Making work pay: the productivity puzzle

Originally posted on the Fabian Review online, 11th March 2014

The restraint shown by the Low Pay Commission recently in recommending a three per cent rise in the national minimum wage is justifiable. The LPC has responsibility over a very successful instrument for attacking serious deprivation in the UK: it has almost eradicated extreme low pay without affecting inflation or employment rates.

But the architects of the national minimum wage did not anticipate that it might become the going rate for many jobs, and they didn’t foresee  the longest sustained fall in real wages on record. Even the founding chairman of the commission, Sir George Bain, came out earlier this month to argue for a radical overhaul of the LPC.

Clearly, a three per cent rise is going to do little to help those stranded at the bottom of the labour market. Thanks to inflation, the cost of a minimum standard of living is rising by around 4.4 per cent, leading to a record number of people relying on food banks, high rates of child poverty, and the second highest rate of fuel poverty in the EU.

As I argued in my previous post, with other economic indicators back on track, many see the continued slump in real wages as necessary suffering. Many believe that as we crawl towards growth, the flexibility of UK workers has been an asset. In the last meeting of the Monetary Policy Committee at the Bank of England, members noted the strength of the employment rate before voting to keep interests rates where they are – in other words, to hold the course.

The productivity puzzle

What baffles economists is how wages interact with productivity, and many aregetting quite concerned. The Office of National Statistics now estimates that UK productivity tails the G7 average by 21 percentage points. It’s clear that many have managed to hold on to jobs through the recession, but divide the output of the economy by the number of hours worked and the result isn’t encouraging.

The dominant view is that we’re facing a problem of supply. The financial sector has been distinctly reluctant to lend since 2008, and there’s less available capital for firms to make investments in productive assets. In particular, firms have stopped investing in people: they’re not hiring fresh talent, or spending money to train existing workers.

If the employment rate holds up and growth is maintained, the supply siders argue, the spare capacity in our economy will kick in. This return to sustainable growth will have been achieved, as Allister Heath claims, through a steely commitment to deficit reduction, the weathering of the Eurozone crisis and a few injections of government backed credit.

Others have turned the productivity puzzle around. What if it’s an issue of demand? Respected labour economist John Philpott recently pointed out that demand in the economy has been supressed for a remarkably long time when the supply of workers has been greater than ever. Large-scale demographic changes – the UK’s growing population, and a workforce swelled by older people retiring later – mean that hose in a job are willing to accept lower wages over unemployment, and so firms can hoard labour and avoid the costs of hiring and firing. Britain’s army of underemployed part-time workers also hold the wage rate down, not least because part-timers earn around two-thirds of a full time wage.

It’s not the case that low paid jobs are a way back in to work for those who have lost out in recession, who might return to boost the economy further. The Joseph Rowntree Foundation has carried out admirable work showing that “large proportions of low-paid workers are not moving up from the bottom of the pay ladder, even over relatively long periods of time”. Instead, low pay is increasingly the norm for particular sectors. The majority of jobs created between 2010 and 2013, noted the TUC, were in low-paid industries: chief among them retail and personal care.

There are serious consequences for everyone when low pay becomes part of the business model. Without readily available credit or solid demand, it makes sense for companies to squeeze value out of their employees rather than invest in creating new products and finding new markets..

One explanation of the productivity puzzle is that the creative destruction usually occasioned by recessions didn’t take place this time. Not only did banks fail to adjust their own business models – relying instead on quantitative easing – they may have extended forbearance on loans to companies that are fundamentally unproductive, as the IFS suggested last year. This idea has led some to dramatic conclusions:

“The real wage can determine the capital- or labour- intensity, and the productivity, of an economy’s output. To be slightly more precise: maximum achievable productivity places an upper limit on wages, but how close to achievable productivity an economy operates depends on wages.”

It’s surprising to read an argument like this in the Economist. But it’s encouraging that we are starting to recognise the long-term risks of our economy’s race to the bottom.

Most immediately, low paid workers are also bad consumers. Recent growth corresponds worryingly to a rise in debt-fuelled spending. The gap between recent rates and a living wage – what we might call a “basic, but socially acceptable standard of living” – also means the Treasury loses out on £5.9 – £6.3bn in tax revenue. Put in perspective, the government will spend on £4.47bn on universities in England this year. This is not much of a public investment in innovation, and business investment is only now beginning to improve. The Bank of England plans to keep interest rates at 0.5 per cent for at least another year. Such a large and sustained stimulus becomes risky if bubbles emerge in housing and the stock market. Before we run out of economic options, it’s time to take on low pay: and to do so we may need to rethink some of our basic assumptions.