Sunday, May 17, 2015
Crunch looms as pay picks up but productivity struggles
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The dust has settled, though the politicians – on the winning side at least – have not yet paused for breath. George Osborne, when he has not been trying to turn the north into a powerhouse, has been laying the groundwork for renegotiating the terms of Britain’s membership of the European Union.

These are early days for both of those, so I shall leave them for this week. More interesting is whether the economy has been given a post-election splash of cold water. The Bank of England, whose praises I was singing last week, left it until the new government had its feet under the table before unveiling a downgrading of its growth forecasts.

Had the Bank told us that during the election campaign, say some, it could have eroded the Tory “stick with us for a stronger economy” message. The post-election shock was not a rise in interest rates – that is still perhaps 12 months off – but a gloomier growth outlook.

Hand on heart, I do not think we should get too excited about this. Until Wednesday, the striking thing about the Bank’s growth forecasts was how upbeat they were. Growth of almost 3% a year this year and next – 2.9% in each year - was perkier than almost all other forecasters.

Its new forecast of 2.5% growth this year (an inevitable downgrade following a weak first quarter) and 2.6% next brings the Bank more into line with the consensus. The Treasury’s latest compilation of independent forecasts has an average prediction of 2.6% growth this year, 2.3% next. There was no drama in the Bank’s downgrade. Nothing to see here.

In other respects, however, the combination of the latest very strong labour market figures and the Bank’s inflation report has exposed a dilemma for the British economy. A crunch may be looming, partly as a result of what John Hawksworth, PWC’s chief economist, describes as Britain’s “incredible job creating machine”.

Let me explain. The latest labour market numbers continued what has been an extraordinary story. In the most recent three months, January-March, there were 202,000 more people in work than in the previous three months, with the new total 31.1m. The proportion of 16-64 year-olds in work rose to 73.5%, the highest since records began in 1971, and no mean feat when 200,000 of the 1.25m rise in employment over the past two years has been among those aged 65 and over.

In the first three months of the year we were collectively working 20m, or 2.1% more hours than a year earlier and 84m more than five years before. Unemployment over the past year has dropped by 386,000 to a new post-crisis low of 5.5% of the workforce. Job vacancies, 736,000 in the latest three months, are close to their highest since records began in 2001.

The labour market is tightening quite rapidly; slack is disappearing, and the really interesting thing about this is that it is now starting to be reflected in the pay figures. The first three months were expected to be difficult for average earnings comparisons, because of a tax-related surge in bonus payments in the first quarter of 2014.

If there was a difficulty, however, pay has sailed through it. In March, total pay – including bonuses – was 3.3% up on a year earlier. The latest three months, a better comparison, showed an increase of 1.9%. The figures for the private sector, not subject to government-imposed pay limits, were 4.3% and 2.4% respectively.

For regular pay, not subject to bonus distortions, there was a 12-month rise of 2.7% across the whole economy in March, and 2.2% in the January-March period. The private sector figures were 3.3% and 2.7% respectively.
One swallow does not make a summer. Pay has ticked up before, only to slip back again. But if this is the start of stronger pay growth, which would fit the picture of a tightening job market, it opens up some interesting possibilities.

The Bank’s inflation report, and the fact that it once again downgraded its productivity forecasts, has put the focus again on this important issue. As I have pointed out before, the productivity picture is more nuanced than is usually reported. Some sectors, such as motor manufacturing, have recorded good productivity growth in recent years and output per job across the whole of manufacturing is 14% up on its recession low point in 2009. Across services the rise is 4.9%.

What is not in doubt is that productivity is a lot weaker than it should be. Had output per hour increased over the past seven years by as much as over the previous seven it would be 15% higher than it is.

For most of that seven years, weak productivity was unfortunate but not hugely problematical. It was the counterpart to strong employment growth, and thus preferable to strong productivity and weak employment. It was also accompanied by weak wages. Indeed, low productivity growth was the usual economic explanation for non-existent growth – and often falling real (inflation-adjusted) wages.

But what happens when wages pick up but productivity does not? This is when a benign combination starts turning malign. Rising real wages – and thanks to zero inflation they are rising strongly now – in combination with weak productivity means that unit labour costs go up. Unit labour costs are the key determinant of competitiveness. The risk is that they now start rising quite rapidly.

Economists would say that firms will keep a lid on pay if productivity growth remains weak. Sometimes, however, theory and practice diverge. In a tight labour market with skilled workers in short supply, businesses may have no option but to pay up.

There is, of course, a safety valve for the labour market in the form of immigration. The tighter the job market, the more employers will turn to foreign workers. Of the 576,000 rise in employment over the past year, 294,000, or 51%, has been among non-UK nationals. No wonder firms are not keen on a clampdown on net migration.

So we have reached an interesting point. Productivity remains weak but pay is picking up. Net migration and other ways of increasing the effective supply of labour – older workers and existing workers doing longer hours – can ease the pressure, as the Bank pointed out. But sooner or later something has to give. And the hope has to be that finally, it is the meaningful acceleration in productivity growth the Bank has been predicting for the past few years.