IFS study serves to rewrite UK narrative on pay, jobs and productivity

The Institute of Fiscal Studies (IFS) analysis, published today, of the interaction between pay, employment and labour productivity in the UK since the start of the financial crisis is the latest output from what’s becoming a cottage industry examining the so-called ‘productivity puzzle.’ John van Reenan at the LSE’s Centre for Economic Performance has done similar work, as has the TUC which published its report on the subject yesterday.

The broad conclusion to be drawn from all this analysis – which chimes with my own view as expressed in previous blogs - is that a combination of increased outsider power in the labour market, caused by an expanded supply of labour, and reduced insider power, resulting from the diminished influence of trade unions in the workplace, has altered the UK’s trade-off between real wages and employment. This changing trade-off is apparent in data stretching back a decade but has only really been noticeable since the start of the crisis with, as the IFS notes, real wages falling by more than in any comparable five year period and associated robust employment growth resulting in a big drop in productivity rather than a 10% unemployment rate.

We can debate until the cows come home as to how to view this. Few would argue that downward adjustment of real wages is preferable to a large shake-out of jobs when an economy is depressed. The IFS reiterates this, going on to note that as a result ‘the long term consequences of this recession in terms of labour market performance may be less severe than following the high unemployment recessions of the 1980s and 1990s.’ But what we don’t know is whether there will be lasting economic implications of a prolonged squeeze on real pay. A low rate of capital investment is the long-standing problem of the UK economy – thirty years of labour market deregulation has not been a spur to a high productivity economy and several years of falling real wages will surely diminish the incentive to invest still further.

However, what is most intriguing about the IFS analysis is that it to some extent rewrites the accepted narrative of how businesses responded to the recession. Back in 2010 it was widely asserted that CEO’s and HR managers in larger firms had learnt the lessons of previous recessions and were holding onto staff during the downturn rather than resorting to large scale redundancies. Although this meant a fall in productivity while order books were thin, and hence a rise in unit labour costs and a squeeze on profits, business could either meet this out of healthy cash reserves or keep a tighter rein on pay, aided by a more equable employment relations climate.  Small firms by contrast were said to be hit hard by restrictions in bank lending, and with little or no cash reserves to fall back on were cutting jobs, if not going to the wall. As a result the business lobby was calling on the incoming coalition government to freeze the National Minimum Wage and cut employment red tape, especially for small firms, to preserve jobs.   

In fact, the IFS finds, it was mainly larger firms who cut jobs whereas small firms were more likely to keep workers on at lower pay in order to limit the impact of a fall in productivity on unit labour costs. With credit hard to come by but labour getting cheaper, small firms instead cut investment rather than jobs, this probably further reinforcing the drop in productivity. The IFS shows that firms with fewer than 50 employees suffered a productivity fall of 7% relative to a pre-recession trend, compared to no change for firms with more than 250 employees.

All this suggests that an explanation for what’s happened to UK jobs, pay and productivity in recent years mainly revolves around the balance of power between bosses and workers in small firms, where employment relations are highly individualised and staff are most exposed to the availability of an abundant supply of people in the external labour market. It also suggests that the micro-economic policy response lies in easing credit constraints to small firms and supporting their ability to invest in physical and human capital in order to boost productivity, rather than further watering down of employment regulations which would simply reinforce the foundations of our low-pay, low productivity economy.