What combination of shocks hit the UK economy?

Published on by chrisbowdler

The prospects for the UK economy and the debate concerning the optimal macroeconomic policy path depend in part on the kinds of shocks thought to have impacted UK markets during recent years. One perspective, which I fully endorse, is that the UK has been hit by a large negative demand shock in the goods market, as consumers and governments aim to deleverage in response to increased economic uncertainty and declining asset prices, and firms delay investment spending in anticipation of weak public and private spending. This kind of shock can certainly explain many of the weaknesses in recent UK economic performance.

One thing that a pure expenditure shock cannot fully, explain, however, is the recent coincidence of (i) rising unemployment and (ii) declining consumer real wages in the UK labour market. Instead, I would argue that in addition to being buffeted by a Keynesian demand shock in the goods market, the UK has seen a decline in the effective demand for labour at each value of the real wage. In order to see this point, consider this very simple diagram that uses the notation in the excellent intermediate macro textbook by Wendy Carlin and David Soskice. The real wage for consumers is measured on the vertical axis and the quantity of labour on the horizontal axis. The WS curve is the effective supply of labour after controlling for trade union and other influences and the PS curve is what firms can afford to pay at each level of employment, given the value of what labour produces and the non-wage costs of production that firms must pay. Importantly, the real wage is measured from consumers' perspective, i.e. it is the quantity of goods and services consumers can purchase using the nominal wage that is paid.

Suppose that in 2007 the market started at an equilibrium denoted by A in the diagram. A pure expenditure shock would constrain employment to a lower level, consistent with recent UK experience. But there is no obvious reason for this to be accompanied by the sharp reduction in consumer real wages that has attracted recent media attention. Indeed, a lot of standard macro analysis, including that in the Carlin and Soskice book, predicts a non-negative change in real wages in the aftermath of an expenditure shock that constrains employment (in older literature this point is captured in the Tarshis-Dunlop problem).

In order to account for the two dominant trends in UK labour markets, consider a leftward shift of the PS curve -- firms offer a lower consumer real wage at each level of employment. In the diagram this shifts the equilibrium from A to C. Adding in the effects of employment constrained to be below the new equilibrium, due to the widely recognised shortage of demand in the goods market, points to an intermediate labour market position at a point such as B. A possible transition path for the economy is then A -- B -- C. With unemployment still rising in the UK, one estimate of the current position of the UK labour market is that it is somewhere along the first step in the transition A -- B. This kind of hypothesis, combining the classic Keynesian expenditure shock with a negative PS curve shock provides one simple explanation for the coincidence of rising unemployment and a sustained squeeze in consumers' take-home pay.

But what might account for the negative PS curve shock in the second part of this story? Firstly, an adverse movement in the terms of trade has seen the share of revenues that firms must allocate to imported commodities and intermediate goods rise significantly. Secondly, non-wage labour costs to be paid by firms, for instance employer pension contributions and payroll taxes, have increased. Thirdly, fiscal consolidation has required large rises in sales taxes such as VAT. The first and second factors shrink the real wage that firms can afford to offer workers. The third factor reduces the value of any wage offer to consumers. All three factors effect a leftward shift of the PS curve, which may play a role in the recent evolution of the UK economy.

What are the implications for macro policy and the economic outlook in the UK? A first point is that a decline in consumer real wages is part of the adjustment that is necessary following the double whammy of a Keynesian demand shock and a surge in the non-wage claims on corporate earnings. The main mechanism through which this adjustment has been achieved thus far is a rise in the consumer price inflation rate and the retail price inflation rate. This is more easily accomplished than the alternative method of squeezing real wages, namely a decline in nominal rates of pay. In this case, the consternation felt by some as a result of inflation in excess of the Bank of England target may not be such a cause for concern. Rather than being the result of policy failing to dampen inflation shocks, it could be interpreted as the most efficient route by which to equilibrate the UK labour market, given the obstacles to directly cutting nominal wages. Carrying the argument into the future, if the route A -- B -- C points to further real wage reductions ahead (and I find it hard to say whether or not it does), then the case for an immediate tightening of UK monetary policy in order to slow inflation is weakened.

A second conclusion to which this narrative points is that equilibrium unemployment has risen in the UK, given that employment at C falls short of that at A. Consequently, even when the shortage of demand is overcome and firms, consumers and governments switch their focus from saving to spending, the unemployment rate that supports stable inflation may be somewhat higher than the 5% or so that seemed to apply in the middle part of the last decade. For similar reasons, the strong recovery in GDP growth that has followed most post-war UK recessions, may be somewhat muted this time around if the factors holding back the PS curve (elevated import prices, consumption taxes and employer costs) outlive the Keynesian demand deficit.


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