Pay and productivity – an economic perspective

01 April 2014

By John Hawksworth

The UK economy is recovering, but so far pay and productivity have been the two key missing pieces in the jigsaw. How do they fit together and when might they also mount a strong recovery?

Economic theory suggests that pay and productivity are closely linked, since if companies pay workers more than they produce then profits will suffer, but if they pay less then workers will go elsewhere. So called ‘efficiency wage’ theory further suggests that, at least up to a point, higher wages can encourage workers to be more productive, as well as saving money by reducing labour turnover rates. Other theories emphasise the role of relative employer and employee/union bargaining power in determining how pay relates to productivity.

All of these theories have some insights to offer, but the link between pay and productivity will not be exact in the real world. For a start, employers also need to consider non-pay elements of total labour costs. In the UK, some of these extra costs (e.g. employer contributions to eliminate pension fund deficits) have been relatively large in recent years, making it hard to keep basic pay in line with productivity without reducing employment.

Second, workers have faced rising consumer prices since 2007 due to a generally weak pound, rising global commodity prices and (in January 2011) a sharp hike in VAT. These factors do not add to what employers receive for their products, so they may be reluctant to compensate workers for them through higher pay. This has meant that, while UK productivity growth has been unusually weak since the recession, real wage growth for consumers has been even weaker.

The good side of low real wage growth has been to allow companies to create a large number of jobs since mid-2009, keeping UK unemployment well below what it was in past recessions, or indeed what it has been in many other major economies in recent years.

The bad side is that it has squeezed working age households (although not pensioners), who have had to run down their savings ratio to fund an upturn in consumer spending over the past 18 months. That is not a sound basis for the recovery in the long term.

What we need to do is switch from a low pay, low productivity equilibrium to one where both start rising strongly, which will also provide a more sustainable basis for consumer spending to continue to rise. How might this happen?

In the short term, reasonably healthy demand growth should allow greater utilisation of existing employees, pushing up average productivity growth and supporting higher real pay levels. But there is a limit to this given that most analysts do not see more than around 1-2% of spare capacity in the economy at present, which might be used up in a couple of years if recent GDP growth rates continue.

In the longer run, therefore, we need a revival in business investment. This has been low in recent years due to credit constraints and high levels of demand uncertainty and risk aversion by companies. So we have seen a falling average ratio of capital to labour in the UK economy, leading to lower productivity and real wage levels (just as you would expect from economic theory).

Business investment should pick up over the next few years, unless there are major global shocks (e.g. the Ukraine/Russia conflict escalates and/or the Eurozone crisis flares up again, leading to a spike in risk premia and declining business confidence and investment).

Increased business investment should eventually push up productivity growth. This in turn should underpin real pay growth beyond the short term benefits from demand-side increases in the utilisation of existing employees.

But will this occur fast enough to keep the recovery going before the current consumer-led upturn based on a falling savings rate runs out of steam? We are cautiously optimistic that it will, but it could be a very close run thing. There is still no room for complacency on the economy.

John Hawksworth:
Read profile | Contact by email | Tel: 020 7213 1650



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