Britain is doing well on employment despite a crummy economy. Why?

June 16, 2013

The British economy hasn't been doing so hot in recent years. Things haven't been quite as terrible there as they've been in the rest of Europe, but compared to the United States and Japan — whose recoveries haven't exactly been enviable — growth has been pretty sluggish, as this chart from the Guardian shows:

This economic recovery has also been very slow compared with past U.K. recoveries, including the 1930-34 recovery after the Great Depression hit:

Here's the odd part, though. Even as growth has been sluggish, the British labor market has actually been doing all right. As Stephanie Flanders, the economics editor at the BBC, notes, "There has now been a 6.8% (nearly 1.6 million) increase in private sector employment since the first quarter of 2010. In that same three-year period our economy has grown by less than 2.5%."

So, what's up? One explanation is that the economy is just getting less productive. If more people are working and the economy isn't growing, then per-worker output has to fall. And fall it has. The last quarter of 2012 saw labor productivity fall by 2.3 percent relative to the last quarter of 2011. It's down by around 3 percent compared with productivity before the crisis.

If that drop is permanent, it means things could get really bad for Britain going forward. "If that fall in productivity is permanent, that would mean our long-term economic potential has been cut permanently as well," Flanders explains. "It would also mean there's not much scope for the Bank of England or the Chancellor [the top treasury official] to try to speed up the recovery to get back the output we've lost -- any efforts to do that would just generate higher inflation."

That view has always had its skeptics, economist Paul Krugman among them. And now those skeptics have an important new paper to back them up. Two economists at the London School of Economics, Joao Paulo Pessoa and John Van Reenen, found that total factor productivity, which measures how well the economy is converting capital and workers' labor into economic output, has actually been faring better in the United Kingdom during this recession compared with past ones:

(Source: Pessoa and Van Reenan)
(Source: Pessoa and Van Reenan)

"Since it is TFP that determines long-run economic growth, our view is that this more important measure of productivity has been more resilient than usually imagined," Pessoa and Van Reenan write. That suggests that the potential of the British economy hasn't been permanently damaged, or at least not much. "There is no compelling evidence of a permanent structural change in underlying potential output growth according to these estimates," they conclude.

What's going on? The main clue is found in real wage data. Even as employment grows, wages are plummeting, and considerably faster than in other recessions, as this chart shows:

This seems to explain the divergence between the overall economic situation and the employment situation. Workers are bidding down their real wages enough to avoid losing their jobs. Pessoa and Van Reenan credit this to reforms to the labor market. "This is a secular change over time that is likely to be due to weaker union power and welfare reforms that keep effective labour supply high even when demand is low," they write. "This flexibility meant that unlike earlier recessions, real wages fell significantly and employers faced lower labour costs than in earlier downturns." And lower labor costs mean less unemployment.

The takeaway for Britain, Pessoa and Van Reenan conclude, is that the country needs more stimulus, either on the monetary side or the fiscal side. Not doing so means long-term damage to the economy, a phenomenon known as "hysteresis." That damage, as Harvard's Larry Summers and Berkeley's Brad DeLong have explained, can come from a variety of sources, including, "reduced capital investment, reduced investment in research and development, reduced labor force attachment on the part of the long term unemployed, scarring effects on young workers who have trouble beginning their careers, changes in managerial attitudes, and reductions in government physical and human capital investments as social-insurance expenditures make prior claims on limited state and local financial resources."

But Pessoa and Van Reenan's paper also suggests that Britain has a key advantage over the United States in that regard. Many of the sources of hysteresis — less attachment of the long-term unemployed to the labor market, fewer job opportunities for new workers, and so on — are the result of higher unemployment but are not linked to reduced wages. Because of that Britain might suffer less long-term damage than nations with high unemployment might face.

The United States could try to tilt in that direction through policies like German-style work-sharing, where companies are encouraged to hire workers for fewer hours and less pay rather than not hire at all (or are encouraged to keep existing workers they would otherwise fire under a similar arrangement). Economists on both sides, including Kevin Hassett and Dean Baker, have endorsed that idea.

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