Inflation, recession and the labour market

Perhaps it is due to the fact that I’m focusing a lot on labour markets for my day job, or perhaps it is simply an intriguing topic, but a recent Free Exchange  post really took my attention. It was a terribly interesting piece and one that I read over and over again. Whilst the article cited three studies, the key point was that inflation during a recession matters for how the labour market adjusts, via its influence on real wages. When inflation is high, this translates into low real wages, and firms during a recession can more readily hold onto workers due to this falling wage cost. Conversely, when inflation is low, real wages and ‘sticky’ and firms will be more inclined to lay staff off as a way of reducing costs.

This is highly interesting stuff, as although Okun’s law is still relevant (see this post), the presence of inflation during a recession can influence the type of adjustment that the labour market will make. With stubbornly high inflation in the UK, the recession and recovery has been ‘wageless’, whereas the lower inflation environment in the US has meant that the recession has been jobless.

The endogeneity issue

An ongoing debate over recent times has centred on the curious case of falling productivity in the UK during its recession. The pessismistic view of this ‘productivity puzzle’ is that the supply side of the Bristish economy took such a hit during the financial crisis that the productive capacity of the economy had been damaged. I always found this a difficult concept to come to terms with. When I look back to undergraduate economics, one thinks about the productive potential of an economy being dependent on things like the quality of the workforce, education and skill levels, infrastructure concerns such as roads, ports and even IT, and the quality of institutions. The global financial crisis was especially severe, but I could not understand why it would have significantly damaged any of these factors for the UK economy.

Consequently, I was always curious about the endogeneity issue of this productivity puzzle – was output low because of falling productivity, or was productivity falling because of low output. The latter view stated here is a more ‘demand’ side view of productivity, in that output per worker is influenced by the current state of the economy, even if its long run determinants are the supply side factors listed above.

This quote from the paper by Bill Martin and Robert Rowthorn[i] sums up their findings perfectly:

The UK’s poor productivity is more plausibly interpreted as a symptom of a largely demand‐constrained, cheaper labour economy ‐ a condition misinterpreted by supply pessimists as a sign of structural weakness. Output is well below potential because workers, while cheaper to employ, are not working to potential. More output could be produced, but not sold. There is an effective demand failure, high unemployment and, within companies, under‐utilisation of the employed workforce – a form of “labour hoarding”.

 A mechanism for this effect, both in a ‘financial’ and ‘normal’ recession

The paper from Calvo, Coricelli & Ottonello, titled “The labour market consequences of financial crises with or without inflation: Jobless and wageless recoveries,” outlines an intriguing model that specifies how this might work in a ‘financial recession.’ In the model, a financial shock takes the form of a drop in loan collateral values, but this effect is different for labour versus capital of a given firm. Because capital can be more easily collateralised, as a share of a firm’s capital can be handed over to creditors if a default occurs, loans are skewed to more capital-intensive projects during the recovery. This mechanism in the credit market works to exacerbate the impact of inflation described above.

While the econometric and theoretical paper of Calvo et al was great reading, I can also see how high inflation could impact the labour market in a ‘normal’ recession. Particularly in a cross-country framework, as countries have differing labour market institutions, it seems intuitive that firms seeing high inflation and low real wages  have an incentive to hoard labour, thus leading to a wageless recovery. I’m sure we’ll see more work in this area.

What does this mean for policy?

This work has a number of implications for economic policymakers. Firstly, it has an impact on any assessment of ‘spare capacity’ in an economy, as an unemployment rate around the historical average may still be disguising labour market weakness and economic slack. This is particularly relevant for the UK right now and in my opinion, is something the Bank of England is focusing on. In the UK at present, the unemployment rate has been falling faster than the BoE expected, which put the previous ‘forward guidance’ under pressure. If the unemployment rate was the only indicator to assess slack in the economy, then the BoE might be inclined to raise rates. However, this would be premature, as the BoE believe there is ‘underemployment’ in terms of the hours worked by employees.

It also has implications for conventional monetary policy, if and when developed economies return to historically average policy rates. The point about spare capacity also applies in this economic environment as well.

Finally, it has also broadened our awareness of labour market responsiveness, which will influence our expectations and forecasts of labour market adjustments in future recessions. All in all, some very interesting research indeed.

[i] Martin, B & Rowthorn, R (2012), Is the British economy supply constrained II? A renewed critique of the productivity pessimism. Centre for Business Research, University of Cambridge.


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