historically. And what’s more, this was against a backdrop of higher unemployment (right hand panel) in the first quarter of 2021 (albeit still lower than historical average rates — see here).

Part of the explanation is a compostional effect: because it is mostly lower-paid people who have become unemployed, even if everyone else’s pay had stayed the same, the weighted average wage for the total workforce would have gone up. The ONS estimates that this accounts for more than half of the 3.1% real annual wage growth recorded for the period January to March 2021. This still leaves an “unexplained” real wage growth of around 1.5%.

Another potential, fairly straightforward explanation is to do with relativities. Wage growth in percentage terms in the last quarter of 2020 and first quarter of 2021 was surprisingly strong — but from a low level. After all, real wages decreased by around 2% in the period April to June in 2020, compared to the same period a year earlier. This is similar to the rollercoaster dynamics seen in economic output (GDP): after the sharpest decline in more than 300 years, GDP grew by an astounding 17% in the third quarter of 2020.

But it is still somewhat puzzling that wages saw such robust increases, in otherwise weak economic circumstances. Just to put this into context: a 1.5% increase in pay may sound small, but in the decade from January 2009 to December 2018, average annual wage growth exceeded 1.5% only in 15 of the 120 months — so less than 13% of the time. And, as you would expect, those months were normally accompanied with high GDP growth, low unemployment, and high vacancy rates.

Contrast this with the situation in the last two quarters just gone. With unemployment close to 5%, claimant count averaging nearly 8%, and total output (GDP) not actually growing between September 2020 and February 2021, one would not have expected the price of labour to go up, either. So what does explain this puzzle?

There are three further explanations, all contributing to the answer. First, the demand for labour in the public sector — and in health and social care—was robust, as was wage growth. In the period January to March 2021, average annual total pay growth for the public sector, in real terms, was nearly 4.7%. Second, it’s plausible that employees’ compensation is “catching up” from a decade of very low real growth — even though why that would be happening just now is a little unclear.

Third, the shape of the labour market has shifted markedly. It appears that a substantial number of EU workers have left the UK labour market. And, as I outlined in a previous post, in March 2021, 13% of the workforce was still on furlough. In other words, 13% of the workforce were not counted as unemployed (as they still had a valid employment contract), but neither were they actively working. In my previous post, I implied that this “excess” supply of labour would put downward pressure on wages (and hence prices and inflation) in the medium term, once the furlough scheme comes to an end.

Now I’m not so sure. At the moment, anyway, the people on furlough are not part of the active labour market. Their status is more similar to people that statisticians classify as “economically inactive”: neither employed nor looking for employment. Technically, this leaves the rest of the labour market “tighter” than you might expect — especially if many of the people on furlough are in occupations for which there is now renewed demand (e.g., in construction, retail, and recreation), but not in businesses for whom this is true (e.g., a particular business struggling to adapt to new commercial realities.)

After the global financial crisis, there was a lot of talk and worry about so called “zombie firms”: businesses that were not really viable, but were not dead either, because their bank and owners were not keen to realise the losses that would materialise, were the businesses to be liquidated. Similar fears have resufraced as the COVID-19 crisis has worn on.

However, the analysis above points to a potentially even more serious danger: “zombie workers”. If, by the time the furlough scheme comes to an end, most firms have already hired the new manpower they need to respond to the recovering economy, and if individuals’ skills have become outdated or deteriorated during their furlough period, these workers could be left in limbo, with limited job opportunities. This would not just create problems for the aggregate economy but, of course, for the individuals themselves.