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The UK Employment miracle and productivity catastrophe

October 24, 2012 Leave a comment

Author: Paul Gregg

The UK Employment miracle and productivity catastrophe

There has been a great deal of discussion concerning Britain’s recent employment and productivity record which has regularly been asserted as baffling economists and the bank of England. In essence the conundrum is that employment has recovered to pre-recession peaks whilst in terms of output the recovery has been very limited and stands well below (4%) that peak. This extended fall in productivity (making less with the same workforce) stands in massive contrast with previous recessions and recoveries where productivity growth was strong in the recovery.  The figure below drawn from the recent ONS (2012), The Productivity Conundrum, Explanations and Preliminary Analysis by Peter Patterson, shows the productivity gap compared with the 1980s and 90s recessions stands in excess of 15% – a massive underperformance in terms of productive potential. A similar underperformance is apparent if we compare where we are compared to pre-recession trends. In the past, here and abroad, a loss of output compared to trend as a result of a recession, is subsequently unwound through a catch-up period of above trend growth this hasn’t happened, and a similar story is true of other countries. Whether any of this lost potential is recovered in the near future thus rests on why we have underperformed recently. This is actually easier to explain than the media description of baffled economists implies.

Productivity Levels compared to Pre-recession peak in four UK recessions.

Data

The first question concerns data reliability. Could some of the paradox be down to measurement problems? Certainly tomorrows GDP numbers for Q3 of 2012 will show a return to growth after last quarter’s numbers which were suppressed by the Queens Jubilee bank holiday and will suggest the economy is just growing over the past 6 months but this won’t make a dent on the sustained underperformance described above.

As mentioned previously employment has recovered to the pre-recession peak but unemployment remains very high. This apparent paradox is easily explained. Right through the recession employment among the over 65s has grown quite rapidly. Older workers are not retiring as they used to do, pushed by changes to retirement rules which encourage longer working and penalise early retirement and for women the rising state retirement age. So compared to the early 2008 employment of the over 65s stands 250,000 higher and a similar magnitude of extra employment has occurred among women between 60 and 65. Nearly all of this extra employment among older workers is either part-time or self-employed and often both. When we add in a growing population the proportion of the working population in work stands at 71.3% still well below the pre-recession peak of 73%, a shortfall of nearly ½ million jobs. Further there has been a sharp trend of more people wanting to work, especially among those aged between 50 and 60. This has been going on for a decade now but until recently this was offset by more people studying when young – so the share of the population wanting to work was constant at just under 77%.  Over the last two years this increase in students has stopped. Perhaps because of a surge in the immediate recession period or a response to policy changes but either way it is adding another quarter of a million to the workforce so that whilst employment has reached previous peaks, the need for work stands considerably higher with a deficit of a million or so jobs. The move to more and more people wanting work, especially among older workers, and so we need to add at least 250,000 jobs a year to stand still and the employment recovery is thus not as good as it first appears. Allied to this is the rise in the numbers working part-time who want to work full-time, which is called under employment. The numbers who are unemployed stands at 1.4 million is shortfall which when combined with 2.5 million underemployed suggests huge unmet need for work. However, the fact that most of the jobs created since 2009 are part-time,  fewer hours worked only accounts for about 1% of the productivity decline since 2008 (ONS, op cit).

It has been suggested that there may have been an under recording of employment before the recession, with a large number of migrants not being captured and that these marginal workers have since lost work and left the country again unrecorded. There are a number of major problems with this argument. First, our data on employment comes from two very different sources, one based on households and the other firms. Neither of them questions the legitimacy of an immigrant’s status and so there’s no incentive to hide migrants; therefore in terms of residence these migrants might be hard to find and perhaps be reluctant to reply to a survey, employers have no incentive to hide these workers and both surveys tell the same story about employment. If the firms using this labour are not tracked by the ONS then they will not be present in the output data nor the employment data and hence can’t explain the paradox. In addition it requires a huge number of missing migrants to explain the gap, at least 8% of the workforce and that all these workers lost their jobs with the recession. If only one in five lost their jobs, compared to 1 in 20 in the rest of the population, the numbers would need to be equivalent to 40% of the workforce. This is just implausible.

So the employment story is clear there has been an employment recovery, verified in a number of sources, but this recovery has not met the increased demand for work in the population, leaving 3.9 million unemployed or underemployed. The output side of the story also appears validated by tax receipt data. The ONS report shows how tax receipts VAT, PAYE and in total track the picture of nominal GDP well. That is the total size of the economy measured at current prices and serves to track government receipts well. However when we talk about output we take out the effects of inflation, so there could be a concern the effects of inflation have been overstated and there is more real output out there than estimated and low price increases. This argument tends to be supported by other inflation measures we have, the Consumer Price Index and Retail Price Index (which also includes housing costs) all show that inflation has been strong through this recession. So measurement can only explain a very small part of the story of economic underperformance with a good employment performance.

This provides a serious paradox, so where can the explanations lie?  The first argument is one I would have made two years ago, that firms were hoarding labour in the face of recession. In the first phase of a downturn, firms who are profitable will hold valuable labour, with its skills and experience in the expectation that it will be needed again in a year or two as demand returns. Only if a firm is in acute financial distress does it shed skilled labour, when the firm’s very survival is at stake. This was thus eminently plausible in the early part of the recession. But firms hoarding labour would not recruit new staff to replace those that leave through natural wastage, move to a new job or retire etc. Hence such labour hoarding should start to unwind even if there is no economic recovery. Rather we have seen the reverse of increased employment without growth.  Even though surveys show some firms hoarding labour this should be a diminishing issue rather than a growing one. As such this cannot be it can’t be the major explanation of current trends.

A variant on this is, if you like, is firm hoarding or as NIESR has described it ‘Zombie firms’. The argument is that banks are not lending to new or expanding firms as they seek to rebalance their own finances. It should also be noted that equally they are not forcing poorly functioning firms into bankruptcy and thus increasing bad debts held by the bank, and as such they are being allowed to persist despite the implied capital misallocation. The argument therefore runs that firms are expanding without capital through increasing employment rather than investment, whilst poorly performing firms are employing workers but are experiencing low productivity because of low order numbers. This is attractive and it is certainly the case that investment is low but there is no evidence to date that this low profitability Zombie sector exists. Certainly overall firm profitability is high outside manufacturing, which continues to struggle. Profitability in the dominant service sector is only slightly lower than in pre-recession period and recovered two thirds of the lost profitability during the recession, which in itself was quite muted compared to previous ones. As such the evidence of zombie firms is not obvious and requires an investigation of company level data for further insight, but at first take it does not feel like it is a major factor.

Net Financial Balance of Private non-financial Companies (from Peter Patterson The Productivity Conundrum, Explanations and Preliminary Analysis, ONS, 2012 )

The evidence of low investment is strong however; firms normally borrow money and invest in productivity enhancing technology. Currently firms are saving money rather than spending and are net lenders not borrowers. This is now evident on a very large scale and well that seen in the last recession at a massive 4% of GDP. The scale of this seems to point to healthy profitability being saved rather than invested as opposed to Banks not lending to growing firms and trying to reduce the net debt position of struggling firms. So why would healthy firms choose not to invest?

The obvious answer is that in the current environment it is easier, cheaper and less risky to hire to meet demand rather than invest.  Real wages have fallen steadily since late 2008 and saw a large squeeze in the high inflation burst in 2011. Overall wages have fallen by around 8% since early 2008 in real terms (measured using Retail Price Index), this squeeze on wages is more than enough to explain the fall in productivity since 2008. Using a standard elasticity of demand for labour of around -0.5 then an 8% fall in real wages would raise employment by about 4%. In a period of uncertainty about future demand building cash reserves rather than investing for the long term is safer. Employing extra labour is easy to reverse if demand for product turns out worse than expected. At complete variance with the rhetoric of parts of government and their advisors and evident from firm behaviour hiring workers is easy and low risk. By contrast investments are largely irreversible and therefore inherently more risky. Hence as labour is increasingly cheap and low risk firms are choosing this route rather than replacing ageing infrastructure and machinery.

The apparent divergence between productivity since 2008 compared to previous recessions is huge but can be usefully broken into two parts. The first is that employment has recovered to pre-recession levels despite output still being 4% below the peak. This is partly explained by employment composition moving toward part-time work but mainly because labour has become increasingly cheap and low risk and hence firms are substituting labour for capital. This is occurring because real wages have seen such a large cut over the last four years. Research I’ve undertaken with Steve Machin for the Resolution Foundation shows that this in turn is a combination of a slowdown in real wage growth that occurred well before the current recession In addition there is clear evidence that wages have become more sensitive to unemployment such that the near doubling of unemployment from 4.6 to 8.3% we’ve seen since 2008 results in real earnings being £750 lower now than would have been the case from a similar unemployment rise in the 1990s recession. These changes have their origins in the decline of trade unions, a reduction in the imbalance of unemployment across skill groups and regions and welfare reforms which have meant that the completion for jobs is more intense. The larger part of the shortfall in productivity compared to past trends and recoveries however, stems from low demand in the economy and the corresponding absence on investment to meet that demand.

The implications are threefold. First, employment will rise and unemployment will fall well before there is a recovery in wages and productivity. However, as unemployment falls real wages will start to grow again as the heavy downward pressure on wages in the current labour market eases. This is the pattern already and it will continue until unemployment is firmly on a sustained downward trajectory. When output starts to recover and real wages stop falling firms will mostly likely start to invest their large cash surpluses currently held. This of course, need not all be in this country and the location of this investment will impart depend on the quality of the available workforce and the large scale geographical focus of world growth, with European economic recovery, including the UK, being more important for us. When this dam holding back investment is broken a period of strong growth should follow, as investment and rising wages fuel growth and hence perhaps 2/3 of the lost productivity will be recouped. However in my view at least 1/3 of the 15-18% shortfall in productive potential is lost. The longer the period of high unemployment, falling real wages and low investment continue the greater the damage that will be done.

The policy prescription that follows is reasonably obvious. First, incentives for firms to invest now rather than in the future need to be enhanced. This need not cost a low to the exchequer just rather a change in timing. Second we need to boost other investment in housing, lending to small firms and new low carbon technologies. This could happen through the government borrowing more, the treasury acting as a guarantor for borrowing by housing associations to build more low rent housing (so resources can be drawn from pension funds and the like) or through quantitative easing being invested through a national investment bank rather than used to try and manipulate bank finances.  The government is feeling its way slowly to the second option whilst hoping that it doesn’t need to go further. Meanwhile Rome burns.

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The cost of youth unemployment

February 6, 2012 Leave a comment

Paul Gregg and Lindsey Macmillan

In hard times, young people face two hurdles to finding work.  First, firms tend to hold onto their existing experienced staff but stop recruitment to reduce their workforce. This collapse in new vacancies hits young people hardest. Second, with more unemployment comes more choice of potential employees for firms who are hiring. Firms favour previous experience placing young people in a catch 22 situation of not being able to get the experience they need to get work because they can’t get the work in the first place. For the least educated or those who are unlucky enough to experience long periods out of work now, it is increasingly hard to get that break that opens the door to the labour market.

As the number of youths who are out of work continues to rise the exchequer is left counting the cost. Each 16-17 year old in receipt of benefits costs an average of £3,660 a year whilst each unemployed 18-24 year old who claims costs an average of £5,600 a year. Even though many young people don’t claim benefits, just 19% of 16-17 year olds not in education or employment and 65% of 18-24 year olds with the sheer number of young people out of work, plus the additional tax and NI revenue lost through the lack of earnings, the numbers are non-negligible. In total, the current cost of youth unemployment to the exchequer is £5.3 billion per year. The productivity loss to the economy, often calculated as the wage foregone to measure the output lost, is £10.7 billion. The large numbers not claiming benefits and the low value of benefits relative to potential earnings makes an important point that work incentives are very strong for this group.

On top of these current costs, there are also long-term scars to youth unemployment in the form of future unemployment spells and lower wages. We can see from previous generations’ experiences of youth unemployment that the longer the period spent out of work in youth, the more time spent out of work later in life and the lower potential wages were when in work. This evidence on the future costs of youth unemployment comes from two UK birth cohorts that track all babies born in a window for the rest of their lives. By chance, the participants in the first cohort were aged 21 when the 1980s recession hit and in the second cohort, the participants were aged 20 when the 1990s recession hit. Around one in five young people in the first cohort spent over 6 months out of work before age 23, and it was similar in the second. Furthermore these people spent about 20% of their time unemployed 5 years later and 15% even 12 years later.

For males in the second birth cohort, an extra month out of work before age 25 raised the proportion of time out of work between age 26 and 30 by three quarter of a per cent; an extra year out of work in youth led to 10 months more unemployment later in life. It is a very similar story for wages with an extra month unemployed when young associated with 1% lower wages in their early thirties. It’s possible that these legacies may not reflect just the pure effect of youth unemployment but also that those experiencing more unemployment are less well educated and come from deprived backgrounds. The great advantage of the birth cohort studies is that so much is known about the young person’s childhood from their education to their attitudes and beliefs, their health, their wider circumstances and almost as much is known about their parents.  The evidence suggests that about half of the later lower wages and higher unemployment exposure stems from these background differences between people and about half is a result of the unemployment itself.

The cost to the individual’s future is therefore large. However, it doesn’t end there. There is also a future cost to the public purse in terms of future benefit claims and tax revenues lost from lower earnings as a result of this scarring. Estimates from the second birth cohort suggest that the average unemployed young man will cost the exchequer a further £2,900 in future costs with the average unemployed young woman costing £2,300 a year. Aggregating these up in the context of the current youth unemployment crisis leads to further future costs to the exchequer of £2.9 billion. The future productivity losses in terms of output lost are estimated to be £6.7 billion. If we add the exchequer costs together to give the combined future and current costs of youth unemployment (discounted to adjust future costs to be equivalent to today’s) the total cost to the exchequer is therefore £28 billion. These numbers suggest that doing nothing about youth unemployment is and will continue to cost us dear.

Statistical myopia, measures of unemployment and economic reporting

January 19, 2011 Leave a comment

Neil Davies

Today the ONS published a statistical bulletin of labour market statistics, which was widely reported as evidence of an increase in unemployment.  However, the executive summaries provided by the ONS did not include sufficient information about the precision of the statistics.  This led newspapers to report ‘changes’ in important features of the economy, such as the unemployment rate, that may in fact be due to chance.

Labour market statistics, provided by the ONS, are estimates, not exact measures.  The statistics are   calculated from surveys of thousands of people.  This means that the statistics are subject to sampling variation.  Therefore, if the ONS were to repeat their survey and calculate all their statistics on a different group of people we would not expect them to be the same.  The ONS provide estimates of the size of this variation in additional tables: they estimate the range in which their statistics would be expected in 95% of samples.  However, these ranges are not reported in the executive summaries, or in the much of the discussion of what the statistics show.  The findings of the ONS bulletins are faithfully reported to the public by newspapers, but unfortunately without a measure of sampling variability, it is not possible to tell if the level of unemployment has changed, or if the reported change is consistent with chance.

The summary of latest labour market statistical bulletin reports the following statistics, to which I have added confidence intervals using the measures of sampling variation provided by ONS later in the document:

  • The employment rate for those aged from 16 to 64 for the three months to November 2010 was 70.4 (70.0, 70.8) per cent, down 0.3 (0.0, 0.6) on the quarter.  The number of people in employment aged 16 and over fell by 69,000 (-62,000, 200,000) on the quarter to reach 29.09 (27.53, 30.64) million.
  • The unemployment rate for the three months to November 2010 was 7.9 (7.7, 8.1) per cent, up 0.2 (-0.1, 0.5) on the quarter.  The total number of unemployed people increased by 49,000 (-37,000, 135,000) over the quarter to reach 2.50 (2.42, 2.58) million.
  • There were 157,000 (137,000, 177,000) redundancies in the three months to November 2010, up 14,000 (-14,000, 42000) on the quarter.
  • The inactivity rate for those aged from 16 to 64 for the three months to November 2010 was 23.4 (23.1, 23.7) per cent, up 0.2 (-0.1, 0.5) on the quarter.  The number of economically inactive people aged from 16 to 64 increased by 89,000 (-26,000, 204,000) over the quarter to reach 9.37 (9.23, 9.50) million.

There are 7 estimates of change in levels.  All seven of these changes are consistent with what might be expected from sampling variation, so the statistical bulletin provides no strong evidence of a quarter on quarter change in any of these statistics.  The statistical bulletin contains further statistics that report the change in employment in sub-groups of population, by age or by region.  Each of these sub-populations is smaller, and hence less precisely measured.  Therefore estimated changes in unemployment in sub-populations, such as youth unemployment, are more likely to be due to sampling variation.  However, we cannot know, as the sampling variation of these sub-populations are not provided by the ONS, so it is not possible to tell if these differences are important, or if they are just due to chance.

Understandably, given the executive summaries of the statistical releases, newspapers report that unemployment is rising, when the data do not support this.  This leads newspapers to miss the bigger story: unemployment is still very high after the recession, and there is little evidence of falls in employment.  The ONS could help by stating confidence intervals in their statistical bulletins to enable journalists to easily interpret whether the information in a report is consistent with chance, or if there is evidence of a genuine change.  We know long term measures of unemployment, for example annual measures, with much more precision, because we have larger samples, so if measures of precision were to be more widely reported then debates over the economy might be slightly less myopic.

The season of goodwill

December 21, 2010 Leave a comment

Sarah Smith

Charities might rightly feel that they have had a tough year. First the recession which many charities claim hit their donations. Then, the announcement of public spending cuts which will affect thousands of charities which rely on government funding.

The festive season should therefore bring a brief respite and provide a temporary boost to charity incomes as this is the time of year when people really do dig a little deeper and give more to charity than during the rest of the year. The chart below shows average weekly household donations to charity for each month in the year – there is a spike in march/april, coinciding with the end of the tax year, but a greater spike in December. Santa, it appears, has a greater effect on giving than the tax man. These averages are for households that actually give to charity; the proportion of households who give is also slightly higher in December than at other times of year, but it is the amounts that people give that show the biggest increase at Christmas. The average weekly amount given is nearly £12 in December – more than twice the average amount over the preceding three months.

Source: Living Costs and Food Survey, 2008

It is hard to say exactly what accounts for the festive increase – other than it being the season of goodwill to all men. Some of it may be religiously motivated; the evidence shows that religion is strongly associated with charitable giving and that people who are religious are more likely to give to charity and to give more. Yet as religiosity has declined in the UK over the past thirty years, Christmas giving has remained high and, if anything ,has increased over time. In 2008 (which is the latest year for which we have data) giving in December was 60 per cent higher than the average over the rest of the year; thirty years ago (over the decade 1978-88) it was roughly 16 per cent higher.

As part of the Big Society, the government is keen to encourage charitable giving. Research that we carried out on behalf of HM Treasury showed that tax incentives are not particularly effective at encouraging people to give more. The majority of people do not respond to changes in tax incentives by changing how much they give, although this does mean that Gift Aid style incentives that allow the charities to claim back the tax paid on donations can help to boost charities incomes (more than rebate-style incentives which rely on donors to adjust their giving). Understanding the December effect could give insights into what motivates people to give and be used to design more effective policies. As charities enter 2011 facing up to the reality of cutbacks in public spending both they and the government will be keen to ensure that higher giving is not just for Christmas.