Friday Flyer: “It's the real wage, stupid!”

We are asked to consider what has caused this year's revolt against the conventional wisdom that liberal capitalism is the best way to guarantee economic welfare. It is too early to account for all the reasons. But a primary candidate is the continuing inability of the economy to generate median real wage growth. Figure 1 shows the level of median real wages under a number of measures and we can say that any expectations of year-to-year growth in real wages clearly seem to have been frustrated since 2008. It is surely this frustration that helps us understand the revolt. To be clear though, median wages are simply the person who is the median wage earner at any one moment and does not track that individual over time.

                                                                                                                                                                                                                 Figure 1

One reason that real wages have not risen is for the "good" reason that the employment of the number of workers and their overall hours have held up somewhat more than we might have expected given the path of output. Given that real wages are closely determined by the marginal product of labour, if we increase the employment of labour for a given level of output its marginal product and hence the real wage will fall. Simply speaking, if you want to use more of an input to produce the same amount of output, you can only do so if you pay it less. It is almost as though we have collectively chosen more employment at the expense of lower wages - it is possibly a trade-off to a preferable point given the shock but not one we would have chosen in the absence of the shock.

Let me explain a little more. The large recession that started in 2008 following the financial crisis might have been expected to lead to a large increase in the rate of unemployment, as labour inputs fell alongside output. Indeed many economists posit a stable relationship between GDP, or the output gap, and unemployment, which is called Okun's Law. A traditional view was that a 2-3% move in the output gap would be associated with a 1% deviation in unemployment from its natural level. So if you thought that the change in spare capacity was something like 10-15% following the recession then you might have expected unemployment to have increased by something nearer to 6% rather than the 3% increase we observed.

The UK employment experience after financial crisis can be explained in large part by labour market flexibility. The labour market reforms in the last three decades of the twentieth century created the conditions for a flexible response of employment to the recession. These reforms shifted incentives to employers with reductions in tax and made unemployment (and non-participation) support less generous. There was also an increase in the institutional flexibility of the labour market with some reform of trade union powers and employment protection legislation. Trade union power also diminished because of the decline in both traditional manufacturing industry and of large public sector monopolies. The flexible response meant that firms held on to labour and also allowed capital to scrap.

Economic policy from 2010 was focussed on reducing public sector expenditure and employment to create space for the private sector to create employment. Whilst public sector spending cuts impacted on aggregate demand, which limited the expansion in the private sector, there were two separate channels holding back output. First the continuing Euro Area crisis limited demand for exports but, more importantly, financial frictions placed constraints on firms abilities to re-build the capital stock. This latter effect hampered the transmission of highly accommodative monetary policies.

The post-recession fall in real wages suggests that there was both an increase in labour supply and fall in the capital-output ratio, as firms matched hat increase in supply by hoarding labour rather than invested in new capital machinery in the face of financial constraints. And this may have tended to reduce labour productivity and hold back real wages. So even if we make the case that unemployment and employment surprised us in the right way in the aftermath of the recession there are still major issues of concern. And what we can clearly observe is that median real output per hour has not recovered especially well after the recession. The fall in median real wages and the unemployment faced by younger members of the workforce is a particular concern looking ahead and as long as expectations do not adjust or performance does not improve we can continue to expect some forms of political revolt.

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