Laura Gatz: Hi, I'm Laura Gatz - welcome to the latest episode of Economics in Business. We are now 10 years down the line from the global financial crisis, and finally, recovery is underway. In fact, output now actually exceeds pre-crisis levels in most advanced economies. But, what is happening in labour markets? This is what I’ll be talking about today with Barret Kupelian, who leads our macroeconomics practice. He will explain what we have observed in labour markets in the last few years, and why this is a puzzle for traditional economics. Barret, could you describe some of the trends we have seen recently?
Barret Kupelian: Unemployment is a lagged variable of GDP growth. And, given that most advanced economies experienced a dramatic contraction in GDP about 10 years ago during the Global Financial Crisis, what we observed then was a sharp increase in their unemployment rates.
So, just to give you a few numbers: in the UK, the unemployment rate increased from about 5% in 2007 to 8.4% in 2011. In the US, it was a similar story - from 5% in 2007 to 8.5% in 2011. And, in the Eurozone, which suffered both from the subprime crisis, but then experienced its own debt crisis, the unemployment rate spiked from about 7% in 2007 to 12% in 2013.
So, what have we seen since then? Well, what goes up, must come down. So, as we’ve gradually had these economies starting to grow, as you’ve said, we’ve had the unemployment rate gradually go down.
So again, some numbers – in the US, for example, we have had nine years of virtually uninterrupted growth and this pattern is broadly similar in most of the G7 economies. As a result, unemployment rates have gone down. And, in fact, they are now at record low levels. So, if you look at the headline OECD unemployment rate, it’s virtually at an all time low of around 5%.
Laura: That sounds like a really good picture in the labour markets then. I’m assuming wages have gone up as well?
Barret: Well I’m really glad you’re raising that point, Laura, because that’s precisely the puzzle that’s pre-occupying economists, central bankers and businesses as well. So, normally the pattern we would see in labour markets is that, as the unemployment rate goes down, wages gradually pick up. And this is because businesses would have to compete for a reduced pool of workers and the natural way to respond to this competition would be to increase the remuneration that is on offer for labour. But the increase in wages is not happening despite the record low unemployment rates being experienced in most advanced economies.
So, in terms of numbers - in the UK, for example, in 2005, the unemployment rate was about 4.7% and average weekly earnings were growing at about 4.5%. Right now, the unemployment rate in the UK is closer to the 4% mark, so lower than the 2005 mark, but average weekly wages are just growing at 2.5%. Now that’s against what’s happened historically and against what we would expect as economists.
Eurozone has the same story – so, the unemployment rate was 9% in 2003 and wage growth was around 3%. In 2017, the unemployment rate was again 9%, but wage growth was markedly slower at only 1.5%. So, wages haven’t picked up.
Laura: So, although we’ve seen economies as a whole recover, and output is much better, the unemployment rates are down, but wages haven’t been responding. Do you know why this is happening?
Barret: Well, no-one really knows the precise answer to that question and that’s why we sort of call it a puzzle. What we’ve tried doing at PwC, in our research is try to solve the puzzle by looking more at the Philips curve, which is basically the relationship that economists give to the relationship between wages and unemployment. And we’ve researched this in the June edition of the Global Economy Watch.
So, just before we get into the results of the research, let me just visually describe what this Philips Curve looks like. Basically, what we’re talking about is a downward sloping line, if you’ve got wages on the horizontal or x axis and the unemployment rate on the y-axis.
So, what did we find in our analysis? Two things: First, we found that the relationship between unemployment and wage growth still holds, but is much weaker. So visually, we have found that the Philips Curve gradually has become flatter over time and in particular, for the Eurozone, we find that that’s the case after the introduction of the Euro. And then, secondly, we’ve also found that the Philips Curve has shifted downwards, especially after the Euro was introduced. So, intuitively that means that wage growth has become slower for any given unemployment rate.
Laura: So going back to the theory and looking at it analytically has just confirmed the picture. But going back to my question - what is driving this?
Barret: Well, we think there are two main types of reasons which explain this behaviour. First of all there are structural reasons that have been happening in most advanced economies, and are sort of common across the advanced economies. But, secondly there are also more specific questions to the labour markets and we looked at the Eurozone as well, but the UK as well has some specific points that I’ll mention later on.
So looking at the structural reasons: One factor is the gradual decline of unionisation over the past 20-30 years in the Eurozone, and that’s been partly driven by shifts in the structure of the economy and also by policy changes, like privatisations. So, for example, the services sector, which tends to be less unionised, has seen the most growth in advanced economies both as a share of the total economy as well as employment. So lower relative levels of unionisation could explain why there is reduced sensitivity between unemployment and the wage rates.
So, obviously if trade unions, which operate on the principle of collective power, have weaker market power, then you would probably end up in a situation where they end up negotiating smaller wage increases with businesses compared to a situation where they had a stronger bargaining power. So, that’s one factor.
Another factor we’ve seen, and we think partly explains this trend, is the digitalisation of work through rapid technological change, as a wider variety of work can now be carried out remotely or can be outsourced, making labour supply potentially more elastic. As a related reason, the rise of the gig economy could also be one factor that explains this reduced sensitivity, with more flexible jobs making the unemployment rate and the relationship between that and wages a bit less responsive. Now these are reasons that are more common to advanced economies.
Laura: And you’ve mentioned earlier there are also some reasons specific in the Eurozone?
Barret: Yes, there are. As I said before, our research showed that wage growth is now slower for a given rate of unemployment compared to in the past.
We think the main reason why that has happened was because of the creation of the European Central Bank and the Eurozone itself. Specifically, what we found in our research is that the credibility of the ECB helped adjust inflation expectations downwards, particularly in the traditionally high inflation peripheral Eurozone economies. So remember that before 1999, which was when the Euro was introduced, monetary policy was set by national central banks, some of which were not seen as credible. So, in Italy for example, the average inflation rate for the past 18 years has been in the range of 1.8% per annum. But, in the 18 years before Italy joined the Eurozone, the Italian inflation rate was 7% per annum.
So the broader point there is that if I am a worker and my inflation expectations are gradually adjusted downwards, I or the unions that represent me will demand a lower wage increase from their employers, because my expectations have been adjusted downwards.
Finally, another factor that explains why wages are a bit less sensitive to the unemployment rate is perhaps related to the admission of the lower-income Eastern European economies into the EU in 2004. This would have made gradually labour supply a bit more elastic over time—and I stress the word gradual here as some of the EU-15 economies gradually opened up the labour markets to the newly admitted member states.
Laura: Those are some really interesting points on the EU and more generally, but how does the UK compare to that?
Barret: The UK is in some ways in a similar position. All of the structural factors I mentioned a few minutes ago are in play in the UK as well. You know, the rise of the gig economy, decline in the unionisation rates, digitalisation of work… But, in the UK, you’ve also got economic uncertainty factors flowing in as well with respect to the Brexit negotiations. Now that could well possibly be making workers a bit more nervous about the future and they might be holding on to their jobs for economic security reasons, forgoing any potential discussions with their employers on wage increases which could explain part of the puzzle that we’ve been seeing as well.
Laura: That does make sense. Well, thanks for shedding some light on this puzzle Barret, and thanks for joining me here today.
Barret: Thank you for having me, Laura
Laura: Great to have you. To our listeners, thank you for tuning in. Don't forget to rate and review and also be sure to subscribe to keep up to date with all future episodes. To find out more about topical issues around the UK economy do check out our website: www.pwc.co.uk/economics
Economist, PwC United Kingdom
Tel: +44 (0)207 212 8746
Senior Economist, PwC United Kingdom
Tel: +44 (0)20 7213 1579