Parliament Street’s Head of Policy, Luke Springthorpe, welcomes the good news that real wages are rising- despite what Labour’s ‘cost of living’ campaign says. He argues that although such rises are great, we still need to see a sustained pick-up in productivity, for it to last.
Despite the fact the UK has had economic growth that has ranked as the fastest in the G7 group of economies, the impact of this has not manifested itself in a real rise in wages (increases above the rate of inflation) for a prolonged period of time. Politically, this manifested itself in what Labour termed the ‘cost of living crisis.’ It was essentially a bet that although unemployment was falling and growth was materialising, it would not result in a rise in real earnings and that job creation would be primarily in low paid, part time jobs.
Unfortunately for the Labour party, both of those hypothesis are now in tatters. The latest earnings figures released by the ONS revealed an average increase in wages of 1.8% (excluding bonuses) whilst inflation in December ran at a 14 year low of 0.5%. Hence, real incomes are finally rising.
Excellent news though this is, it should not lead to complacency. The fall in inflation was largely a result of falling gas and electricity prices as well as a continued drop in motor fuel prices. Given that these components of inflation have proved to be erratic and beyond the control of government policy, we should be wary that inflation may increase if oil begins to return to its short-medium term average price in excess of $100 a barrel. With a number of major oil producers announcing cuts in production that will likely take effect at the tail end of 2015, a rise in oil prices from their current lows should not be ruled out.
Ultimately, the only way to sustain real wage growth over the long term is to deliver productivity growth. It is only by ensuring that there is meaningful output growth per hour worked that, ultimately, wage growth will be sustainable for the businesses having to pay the wages- whether that may be above or below inflation.
This has been the one laggard indicator, with any meaningful improvement yet to be sustained. Productivity still remains 2% below its level prior to the economic down turn, and around 16% below what is termed the ‘pre crisis trend’.
For some time now, there have been a series of cyclical explanations for why productivity growth has struggled, with many falling down to the structure of the labour market and increased rates of retention. One unique factor of the recession was that many companies held on to workers even in the face of weak demand and lower levels of utilisation. This manifested itself in an increased use of forbearance rather than outright closure of businesses, which saw a high number of firms with declining output hold employment flat (rising from 11% to 20%).
We also have the additional factor that a large number of jobs have been created for trainees and first time employees with over two million new apprenticeships created since 2010. As a result, the fall in youth unemployment has been marked, falling from a high of 22% in 2012 to 16% towards the end of 2014. Although this is good news in itself, it stands to reason that many of these new employees may have initially ‘less productive’ than their co-workers due to underutilisation whilst being trained. Essential though productivity growth is, it shouldn’t be considered a success to deliver it at the expense of shutting out younger workers. Nevertheless, it is possible there may have been a lag in the productivity growth achieved as this new influx of workers become fully trained and able to be fully utilised.
The fact that productivity is now showing signs of picking up as the recovery takes hold suggests that the decline may have been cyclical and that increased demand will see higher rates of labour utilisation. What’s more, another cyclical factor dragging on productivity has been the decline in business lending. Pleasingly, there are signs that this too is set to turn a corner with business lending predicted to turn a corner with a forecast £66bn boost to business lending forecasted over the next 4 years.
Looking beyond the cyclical factors, there are reasons to believe that there has been a structural change in the economy that could see a sustained uptick in productivity growth over the coming years. First is the fact that most of the jobs created have been in the private sector. There is some correlation to suggest that regions with a higher proportion of workers in the private sector or also those that are most productive (benchmarked against the national average). By comparison, those with the highest concentration of public sector workers, such as the North East, Wales and Northern Ireland, fare poorly. Whilst Scotland is the exception to this norm, it is of note that it ranks among the highest in private sector job creation between 2013-14.
Added to this are the essential structural reforms that have been delivered by the coalition government. This has already manifested itself in a sharp rise in self-employment following mechanisms that have encouraged small businesses during their start-up phase, such as national insurance exemptions for small businesses. Even as inflation begins to return to more normal levels of 2%, the foundations have been laid for productivity growth that can outpace it and allow business to increase their wages. Education reform will also be of long term benefit for productivity, especially with apprenticeships playing an increasing role.
That is not to say that the UK is completely out of the woods. One element of concern that is yet to be addressed is effectively boosting capital investment. One reason unemployment has fallen so sharply is owing to the relative decline in the price of labour relative to capital. Given the important causal relationship between capital available per unit of labour, it should be of concern that there has been a decline in already low rates of capital investment with the UK having one of the lowest gross fixed capital formations in the developed world.
A key determinant of success here will be in boosting the more capital intensive export industry, although it is pleasing to note that the Chancellor has already acknowledged this problem exists as well as passing measures intended to tackle the problem. Time will tell if he can succeed in the face of strong headwinds created by anaemic growth from the UK’s largest export partner- the Eurozone. In the face of this, George Osborne should consider an extension to his tax allowance on investment (currently due to run out by the end of 2015) until there is a demonstrable stability restored to the global economy. This would allow businesses to continue to invest with confidence which may otherwise be rocked by the prospect of a ‘Grexit’.
Another problem is that the proportion of ‘product innovators’ has declined markedly (UK Innovation Survey), meaning that although R&D spending is remaining relatively consistent, less new products have been brought to the market. In this sense, we can see that the credit crisis was as much about a collapse in innovation as it was a collapse in the financial sector.
The good news is that capital investment and innovation activity may increase in line with the up-tick in domestic demand. The challenge will be in ensuring that a potential Eurozone crisis does not scupper UK businesses investing in the future with confidence and bringing new products to the market that lead to the productivity growth needed to boost incomes.
What we can be confident of is that the current UK government is aware of the problems and is taking the steps to remedy the underlying problems. It is this realisation that money doesn’t grow on trees and that higher wages can only be sustained by highly competitive businesses that will allow everyone to notice the difference in their pay packets over the long term.