The rise in the unemployment rate to 8.1% that was reported yesterday is unlikely to be the last of the bad news from the labour market. We think there are good reasons to expect unemployment to rise further. Moreover, persistently high joblessness tends to increase the structural unemployment rate, so that by the time the economy enters a sustained recovery high unemployment may not be much of a brake on wage inflation. The pressure on the government to drop its resistance to loosening fiscal policy is likely to grow ever more acute.
The grave concern expressed yesterday by many policymakers and commentators over the increase in unemployment belied the fact that on an objective measure unemployment is nowhere near as high as might have been expected given the weakness in the economy. This hitherto pleasing development may be starting to turn sour. In contrast to their US counterparts, UK firms hoarded labour during the recession, and output per worker consequently fell precipitously (see Figures 1 and 2). The economy’s failure to put in a sustained recovery means UK productivity remains well below its pre-recession trend.
Although the financial crisis may have lowered productivity permanently in certain sectors, in aggregate the current level seems unsustainably low (see our article We’re busy doing nothing, 1 June 2011, for more analysis and discussion). More likely, in our view, is that firms were banking on a swift recovery in demand to close the productivity gap. As it has become increasingly clear to us that the recovery will be weak and drawn out, a jobless recovery seems likely, and we should expect unemployment to continue to rise. Although our forecast envisages a modest increase to around 8.5% over the next few years (Figure 3) we believe the risks are skewed to the upside, and a rise to double digits is not unconscionable.
The persistence of unemployment is also a concern. The short-term unemployed can soon become the long-term unemployable. According to estimates published by the Bank of England (“Ready, willing, and able? Measuring labour availability in the UK”, BoE Working paper no. 186, 2003), the likelihood of an unemployed person finding a job over a three-month period is around 34% if they have been unemployed for less than six months. For those unemployed for six months or more, however, this probability drops to just 14%.
The longer a person is unemployed, the less competitive they become in the labour market and the less pressure they put on the level of wages. Pay growth depends not on the level of unemployment per se but on the “unemployment gap” – the difference between the unemployment rate and the so-called NAIRU (the “non-accelerating inflation rate of unemployment”). Our model-based estimate of the unemployment gap, which estimates the NAIRU on the basis of the historical relationship between pay growth and unemployment, suggests the gap is close to zero (Figure 4). Although we would hesitate to take such model-based estimates at face value, they highlight the point that resource gaps tend to erode, and if they are not eroded by stronger demand they will be eroded by weaker supply.
The likely regional disparity between job losses and job creation adds to the concern about a rising natural unemployment rate. Public sector job cuts seem likely to be most prevalent in the north of England, Wales and Northern Ireland whereas private sector job creation may be most vigorous in the midlands and the south east. The moribund housing market is likely to impede the mobility of labour that would be necessary to match workers to jobs. When the economy does eventually return to sustained growth, the high level of unemployment may provide little protection against wage inflation.
The traditional macroeconomic prescriptions for alleviating these problems are to cut interest rates and expand fiscal policy. The former is not possible at present. Moreover, whatever the ultimate power of QE might be to stimulate demand, even its strongest proponents would not claim it is likely to work quickly. By contrast, fiscal policy – particularly tax cuts – could be used to raise demand in a timely and effective way. The government’s position on this is well known: it is determined to stick to its current deficit reduction plan for fear of placing the UK’s credit rating in jeopardy. However, chronic labour market weakness could well develop into a major political and social issue. Unless the economy’s fortunes improve promptly in the New Year, we think that the pressure on the government to soften its stance on austerity may become too much to resist.
BARCLAYS CAPITAL
ECONOMICS RESEARCH