Why has UK real wage growth been so low?

Some people have expressed surprise that UK real wages have recently fallen during a period when the UK labour market was pretty tight. (That tight labour market may be coming to an end as unemployment has begun to rise). Here is the real (in terms of consumer prices) level of the monthly average earnings data for regular pay (excluding bonuses) ending in April this year.

Levels of this measure are a little messed up in 2020 because of the pandemic, but the recent fall in real wages is real enough, reflecting consumer price inflation rising more rapidly than regular pay. In April consumer price inflation was over 3% above the increase in regular pay.

That real wages should be falling even though the labour market is tight is no surprise when we recognise that a key reason why inflation is rising so rapidly is a huge hike in the price of energy. Higher energy prices represent a transfer from consumers of energy to producers of energy. Unless you can stop that transfer happening by some means (by, for example, taxing energy producers making unusually large profits), then consumers have to pick up the tab.

That in turn must mean a reduction in real consumer wages (nominal wages less consumer price inflation). That is likely to happen because in most cases firms set wages, and in looking at what they can afford to pay they will not look at consumer prices, but at the prices of the products they produce, which are rising less rapidly than consumer prices. They may be forced to raise wages above this and productivity growth in a tight labour market, but they have absolutely no reason to compensate workers for a rise in energy prices. Equally, to argue that workers on average do not have to take a real (consumer) wage cut in these circumstances is at best wishful thinking, which is why I didn’t sign this letter.

Does this reflect weak union power?

But why should workers shoulder all the higher costs of energy? What about those living off rents or dividends, or pensioners? Well landlords and shareholders consume energy as well, so they will pay, although as they tend to be richer than average they will feel it less. In the UK, however, the government has said that state pensions will be protected from higher energy prices (with a delay) because pensions are indexed to either earnings or consumer prices, whichever is the higher. This illustrates a more general point, which is that the government can (and indeed should) adjust who pays for higher energy prices among the population by altering taxes or benefits. [1]

What would happen if some or all workers did manage to persuade companies to keep nominal wages at the level of consumer price inflation? Consider the case where only some rather than all workers did this first. It is just possible that the companies they work for would absorb higher wages through lower profits, but the more likely outcome is that their prices would rise by more than other firms. Consumers would pay those higher prices, so this is another way besides government action of redistributing the cost of higher energy among consumers. (Workers who get a high pay rise gain, those that don’t lose.)

But belonging to a union is not the only way some workers can transfer real income falls due to higher energy prices to others. In terms of the current situation it also matters how much personal bargaining power they have, which in turn depends on how tight particular labour markets are, how much money their employers are making or whether their employer is the state. This last factor is particularly important at the moment, as the following chart shows (from here).

Currently it is public sector workers who are really being hit by higher energy prices, while workers in finance are (on average) getting wage rises that are at least keeping pace with inflation. The former is untenable if we want good public services, and the government can hardly argue that bringing public sector pay in line with the private sector will be inflationary (although that probably won’t stop them trying!). The latter raises a question over why financial firms think they can afford such pay rises, and whether recent fiscal transfers from the government to banks (e.g.) have been wise.

Now consider what would happen if all workers managed to emulate their comrades working in finance? Would all workers avoid an immediate fall in real wages? In this situation it is then even more likely that firms would raise their prices to protect profits, producing a wage price spiral. [2] The Bank of England would raise interest rates sufficiently high such that unemployment rose, and aggregate demand fell, substantially, persuading enough workers to accept lower real wages and some firms to accept lower profits. This 1970s scenario will not happen today, because unions are not nearly as strong now as they were then.

While the reduction in union power since the 1970s will help avoid the kind of wage-price spiral we saw then, it is also reasonable to suppose that a tight labour market will have some effect on nominal wage inflation. This in turn could lead to higher domestically generated excess inflation (threatening the inflation targets of central banks). In addition when inflation is high firms may find it easier to raise profit margins. Arguments about whether its wages or profits being too high that is risking persistent excess inflation are not very helpful when the only solution we currently have to reduce inflation from either source is to reduce the aggregate demand for goods and services. [3] Equally, arguments that generally higher wages or profits will have no consequence for the economy are simply false. [4]

This is why in the US and UK short term interest rates are rising. In general it is hard trying to decide how far interest rates need to rise (and economic activity to be correspondingly lower) to avoid a large temporary energy price shock and temporary supply side shock (and temporary Brexit inflationary shock in the UK) leading to permanently excess inflation. That also means it is possible to make big mistakes, allowing either inflation to persist or creating an unnecessary recession. Given the mandates of most central banks, the latter is more likely than the former.

So why have real wages grown so little over the last 15 years?

If we return to the first chart, we can see that basic real pay is now around where it was before the Global Financial Crisis. (Total pay, including bonuses, would be a little higher.) Does this reflect a general shift in GDP from labour to profits?

Here is the share of corporate income in GDP since 1970 (source ONS).

There has been no trend rise in the share of GDP going to profits since 1970, so rising profits are not why real wages have grown so little over the last decade and a half. Where there is a problem is that this steady profit share has been accompanied by a recent slump in business investment.

By far the most important reason for stagnant real wages can be seen by looking at an old favourite, real GDP per capita, over the same period as the first chart..

You can see from this that there just has not been much growth in national output per head after the GFC. GDP per head was about 6% higher in the first quarter of this year than at its pre-GFC peak, which is pretty pathetic over a 14 year period. The UK economy has been hit by one disaster after another: the GFC, then the austerity period that squashed growth during what should have been the recovery period 2010-2013, a certain vote in 2016, and then Brexit and the pandemic.

Why is GDP per capita 6% higher since the GFC compared to no growth for average real earnings? The most obvious reason is the decline in the terms of trade caused by higher energy prices at the end of the period, which reduces the real wage when deflated by consumer prices but does not reduce the amount produced in the UK to the same extent. Other reasons include a slight fall in the share of wages in income caused by a rise in indirect taxes (e.g. the 2010 increase in VAT). In addition I have already noted that there is some small positive growth in total real earnings once we include bonus payments.

The main message is that a lack of growth in real wages over the last 15 years reflects a lack of growth in the economy as a whole. The current cost of living crisis is all the more painful because of this lack of real growth over the last decade and a half. No one should be fooled by government ministers talking about ‘a strong economy’: on this like much else they are lying. Furthermore we know why the UK economy has been so weak since the GFC. First austerity severely limited our ability to recover from the GFC recession, and then Brexit has cut UK growth and increased UK inflation.

Declinism

David Edgerton wrote recently in the Observer about the dangers of declinism (in short, the UK economy has suffered because of deep longstanding and particular problems that we have never solved) and its opposite, revivalism (from cool Britannia to Brexiter hype). Both as generalities are nonsense, and as he points out there is a danger of looking at the UK independently of trends in other major economies, particularly those we trade a great deal with.

So, for example, our economic performance after the GFC crisis was terrible because of austerity, but austerity also happened in the US and was perhaps more severe in the Eurozone, where it generated a second recession. As I noted recently, since the pandemic the US has grown more rapidly than Europe (including the UK) in part because of a fiscal stimulus that spurred the post-vaccine recovery.

Declinism stems in part from not seeing the UK in an international context. Of course the UK has many deep seated problems, but the same is true in most other countries. This chart, from here, can perhaps make this point more clearly than any words.

Compared to the original EU countries, UK growth was lower before we joined the EU, but since we joined the EU it has at least kept pace with those countries. I suspect this overstates the beneficial impact of joining the EU, as the EU5 were recovering from a much lower base after WWII and therefore could grow faster. But what it does show is that from the 1980s onwards, for whatever reasons (and there were probably many) the UK was actually doing rather well compared to our European neighbours. As I noted here, the same was true relative to the US. So stories about some unique UK national economic decline that starts well before 2010 are simply wrong. It is why we should not regard accounts like this as applying to the UK alone.

But while this chart may exaggerate the beneficial impact of EU membership, those benefits are real enough, and what we may already be seeing since the GFC and particularly Brexit is the beginning of another period of relative UK decline. Italy may save us from being the sick man of Europe once again, but if we want to see reasonable real wage growth again we have to do something about improving trade with our neighbours, which means getting rid of a hard Brexit, which in turn inevitably means removing from power the political party that delivered Brexit.

Postscript (23/06/22) The key difference between public and private sector pay

From comments I think it is worth expanding on a point I made briefly in the main post. I suggested that while high (i.e. matching inflation) private sector pay awards would generate domestically generated inflation, and therefore prompt yet higher interest rates and increase the probability of a recession, this was not true for higher public sector pay awards.

The intuition is very straightforward. Widespread private sector pay awards that matched inflation would prompt firms to raise their prices by a lot more than the inflation target of 2%. In contrast, if most public sector pay goes up, there are no prices to increase. In that very simple sense you just cannot get a public sector wage-price spiral.

Of course higher public sector pay will increase aggregate demand, which adds to inflation. But keeping public sector pay well below inflation should never be a demand reduction tool. That is the job of interest rate and fiscal policy. It is totally inappropriate to hold public sector pay well below both private sector pay and inflation as a means of regulating aggregate demand.   

In different situations it might be the case that high public sector pay awards might encourage those in the private sector to seek matching increases. But that will not happen this year, because public sector wage increases have been so much lower than private sector wage increases. Most of the public sector is playing catch-up, or to put it differently, the public sector is currently being asked to shoulder much more of the energy price hike than those in the private sector. As a result, the knock-on effect of higher public sector pay awards on private sector pay, and therefore inflation and interest rates, is likely to be minimal.

What will happen if public sector pay awards begin to match those in the private sector is that the government will need to find the extra cash. But we know that it has the money, without having to increase taxes, because the Chancellor has made no secret that he is assembling a large sum of money for additional tax cuts before the next election. So the choice is in many ways a very simple one. Do we want public sector workers to be paid more, like nurses and doctors where there is a current chronic shortage of staff, or do we prefer tax cuts to help the Conservative party win the next election?

  

[1] It could also shield all consumers by borrowing, transferring some of the cost of higher energy into the future, although that would make no sense if higher energy prices were permanent.

[2] The employment contract is not symmetric in terms of power between employee and employer, which is why trade unions are important in improving terms and conditions, preventing exploitation etc. However if union membership was widespread, the ability of unions to improve the real wages of workers as a whole is severely constrained by the fact that firms set prices.

[3] What about passing laws to prevent excessive increases in profits or wages? They were tried in the 1960s and 1970s, and they failed because they require the state to work out, product by product or worker by worker, what reasonable profits or wage increases are. Over the longer term it is better to ensure excessive profits are controlled through competition (enforced, if necessary, by breaking up monopolies) or, when competition is impossible, through forms of regulation.

[4] If the aim is to reduce the proportion of profits going to dividends, or share buy backs, high nominal wage demands is a very uncertain method of achieving this (as firms set prices). A more inevitable outcome is widespread unemployment as the central bank attempts to control inflation.