THE EMPLOYMENT/PRODUCTIVITY PUZZLE: SUPPLY(ING) THE ANSWER. BILL WELLS DEPUTY DIRECTOR: LABOUR MARKET ANALYSIS: DEPARTMENT FOR BUSINESS, INNOVATION AND SKILLS.

STRUCTURE OF THE PRESENTATION STRUCTURAL FEATURES OF THE UK LABOUR MARKET. LABOUR SUPPLY. LABOUR DEMAND. EFFECTIVENESS OF JOBSEARCH. FUTURE PROSPECTS. WAGES, TAKE HOME PAY & LABOUR COSTS. CONCLUSIONS

1. STRUCTURAL FEATURES OF UK LABOUR MARKET The UK product and labour markets are amongst the most open and competitive in the world… …however, the price of labour is ‘sticky’ – the real wage - does not seem to be affected much, if at all, by market forces… …and it is quantity rather than price adjustment that enables the UK labour market to clear, and employment to grow… …with supply rather than demand for labour apparently the main determinant of employment… …but since 1992 there are very different results for those aged 25 and over – fairly continuous employment growth - compared to young people - structural employment decline.

UK product & labour markets are characterised by near-’Perfect Competition’… UK product & labour markets are amongst the most open and competitive in the world with ‘light and even’ regulatory regimes… 1st in the OECD Product Market Regulation Index; and 3rd in the OECD Employment Protection Regulation Index. …and they are becoming increasingly individualistic and decentralised. Product Market 2.1 Million Vat Businesses: Up nearly ¼ since 1984 4.2 Million Self Employed Jobs: More than doubled since 1979 Labour Market 23.3 Million Non-Union Workers: Almost doubled since 1979 (95%) & up from < ½ to > ¾ of all LFS employment (47% to 79%)

…but despite being in a competitive labour market UK real wages do not respond to market forces – unemployment etc. – and with few exceptions have tended to rise each year. Therefore, unlike in the US, wages do not adjust in ways that helps employment.

The quantity rather than the price of labour does adjust The quantity rather than the price of labour does adjust. The ‘light and even’ employment regulation regime enables workers to move in and out of work easily. Consequently, there are always vacancies coming up as part of the high natural turnover in the UK…

…and because there are few legislative restrictions on types of work the UK has a greater range in work patterns . This diversity means that workers have more opportunities to find a job that suits then and their personal circumstances…

…and as a result of these structural features it seems that labour supply rather than the demand for labour is the primary determinant of employment…

With over 90% of the rise in employment ‘explained’ by the rise in labour supply – the economically active – over the whole period from 1971 to early 2013.

Conversely, here is relatively little sign of a relationship between demand and employment with little more than 10% of employment growth ‘explained’ by the demand for labour – the growth in real (adjusted for inflation) GDP .

The structural and institutional features of the UK labour market also seem to deliver very different employment results for those aged 25 & over – with fairly continuous employment since the early 1990s. Employment for those aged under 25 has fallen.

2. LABOUR SUPPLY A combination of rapid population growth and rising activity rates has led to a rapid increase in the numbers in the labour force – the economically active – around 400 thousand p.a. … …but this growth is restricted to adults. Young people are now taking longer to move from education to work – having fallen through the cracks between the education and the benefit system. The growth in adult activity rates is due, at least in part, to welfare to work policies for people on ‘inactive’ benefits; the equalisation of the state pension age; and removal of barriers to participation for older workers… …and this has led to increases in employment rates for lone parents, the disabled and older people – despite the recession.

Population growth has been very rapid since around 2004 – more than 350 thousand per year…

…and increasingly population growth has been concentrated amongst people aged 25 & over – over 400 thousand per year – with the number of young people now falling.

After a period when the proportion of young people in full-time education grew only slowly it jumped during the recession – presumably as a recession response – and has remained at the higher level. This left fewer young people available to take up work.

Also, young people are now taking longer to move from education to work – having fallen through the cracks between the education and the benefit system. By contrast, the number of workless young people already in the labour market – they have had a job – are close to pre-recessionary levels and historic lows.

The activity rate of people aged 25 & over has grown strongly since the late 1990s – even during the recession - which is unusual.

For adults, with rapid population growth and rising activity rates the number in the labour force has been growing very rapidly recently. By contrast, there have generally been fewer young people in or looking for work.

A major driver of the rising adult activity rate is the growing number moving from inactivity – where you are not looking for work – to ILO unemployment – where you are looking. Now around ½ a million a year (net) move into unemployment . Over twice as many as in 2000.

…as welfare to work ‘activation’ policies were extended to ‘inactive’ benefits in the 1990s and they have been ramped up since then. The numbers are now at a 20 year low and the rate of fall is getting faster.

…and the number retiring before 65 is now falling despite more older people. The process of equalising pension age at 65 starting from 2010 has kept more women in the labour market…

…and the removal of barriers in the benefit and pension system to working after 65 has also reversed the historic trend towards fewer older people staying in the labour force. Since the turn of the Century there has been a rapid rise in activity rates.

Employment rates of lone parents, the disabled & older workers are all rising. As they rose in the recession. Welfare to work policy rather than demand seem to be main driver. It seems to have got more people to look for work and helped them to look effectively – so they got a job.

3. LABOUR DEMAND A combination of a decline in labour demand in the recession and ‘sticky’ real wages led to a surge in redundancies in 2008 as it had in the previous recession in the early 1990s… …but more job losses and separations seem to be moving into unemployment rather than inactivity and so are remaining in the labour market (but boosting unemployment). There are indications in the labour market statistics that the private sector recession lasted until early 2010. Then in 2011 public sector cuts in 2011 may have stalled the economy… …but from early 2012 it seems that labour demand picked up again – perhaps also indicating a pick-up in underlying GDP.

As demand falls it can damage employment without a change in wages… Labour demand curve paid shifts inwards due to fall in demand Area 3 represents loss to businesses due to lower employment Area 1 and 2 represent loss to workers due to lower employment 3 W 1 2 E2 E1 Employment - PROTECT -

…and as in the early 1990s the combination of the fall in labour demand during this recession and ‘sticky’ wages led to a surge in redundancies. However, the level of redundancies fell back quite quickly and are now back to pre-recessionary levels.

But, despite the fact that total separations – including redundancies - are now at pre-recessionary levels – the flows into ILO unemployment are still above that level – perhaps because of the Government’s aim to raise participation rates rather than promote labour market exits…

…and inflows to the claimant count – usually a good indicator of labour demand - are improving but still high. This is partly because fewer people are now allowed on ‘inactive’ benefits and join JSA. Also, more – both lone parent and IB/ESA – have been moved on to JSA.

Other indicators suggest that the demand for labour picked up from early 2012. The numbers remaining in work is consistent with a private sector recession between 2008 and early 2010 followed by a stalling in 2011 due to public sector cutbacks and then growth resuming from early 2012…

…and movements in ‘demand-type’ jobs (full time employees and voluntary part time work) tell a similar story. They also suggest that demand for labour has picked up from around the early 2012…

Finally, hours have grown faster than employment since mid-2009 and particularly since mid-2011. Now, both hours and employment have passed pre-recessionary peaks and, over the period since April 2008 have grown at exactly the same rate.

4. EFFECTIVENESS OF JOB SEARCH There is evidence that vacancies are being filled more quickly; some people are willing to take up ‘second choice’ jobs rather than remain unemployed; and some even seem to have constructed their own jobs… …so hiring has risen during and since the recession and this is the major reason for the UK’s good employment performance. The welfare to work policies associated with the JSA regime have played a large part in this and people are moving off JSA more quickly than in the 1980s and 1990s recession… …however, the recession has left a legacy of young people – in and out of education – and long term unemployment that may require extra attention.

A rise in hiring is the main reason for the good recent employment performance. This rise was concentrated amongst people moving from ILO unemployment into a job. As this was during a period of low/no growth it suggests a supply rather than a demand effect.

The improvement in the job search effectiveness in the JSA regime is a major reason for the increase in hiring of the unemployed. Claimant unemployment has now peaked at less than ½ the 1986 peak – with the vast majority of the improvement amongst the longer durations...

…with people moving off benefits and into jobs more quickly – bringing the average duration of those who remain down. And although the JSA outflow rate is worse than the pre-1966 regime it is much better than in both the 1980s and 1990s recession.

Since 2008 survival (1 minus outflow) rates have worsened Since 2008 survival (1 minus outflow) rates have worsened. However, they still remain high by historical standards and the deterioration is largely in the longer durations. So, although long term unemployment is a problem a large majority of people move off benefits very quickly…

…and this is even more true of young people …and this is even more true of young people. The leave JSA even more quickly than the average. The problem groups of young people are not JSA claimants but mostly the people making the transition from education to work.

However, the rise in job search effectiveness has meant that some people have taken up ‘Second Choice’ vacancies rather than remain unemployed. ‘Supply-side’ type jobs rose by 1.4 million but they seems to have peaked by early 2012 – perhaps as demand has picked up…

…and although the rise in ILO unemployment has not been as substantial as feared it has left a legacy of young people – in and out of education – and the long term unemployed. It may be difficult to convince them that the vacancies that are out there are for them.

5. FUTURE PROSPECTS Recently there has been rapid labour supply growth but this may now be coming to an end as the Post-War baby boom reaches retirement age… …and unless we can raise activity rates both substantially and quite quickly we may face labour shortages relatively soon. In order to raise activity rates we will need to address the structural problem associated with the transition from education to work. For all qualifications not just the unskilled… …and also to address thorny issues associated with inactivity – particularly amongst single adult households – and the long term unemployed.

Population growth has, until this year, been beneficial to labour supply and, therefore, employment growth. However, that is now changing…

…the peak of the 1942-48 baby boom reaches 65 in 2013 and the mini-peak in 1964 reaches 50 in 2014…

…which means that if the current economic activity rate does not increase then increase in labour supply will more than halve from over 400 thousand a year to around 200 thousand a year…

We need, therefore, to increase both activity rates and the effectiveness of the job search regime. The most acute problem remains the breakdown in the transition from school to work. And it is a problem that affects all qualifications not just those with no or low skills.

In fact, the trend increase was greater amongst the more rather than the less qualified. The system seems to be the cause rather than the characteristics of the individual…

…as there has also been a rise in worklessness amongst graduates - again suggesting that more needs to be done in order to help people leaving education find a job.

…but it may also be increasingly more difficult to attract more people into the labour market and help them into jobs. The vast majority of workless people are economically inactive – not looking for work…

…and the people in workless households are overwhelmingly single adults – with and without kids. These groups are difficult to help because they tend not to have job-finding networks and the overhead costs of taking up a job – childcare etc. – are greater.

6: WAGES, TAKE HOME PAY AND LABOUR COSTS Real wages, take home pay and labour costs are amongst the highest in the world because nominal wage growth only seems to be affected by (labour) market forces in recessions. Between recessions wage growth seems to get stuck in a groove. Take home pay remained roughly constant between 2002 and 2008. Since real take home pay fell by around 3 ¼% - roughly half the fall in real wages - as interest rates and taxes were cut… …but if an inflation target of 2% had been hit take home pay would be at its highest ever level. Finally, it is important to choose the right wage and price statistic. Base weighted indices are preferable as they just reflect price and not quantity changes. This is particularly true since the quantity adjustment is likely to be a response to the price change.

Base weighted indices measure just the price effect whilst current weighted also includes quantity effects. This effect can be large – 3 percentage points on the AWE in the 5 years from 2008-2013. Therefore, where possible base weighted indices for wages are used.

Similarly, the RPI rather than the CPI should be used as the deflator for wages from a worker’s perspective. The GDP deflator is used as a deflator from a business perspective. Between 1997 and 2013 no index was able to hit an inflation target of 2% per year.

The sustained real wage growth in the UK over a long period of time is relatively unusual internationally. Consequently real earnings in the UK are amongst the highest in the world.

…and it seems that the real wage growth is largely a consequence since 1980 of inflexibility of nominal wage growth. In the 1980s it settled down in the range 7 ½-8% before being shocked down to 3-5% by the 1990s recession and 1-3% by the 2008 recession…

If a 2% inflation target had been hit then real wage would have peaked in 2008 and then stagnated. Since 2008 inflation exceeded the target so real wages have fallen – more for workers than businesses…

Workers pay tax and NICs to government so their take home pay is less than earnings. Businesses also pay NICs so their labour costs are more than earnings. And taxes and NICs change – taxes for the low-paid have been cut since 2007 and the NICs contribution rate rose.

With high wages & low and falling taxes, UK take-home pay is amongst the very highest in the developed world – 3rd only to Switzerland and Korea. And at least 10% higher than the other G7 countries…

…and despite the fact that our earnings are very high, the UK’s labour costs are lower than in some countries where earnings are lower as employer NICs are lower. But still amongst the highest in the OECD.

Between 1997 and 2013 in real terms labour costs grew by over a fifth and take home pay by over 13%. Having remained constant between 2002 and 2008, real take home pay has fallen by around 3% since. This is ½ the fall in real wages due to the cuts in interest rates & taxes…

And, if an inflation target of 2% per year had been hit then real wages and labour costs would have levelled off at around 2008 levels. And real take home pay would be at historic highs because of the substantial income tax cuts since 2007.

CONCLUSIONS Labour supply not demand seems to be the main determinant of employment. This is despite the fact that UK wages are very ‘sticky’. Quantity rather than price/wage adjustment seems to be the important factor. Recent employment growth has been strong because labour supply growth has been rapid – partly down to government policy. And welfare to work policies have meant that this supply growth can be translated in employment through effective job search. UK nominal wage growth is very ‘sticky’ and movements in real wages are largely determined by price inflation. Tax and interest rate cuts since 2008 has meant that if a 2% inflation rate target had been met average take home pay would be at a historic high. Because we are entering the ‘ageing society’ period labour shortages could soon emerge unless activity rates rise. Young people entering the labour force and single adult households are potential priorities.