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The Benefits of a Flexible Economy

Employment in Britain has been remarkably resilient given the depths of the UK's recession...

THE MOST recent UK unemployment figures showed a welcome fall in the jobless total, after increases last year. But unemployment in the UK remains high, writes former Bank of England Monetary Policy Committee member Andrew Sentance.

It is currently around 2.6 million – 8.2% of the workforce, an increase of about a million since before the global financial crisis and the 2008/9 recession.

Though higher unemployment is unwelcome, the fact is that the UK labour market has performed better than many feared in the immediate aftermath of the financial crisis. The drop in GDP in the recent recession appears larger than we saw in the early 1980s and early 1990s recessions. And in 2009 there were forecasts that unemployment could rise to over 3 million or even 4 million. The fact that growth over the recovery so far has been disappointing might have compounded these concerns. 

Yet unemployment has still not risen as high as it did in the 1980s and 1990s. In both of these previous recessions, unemployment rose above 10% of the labour force and in the 1980s remained at a double digit rate for over five years.

The contrast between recent employment performance and these two earlier recessions is stark (see Chart). In the early 80s and early 90s, employment dropped by about 6% and only started to level out and recover after 3-4 years. In the 2008/9 recession, the decline in employment was initially much less – about 2.5% – and the decline levelled out after about a year. 

Since the end of 2009, we have recovered about half of the jobs lost in the recession. The private sector has created nearly 850,000 new jobs in the past two years, though recently this has been offset by job cuts in the public sector. And the difference between the employment track we are now on, compared to the previous recessions is around 5% of the labour force – about 1.5 million jobs.

How do we square the circle between figures which show a very deep recession, but relatively good employment performance? One possibility is that the GDP figures will eventually be revised to show a milder recession and a stronger recovery. The Office of National Statistics (ONS) has made significant revisions to the course of previous recessions and recoveries – notably the early 1990s recession. 

However, we would have to see quite dramatic changes to the GDP picture to explain such a significant difference in the profile of employment between the latest recession and earlier economic cycles. Rather, I believe the explanation lies in changes in the structure of the economy and the way in which the labour market,  businesses and policymakers have responded to the shocks created by the financial crisis.

Four factors have played a part in delivering a more positive outcome for UK employment than we have seen in previous recessions. The first is a change in the structure of employment, with the services sector now playing a larger role in the economy. In the 80s, 90s and 2008/9 recessions, around 90% or more of the job reductions occurred in two highly cyclical sectors of the economy – manufacturing and construction. Between 1979 and 1981, these sectors shed over 2 million jobs in the space of two years, and between 1990 and 1992, they cut employment by nearly 2.5 million. Employment in the services sector has tended to be much more stable during UK recessions.

In the 2008/9 recession, job losses in manufacturing and construction were much lower – at just over one million. A large part of the explanation for this difference lies in the long-term decline in the manufacturing share of employment in the UK. In the late 1970s, manufacturing industry accounted for over a quarter of total employment, whereas by 2007 its share of jobs had dropped below 10%. This meant that the same proportionate drop in manufacturing employment had a much less significant impact in terms of the number of lost jobs, even though UK manufacturing employment fell by over 15% in the 2008/9 recession.

A second factor contributing to better employment performance through the latest recession was the underlying health of the UK business sector. In both the early 80s and early 90s recessions, the shake-out of employment was intensified by the need to address underlying structural problems. In the 1980s, businesses faced the challenge of restoring competitiveness after the turmoil of the 1970s – when British industry struggled with turbulent industrial relations, poor productivity and low profitability. In the early 1990s recession, there was a big job shake-out in consumer and property-related businesses which had grown rapidly in the preceding "Lawson Boom".

In the run-up to the recent recession, the non-financial business sector of the economy was in much better shape. Profit margins were healthy pre-crisis. And the UK had developed a diverse and flexible business sector mainly based on services activities, which had enjoyed consistent growth from the mid-90s until the advent of the financial crisis. Though there was then a big shock to the financial sector and to banking in particular – this did not have large direct employment consequences, as UK financial services only accounts for around 1 million jobs – around 3% of the total.

The other two factors which helped to support employment through the recent recession and into the recovery are wage flexibility and policy measures. Though inflation has been high, wage increases have remained subdued, and the resulting flexibility in real wages has allowed employers to maintain a higher level of employment without incurring excessive costs. There have also been other aspects of labour market flexibility which have supported job growth – with part-time jobs and self-employment growing strongly. The UK also benefits from now having a well-developed suite of "active labour market policies" – programmes which support the transition of the unemployed back into work, either directly or through training opportunities. 

Macroeconomic policy has also operated more flexibly through the most recent recession than in the early 80s and early 90s – when policymakers were battling to bring down inflation. The Bank of England has been remarkably tolerant of above-target inflation in recent years. There may be a price to pay for this in the future.

What lessons can we draw from the performance of the UK labour market through the recent recession and the rather faltering recovery? The first lesson is that the change in the structure of the UK economy over the past 20/30 years has not necessarily been bad for job prospects. Yes, we do not have the substantial manufacturing base we had back in the 1960s and 1970s. But the manufacturing we do have is much stronger and more competitive. The current structure of the UK economy – with a diverse range of services activities and a leaner and fitter industrial base – has enabled the labour market to cope better with recessionary conditions than we did in earlier downturns.

A second lesson is that the UK non-financial business sector is remarkably resilient. Despite big shocks to demand and financial markets, we have not seen the shake-out of employment experienced in previous recessions. The third lesson is that labour market flexibility – in terms of wages, employment conditions and the deployment of active labour market policies – has been a great asset for an economy exposed to big international shocks like the UK.

We should therefore take encouragement from recent UK labour market and employment performance. The Euro crisis may make it difficult for unemployment to continue to fall in the short-term. But the business resilience and labour market flexibility of the British economy should be positive for medium-term economic prospects.

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Now senior economic advisor to PricewaterhouseCoopers and part-time professor of sustainable economics at the University of Warwick in England, Andrew Sentance is a British business economist who from 2006 to 2011 served on the Bank of England's Monetary Policy Committee. Consistently calling for higher interest rates to combat rising inflation during his last 12 months in the role – and overwhelmingly outvoted each time – Dr. Sentance today shares his views on macroeconomic and monetary developments in his weekly blog, The Hawk Talks. His previous roles include senior economist at the Confederation of British Industry (CBI), chief economic advisor to the British Retail Consortium, and chief economist at British Airways.

See full archive of Andrew Sentance articles

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