Having spent the last five years providing as much slack as possible to keep the banking system on its feet and the economy off its deathbed, there is now a new mood and doctrine. When Mark Carney arrived in the UK in July last year he promised us Forward Guidance on interest rates – he would hold rates at 0.5% until we achieved full employment. So like a seasoned skipper he turned the yacht downwind and let all her sails out. The economy (helped by a friendly gust of overseas investment) has picked up speed, employment rates have shot up and people are wondering when we will need to tighten things up. If we don’t tighten things up and the economic tail-winds pick-up we could get into a real mess.
|He should have tightened up a bit earlier|
But Mr Carney reckons there is still a spare capacity in the labour market and he is now telling us that until this capacity is utilised (about 1% of the economy) we will stay on this bearing – this may mean that we suddenly get over taken by a nasty gust (of inflation) and get dumped in the water but the Governor is not tacking quite yet. As he said we are on a good run “The recovery has gained momentum. Output is growing at the fastest rate since 2007, jobs are being created at the quickest pace since records began, and after four years above target the inflation the rate is back now at 2%”.
Since his first months as Governor there has been exceptionally strong jobs growth – almost half a million more people have found work since August – the unemployment rate has fallen much faster than anticipated to 7.1%, and is likely to reach the 7% anytime (the target rate for reviewing interest rates). But despite all this good news on employment and growth the BoE believe there is significant slack in the labour market, which will allow a lower level of unemployment with stable inflation. Mr Carney is break new ground by now confirming that he doesn’t like this wasted capacity and that we will keep rates lower for longer to eradicate the slack in the economy over the next two to three years.
This recovery has been good for the unemployed (who have found jobs) and for employers who have been able to retain and hire new staff at low rates. We don’t yet know if the recovery will be good for Mr Carney but the signs are okay - but the recovery it has not been so good for Keynesian economists. Much of Keynesian economics is based around the notion of sticky wages (the idea that employers have to sack staff rather than reduce their wages in recession). The idea that the Great Recession has proved that wage stickiness maybe a thing of the past doesn’t sound all that interesting does it? But it is probably the most important economic revelation of the last 30 years. The reason for this is that without proof for wage stickiness the whole General Theory is pretty much worthless and the Keynes’ General Theory is still the mainstream economic theory for the great and the good. Janet Yellen is a New Keynesian Economist and so are many of those in positions of authority over the global economy. So what’s the detail here?
In 2008/9 there was a steep rise in unemployment but it didn’t reflect the very sharp downturn in GDP and since the Great Recession economist have struggled to square the relatively high levels of employment with the very low levels of demand / growth. What is now becoming clear is that employers in the UK have used a number of devices to maintain work forces at lower costs. They have proved that wages don’t have to be sticky. Countless firms have: shortened hours of work, implemented wages freezes of 3-4 years, cut wages, introduced flexible contracts, sent people off on unpaid sabbaticals, cut all bonuses and commission (variable pay). Particularly in private sector white collar work places there is now a great deal of flexibility in wages. This means that employees have been able to reduce their costs to meet new levels of demand and price and this has helped keep employment rates high. The effect of this unsticky wage bombshell is that productivity (which should have been rising sharply) has fallen off quite badly – more people have been doing less work – and have been paid a lot less as well.
Keynes asserted that the reason for “involuntary” unemployment is that a nominal-wage reduction would not reduce “involuntary” unemployment. Furthermore he insisted that involuntary unemployment can only be eliminated by an increase in the price level, but not by a fall in wages wages. The UK economy may well have proved the great man wrong! - I paraphrased Paul Krugman who is pretty hot on all things Keynesian.
The ultimate proof for the un-sticky wage theory will be a rapid rise in productivity as the UK economy takes up the slack. If wages are sticky (as Keynes claimed) then we can expect very little in the way of improved productivity, but if he was wrong then the UK economy could be in for a very strong period of growth accompanied by low inflation. So this is a pretty exciting time in economics and if wage un-stickiness is proved then much of the accompanying General Theory will have to re-examined. If companies can now reduce costs without resorting to sacking employees; and on the other side of the cycle if companies can increase production significantly without direct investment we may well need some new economic models to keep track of all this.
Mr Carney has promised to serve a single five year term at the BoE but he has timed his run well, as he may well have the privilege of proving one of the pillars of modern economics is actually a rather sticky mess.