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COMMENTARY COVERSHEET
Economics commentary number 1/3
Candidate name & number: Matt McGee, nr 0666-666
School code: 0666-666
Title of extract: “The Bank of England should get ready for more downside surprises”
Source of extract: Independent, accessed 31 October 2014
(http://www.independent.co.uk/news/business/comment/david-blanchflower/davidblanchflower-the-bank-of-england-should-get-ready-for-more-downside-surprises9819889.html?origin=internalSearch)
Date of extract: 27.Oct.’14
Word count: xx words
Hand-in date: 12.Nov.’14
Syllabus sections relating to commentary: Sections 2.2, 2.3 & 2.4
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Extract (entire article)
David Blanchflower: The Bank of England should get ready for more downside surprises
The Monetary Policy Committee’s raptor in chief, external member Martin Weale (MW), in his most recent
speech drew the astonishing conclusion that the “margin of spare capacity is now small and it is currently
being used up rapidly”, despite the fact that the underemployment rate – which adds together
unemployment and the number of extra hours workers want – being around 7.5 per cent and there is no
credible evidence of any wage pressure.(*A*)
Apparently MW based his belief on the following evidence: “Most of the businesses I talk to discuss
settlements in the range of 2 to 3 per cent.” MW concludes that the tightening of the labour market means
“instead of waiting to see wage growth pick up, I think it is appropriate to anticipate that wage growth.”
So let’s look at the evidence.
The national statistic Average Weekly Earnings (AWE) has shown absolutely no evidence at all of any
wage growth for a couple of years. Indeed, the level in August 2014 is up only one pound since December
2013 – from £478 to £479 – and up seven pounds from the £472 in August 2012. In the latest data release
the AWE grew by 0.8 per cent. (*B*)
The first chart reports data for seven of the 24 sectors for which data is available – I include only those
sectors with growth of over 2 per cent or negative growth. Six industries had wage growth of over 3 per
cent, but another six had negative wage growth. A mean of 0.8 per cent includes some sectors with high
positive wage growth as well as others with negative. Of the 24 sectors, 12 had higher growth rates than the
mean and 12 had lower rates. A mean of 1 per cent is entirely consistent with some individuals having wage
growth of 10 per cent as well as some workers having falls of 10 per cent; the danger is to assume they tell
you much of anything about the mean.
The evidence of low nominal wage growth is even more stark in the Labour Force Survey data which is a
random sample of employees, in contrast to the AWE which excludes all workers in firms of fewer than 20
employees. Both the AWE and the LFS exclude the self-employed, whose real earnings in the last year have
fallen by around 20 per cent. (*C)
In the LFS mean earnings fell by 0.6 per cent, and there were nominal falls in wages in nine of the 15
identified sectors. But even in the LFS five sectors had wages growing above 3 per cent, with wage growth
especially marked in Information and Communication. In contrast wages in Professional, Scientific and
Technical Activities fell by 10 per cent.
But this has to be set against the flies in the ointment, the agony. On the net the agony is in the ascendant.
AH suggests the evidence for his agony is threefold. First, annual real wage growth has been negative for
all bar three of the past 74 months and is currently running at minus 1 per cent. (*D*) Second, productivity
remains 15 per cent below pre-crisis trend level and was broadly unchanged in Q2 2014. Third real interest
rates are around zero and have been there for close to four years.
Importantly, Haldane asks whether these downside surprises are likely to continue. In contrast to MW his
answer is yes, not least because the rising demand for labour has been more than offset by a rise in the
supply, pushing down on wage growth. This includes displaced skilled workers forced to take jobs for
which they were over-qualified, rising participation rates driven in part by the abolition of the default
retirement age, concerns about the adequacy of pension and saving income and changes to the benefits
regime alongside increases in immigration. (*E*) Haldane’s stark conclusion is “I am gloomier”. He goes
on to explain why: “This reflects the mark-down in global growth, heightened geopolitical and financial
risks and the weak pipeline of inflationary pressures from wages internally and commodity prices
externally. Taken together, this implies interest rates could remain lower for longer, certainly than I had
expected three months ago, without endangering the inflation target”.
Thankfully the MPC’s latest Inflation Report in November is likely to reflect the views of its chief
economist, who runs the forecast team.
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Commentary
This article is written by a leading labour economist, David Blanchflower. The core issue he brings up
is that the optimism of the Bank of England’s Monetary Policy Committee (MPC) is unwarranted.
Blanchflower claims that the possible ‘downsides’ (e.g. economic forces that are contractionary and
lead to a decrease in aggregate demand, AD) are greater than the ‘upsides’ (economic forces that
would stimulate AD). Also, he points out that real wages (nominal wages adjusted for inflation) have
in fact fallen over the past year in spite of nominal growth in wages.
Starting with the issue of ‘spare capacity’, Blanchflower takes issue with the MPC’s view that the UK
economy is in ‘upside’, e.g. increasing AD is leading to a lack of spare capacity (see *A*). In using
this particular term, he is clearly using a Keynesian approach, as the long run aggregate supply
(LRAS) curve in this model indicates that output beyond a certain level of real GDP (gross domestic
product adjusted for inflation) simply is not possible due to constraints on factor availability.
Taking this Keynesian view, we can see the point being made by the MPC. With the UK slowly
coming out of the lengthy recession (falling real GDP for two or more consecutive quarters) starting
in 2008 and demand recovering moving the economy towards GDP at the full employment rate of
unemployment (where GDP is at a level where labour and other factors are fully employed).
Fig. 1: Keynesian model
Price level
(index)
AS
P1
P0
AD1
AD0
Y0 YFE
GDPreal/t
Fig. 1 above shows the issue put forward by MPC, where aggregate demand (sum of expenditure
demand in the economy) is rising (AD0 to AD1), leading the UK economy towards the full
employment level of output (YFE). In this scenario, inflation is rising due to increasing factor scarcity,
and unemployment is falling due to the derived demand for labour. We will see lower unemployment
but also decreasing excess capacity in industries – fully in line with the Keynesian view that aggregate
supply (AS – total ) becomes increasingly inelastic as the economy moves towards the long run
maximum capacity shown by the full employment level of income.
Blanchflower then critically comments (*A*) on the fact that the unemployment rate (percentage of
total labour force holding a job), at 7.5%, is very high, implying that the economy is indeed nowhere
near the full employment rate.
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Fig. 2: Keynesian view of an economy exiting recession
PL (real wage
rate)
ASL TLF
ADL1
ADL0
W*
U0
Increasing ADL does not in fact
cause wage inflation due to the
assumption of downward stickiness
of wages.
FU
U1 FE
U* QL/t
The cyclical addition to
unemployment when ADL
decreases during the 2008
recession. The average wage rate is
unchanged at W* due to downward
stickiness of wages.
This is where Blanchflower seems to neglect parts of Keynesian theory, namely the issue of
downward stickiness of wages! Wages, according to this school of thought, tend not to fall in
recession since both wage-earners and firms are strongly disinclined to lower wages – this is the
‘downward stickiness’ of wages in Keynesian thought. As seen in fig 2 above, a decrease in AD (from
AD1 to AD0 in fig.1) leads to a subsequent decrease in the aggregate demand for labour (ADL1 to
ADL0) will not cause market clearing (where the price of labour falls to create a new equilibrium) and
render an increase in so-called demand deficient unemployment of U0 to FE. (We note that the
demand for labour is largely derived from the demand for goods and services, e.g. GDP.)
During what the MPC is referring to an ‘upbeat’ economy, the ADL0 is the effect of the recession.
Now (see fig 1 – AD0) due to the increase in AD, the ADL will increase towards FE (ADL0 to ADL1)
but; contrary to what Blanchflower seems to find so remarkable (see *B*), the lack of real wage
inflation (e.g. while nominal wages might have risen, inflation has also increased) is totally
unsurprising. The Wr remains the same at W* - and can be fully explained by the Keynesian concept
of downward sticky wages.
Having said the above, clearly Blanchflower is referring to nominal rather than real wages (see *B*)
and states low nominal wage increase (see *C*)….
TIME’S UP!