UK: Economic Review, Third Quarter 2006 - Why Rising Unemployment Might be Good for the Economy
Jobless Benefits

Foreword

In this Review, Roger Bootle, Economic Adviser to Deloitte, looks at what has been driving unemployment higher over the last year and considers what impact the jobless are having on the UK economy.

Roger says that although higher unemployment can never be a good thing for an economy, he believes that this latest rising trend may not have the same adverse impact as we saw in the 1980s and 1990s. He says that the key distinction is that this time higher unemployment has not been driven by swathes of people losing their jobs but rather by sharp increases in the workforce as immigration has risen and many older workers have decided to work for longer – presumably because they are concerned about their provisions for retirement.

Although Roger admits that it is possible that firms have been more reluctant to raise headcounts at a time when energy prices have risen rapidly and the regulatory burden has increased, the main factor has probably been the cyclical weakness of the economy seen over the last year or so.

Roger believes that although there is a danger that rising unemployment will have a dampening effect on economic activity as it undermines job security and confidence amongst consumers, rising unemployment will act as a restraint on wage and inflation pressures and this will allow the economy to prolong the next period of economic expansion. So, recognising that a rise in unemployment always represents a waste of human potential, Roger thinks that the recent increases, and those soon to come, could be almost as good as it gets.

Once again, I hope that this Review helps you in both your immediate and strategic thinking.
John Connolly
Senior Partner & Chief Executive Deloitte

• The downward trend in UK unemployment seen for more than a decade has gone into reverse over the last year. The jobless total has climbed by more than 200,000 already and looks likely to rise further.

• This rise in unemployment may not have the adverse effects on the economy of those seen in previous decades. For once it has been driven, not by large scale job losses, but by sharp rises in the workforce.

• This in turn has reflected the strong inflows of migrant workers from the new members of the EU, as well as a rise in activity rates amongst older workers presumably concerned about their provision for retirement.

• It is possible that structural constraints on employment growth have played some part too. Rising energy prices and an increased regulatory burden may have discouraged firms from hiring. • Meanwhile, there is a danger that the rise in unemployment has a dampening effect on activity by undermining job security and sentiment amongst consumers.

• The fact that employment growth has slowed sharpest in nonenergy intensive areas like retailing suggests that the main factor preventing employment from keeping pace with the workforce has been the cyclical weakness of the economy.

• This message is supported by the news on wage pressures themselves, which appear to have eased over the last year as unemployment has risen.

• The upshot is that the rise in unemployment has acted as a useful pressure valve in easing capacity constraints in the economy and keeping wage and inflation pressures subdued. This could help to prolong the period of expansion in the UK economy.

• Elsewhere, the economy has shown some encouraging signs of re-balancing in recent months as the industrial and external sectors have benefited from the strength of overseas demand.

• It remains doubtful that such areas will be able to compensate fully for the slower growth of household spending than that seen in recent years, particularly if the US economy soon starts to slow. While we have revised our forecast for GDP growth in 2006 a touch higher from 2.2% to 2.5%, we expect a modest slowdown next year to 2.2%.

• Even if growth turns out to be stronger, the combination of spare capacity in the economy and intense competitive pressures is likely to keep underlying inflation pressures subdued.

• As such, while the prospects of further falls in UK interest rates this year have evaporated, we think that speculation of rate rises by the autumn is premature.

It looks like everyone’s worst nightmare is coming true. The downward trend in UK unemployment seen for more than a decade has gone into reverse over the last year or so, with the jobless total already up by over 200,000 and counting. In the past, such developments have often spelt seriously bad news for the economy.

The implications of the latest rise in unemployment are less clear. One interpretation is that it indicates a growing degree of slack both in the labour market and in the economy as a whole. Another possibility, however, is that it is a supply-driven result of the growing inflexibility of the labour market and the damage to capacity inflicted by the sharp rises in energy prices. Needless to say, these two interpretations have significantly different implications for the resulting effects on inflation, and hence for the likely path of interest rates and, ultimately, economic growth.

In this edition of the Economic Review, we therefore take a closer look at the causes of the rise in unemployment and its likely consequences. Will the same old nightmare have a different ending?

Unemployment on the up
Chart 1 shows the history of UK unemployment over the last four decades. Having climbed sharply in the wake of the late 1970s/early 1980s recession, unemployment fell sharply during the economic boom of the mid to late 1980s, only to rise again during the early 1990s downturn. It then embarked on a long downward trend which saw both the number of unemployed workers, and the unemployment rate (as a share of the workforce), fall back to the levels seen in the early 1970s.

But this downward trend has come to an end over the last year, with the claimant count measure – which counts all those claiming unemployment-related benefits – rising by a total of some 126,000 since January 2005. This has caused the unemployment rate to rise from 2.6% to 3.0%.

Neither has the rise in unemployment simply reflected changes in the benefits system, as has sometimes been the case in the past. Indeed, the wider ILO measure of unemployment, gauging the number of people who are out of work and actively seeking employment (but not necessarily claiming benefits), has actually risen a bit further than the claimant count, climbing by a total of 213,000 since its low-point back in September 2004.

On either measure of unemployment, the recent increase has been very modest by the standards of previous upturns such as those in the early 1980s or 1990s. So far, the rise in the ILO measure, for example, has been less than a quarter of the size of that seen between May 1990 and March 1993. What’s more, the level and rate of unemployment both remain very low by recent historical standards.

Nonetheless, even a modest upward trend in unemployment represents a significant change from the long downward trend seen over the previous decade or more and could potentially have important effects on various aspects of the economy’s behaviour.

Employment still growing
To get a better idea of the possible effects of the rise in unemployment, however, we need first to understand what has lain behind it. The key point to make is that it has not been a consequence of a fall in employment. Indeed, the ILO measure of employment has risen by almost half a million in the period since unemployment first began to rise, not too dissimilar from the rate of increase seen during the preceding years of falling unemployment. (See Chart 3.) The alternative workforce in employment measure has risen by a similar amount.

This contrasts strongly with the rises in unemployment seen in the early 1980s and 1990s, which were driven by a sharp fall in the number of jobs in the economy. Indeed, the rise in unemployment of just over 1 million in the three years to February 1993 was more than matched by a 1.6 million fall in employment.

It also helps to explain why the immediate impact of the rise in unemployment on indicators such as consumer sentiment and spending appears to have been pretty limited this time round.

With employment continuing to grow, it follows that the rise in unemployment must have reflected even stronger growth in the workforce, that is, the number of people either in work or available and looking for work. Indeed, the ILO measure of the workforce, otherwise known as the total number of "economically active" has climbed by some 683,000 since unemployment started to rise and by over 470,000 in the last year alone. This represents a rise of some 1.5%, the fastest annual rate of increase – with the exception of one brief (and rather suspicious-looking) spike back in 1984 – since the data began in 1978.

Immigration boosts the workforce
So what has driven the recent rapid growth of the workforce? The most straightforward factor has been a rise in the population itself. The number of people in the UK of working age (16 to 59 for women, 16 to 64 for men) has risen by 274,000 over the last year and by over 450,000 since unemployment troughed in September 2004. The total number of people aged 16 or above has risen by 637,000 over the same period.

Part of this increase no doubt reflects the effects of immigration flows into the UK following the expansion of the European Union. Unfortunately, the official data on such flows is of questionable accuracy and out of date, with the latest numbers referring to 2004 and showing net inward migration of some 220,000 people in that year.

However, we have produced our own estimates suggesting that net migration actually totalled a rather higher 300,000 or so in 2004, before rising to around 470,000 in 2005. Of course, these totals are unlikely to have shown up in full in the official data on the workingage population, not least because some of the migrants will presumably have been children. Nonetheless, they suggest that much of the recent pick-up in the growth of the working age population, and indeed of the actual workforce, has been down to the effect of increased immigration.

Older workers stay on
On top of the rise in the population there has been an increase in the proportion of the population which is either in work or looking for work, otherwise known as the activity or participation rate. Chart 6 shows the activity rates both for the 16 to 59/64 group and all aged 16 and above. Both rates are at their highest levels since the early 1990s.

Quite why a greater share of the population is joining the workforce is unclear. One possible factor is the rise in immigration again, since a relatively high proportion of those entering the country are probably doing so to work or at least look for work, though admittedly some of those may not show up in the official workforce figures.

Another possible explanation is the opposite of the "discouraged worker" effect seen in the early 1980s and 1990s, when activity rates and the workforce dropped sharply as people essentially gave up looking for work in the belief that there was simply none available. With the economy having expanded solidly for a number of years, workers may have been encouraged to re-join the search for work.

A third factor, though, appears to be a growing tendency amongst older workers in particular to remain in the workforce for longer, or even to re-join the workforce again having previously left it. As Chart 7 shows, activity rates amongst the 50 and above age groups have risen sharply, with 103,000 people aged 60 and above joining the workforce over the last year (out of a rise in the population of that age group of 115,000). The obvious explanation for this trend is the inadequacy of savings for retirement.

Looser labour market to dampen wages?
Table 1 provides a snapshot of the behaviour of the labour market both over the last year (in the 12 months to April) and since the ILO measure of unemployment started to rise back in September 2004. To summarise, the key development has been the sharp rise in the workforce, which itself has reflected both a rising population and a rise in the activity rate. Employment has risen reasonably solidly over the period, but not by enough to match the rise in the workforce. As a result, unemployment has picked up.

So what does all of this imply about the behaviour of the economy and its future prospects? Needless to say, the fact that the rise in unemployment has been driven by an expanding workforce, rather than by falling employment, is good news as far as the impact on activity is concerned. It also suggests that the downward effects on wages growth and inflation will be significantly milder than if the economy were losing large numbers of jobs.

But on the face of it at least, the rise in the workforce still represents a loosening of labour market conditions in that it has increased the supply of labour available to employers. This should lead to rather weaker upward pressure on wages growth and, ultimately, inflation than if unemployment had remained stable or continued along its previous downward path.

Another way of putting this is that the actual rate of unemployment has risen relative to its natural rate or, to use economists’ jargon, the non-accelerating inflation rate of unemployment (NAIRU). As its name suggests, this is the rate of unemployment consistent with steady growth in wages.

The counterpart to this, of course, is that the faster growth of the workforce has at least temporarily increased the rate at which the economy can expand without prompting a pick-up in inflation pressures, the trend or potential growth rate. Other things being equal, this will lead to a greater degree of spare capacity, hence reducing price pressures in the economy and allowing interest rates to stay lower.

In addition to these effects, the rise in unemployment could also have a downward influence on consumer sentiment and activity if households fail to appreciate that the rise has reflected stronger growth in the workforce rather than falling employment. As Chart 8 shows, the recent modest decline in consumer confidence has coincided with a pick-up in households’ expectations of unemployment to their highest levels since the early 1990s.

Is the rise in unemployment structural?
At face value then, while the recent rise in unemployment does not carry the potentially grave implications for the economy of previous increases, it could nonetheless prove to be an important development in keeping inflation pressures in the economy subdued. This, in turn, could help to prolong the period of steady expansion seen in the economy over the last decade or more.

But things might not be quite as straightforward as all of this suggests. Some commentators have suggested that the rise in unemployment might also reflect structural downward influences on employment growth resulting from various factors including the effect of increased regulatory constraints and the sharp rise in energy prices.

If this is the case, then the implications for wage and price pressures in the economy might be very different. The natural rate of unemployment or NAIRU may have risen and the trend rate of GDP growth will not have increased. Indeed, it may even have been depressed.

These developments would imply a rather smaller degree of slack or spare capacity both in the labour market and in the economy as a whole. This, in turn, could curtail the rate at which the economy can expand without a build-up of inflation pressures, implying the need for a higher path of interest rates and/or a slower rate of economic growth.

There is certainly some evidence in support of such theories. After all, although we have noted that employment has continued to rise throughout the period of rising unemployment, this still leaves the question of why it has not actually picked up in line with the bigger increases in the workforce.

Of course, this may simply reflect the cyclical weakness of the economy. If this were the case, however, we might have expected an easing of bottlenecks and recruitment difficulties in the labour market. So far, however, measures of skill shortages have shown no discernible easing.

This message is supported by the equivalent balances of the monthly Report on Jobs published by the Recruitment & Employment Confederation (REC). As Chart 10 shows, it is noticeable that, while unemployment has risen, the level of staff availability reported by employers has remained at historically low levels. This might also suggest that employment growth has been constrained by a mismatch between supply and demand or by regulatory issues.

There has also been some more general evidence that the economy’s supply potential may have been reduced by the surge in energy prices, perhaps as firms have been forced to reduce their productive capacity in particularly energy-intensive areas. The CBI’s measure of firms reporting that capacity pressures are limiting output has risen alongside the rise in oil prices, while investment intentions have fallen.

Whilst we would not dismiss such arguments altogether, we very much doubt that such structural constraints have been the principal factor behind the rise in UK unemployment.

For a start, although there is some evidence that firms have been scaling back their investment plans in response to the rise in energy prices and other factors, it is less clear that employment plans have been affected in the same way. The employment intentions balance of the CBI survey has looked much more positive than the equivalent balance for investment intentions and, at just above its long-run average, is not at levels which might indicate an unusually low demand for labour.

This picture is supported by the figures on productivity, which seem to be more supportive of the idea that companies have been hoarding staff rather than scaling back their employment plans in response to structural constraints. Productivity growth has recently been running at its slowest rate since the late 1980s. This might suggest that firms have been holding on to workers in the hope that the slowdown in the economy seen over the last several years will prove to be temporary.

Meanwhile, a quick look at the behaviour of employment across different sectors also casts doubt on the idea that it is supply side factors such as rising energy prices which have prevented the number of jobs in the economy from growing as quickly as the workforce.

The major slowdown in employment growth has come, not in the energy-intensive manufacturing sector (where employment has actually been falling less quickly), but in other areas such as construction and parts of the services sector like hotels and distribution. This seems most likely to reflect the cyclical slowdowns in the housing market and in high street spending. Employment growth in the public sector has also slowed as the government’s spending splurge has come to an end.

Finally, and perhaps most tellingly, the news on wage pressures in the economy does not seem to be particularly consistent with the idea that the rise in unemployment has reflected structural constraints on employment growth. Average earnings growth has remained extremely subdued, even allowing for the upward influence of bonus payments in the financial sector.

What’s more, average earnings growth has behaved pretty much as would have been expected given the historical relationship between earnings and unemployment. As such, there is again little evidence here that the rise in unemployment has reflected an increase in the natural rate of unemployment rather than cyclical weakness in the demand for labour.

Chart 17 bangs the point home by plotting the rate of average earnings growth against the Bank of England’s regional agents’ own score of recruitment difficulties (which varies between +5 and -5). Not only does it seem to confirm that the labour market has loosened considerably since unemployment started to rise at the end of 2004, but it also suggests that wage pressures will continue to soften in response.

Most people of a certain age are scarred by the experience of previous periods of rising unemployment, which have invariably been a signal of major and prolonged problems in the UK economy.

But there are good reasons to believe that things are rather different this time. For once, the rise in unemployment has been driven, not by large-scale redundancies, but by sharp rises in the workforce as workers have flooded into the economy from the new EU countries and older workers have remained in the workforce for longer.

It is possible that structural factors have also played a part by preventing employment from rising as quickly as the workforce. The failure of skill shortages to ease as unemployment has risen might be an indication that the natural rate of unemployment has picked up a bit. Meanwhile, there is a danger that the rise in unemployment, whatever its cause, has a detrimental effect on consumer sentiment and spending by undermining job security.

The continued softness of average earnings growth suggests that the rise in unemployment has still acted as an important pressure valve in easing capacity constraints in the economy and keeping wage and inflation pressures subdued. There is every prospect that this process will continue for some time as the further gradual expansion of the EU maintains the flow of overseas workers into the UK and worries about pensions encourage more older workers to remain in the workforce. This, in turn, should help both inflation and interest rates to remain at pretty low levels with the result that, for once, a rise in unemployment could actually help to prolong the period of expansion in the UK economy. It is hard to imagine a set of circumstances in which rising unemployment could ever be described as a good thing. But this is probably as close as it gets.

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