Keynesians, supply-siders, and the labour market

Reacting to Wednesday's labour market figures, Allister Heath wrote an article with the self-explanatory title: "Free-marketeers were right on jobs – and the left got it wrong".  The following excerpts give you the idea:

This is how the conversation kept going, until about six months ago.

Pundit: Aren’t you worried that unemployment will rocket if we cut public spending?

Post Date
23 January, 2014
Reading Time
6 min read

Reacting to Wednesday’s labour market figures, Allister Heath wrote an article with the self-explanatory title: “Free-marketeers were right on jobs – and the left got it wrong”.  The following excerpts give you the idea:

This is how the conversation kept going, until about six months ago.

Pundit: Aren’t you worried that unemployment will rocket if we cut public spending?

Free market economist: Not if the economy recovers, and in any case employment has been the one bright spot of this economy.

It turned out that the free market economists got it spectacularly right on jobs, and the left got it completely wrong.  Employment has been the great success story of the UK economy, with jobs going up even before GDP growth finally took off..regardless of whether we are in a bubble, or whether the government is right and the recovery will soon solidify and wean itself from monetary stimulus, we can all agree that the jobs market is performing extremely well, something that those who opposed the cuts failed to foresee…The bottom line is this: the free market economists called it right on jobs – unlike their more left-wing and Keynesian colleagues.

It’s always a bit suspicious when journalists attribute views to people they disagree with without naming or quoting them. So I thought I’d look back and see what “free market economists” and their “Keynesian colleagues” said about jobs.  In fact, going back six months doesn’t help much, because by then it was already obvious that the labour market was performing extremely well, given the long period of economic stagnation that preceded the current recovery, so I went back 18 months. So, from May 2012, here’s a “free market economist”, explaining why the flexibility of the UK labour market has kept unemployment down:

Overall, today’s employment statistics are good news. They confirm the resilience of the UK labour market in the face of a very weak economy… So what’s going on? At a headline level, the most important factor is that British workers have proved to be far more flexible than in previous recessions. Wage growth has fallen sharply; earnings, excluding bonuses, have only increased 1.6% in the last year, well behind inflation. Meanwhile, there are far more people working part-time, with the number of involuntary part-timers at a record level. And the net increase in the number of people in employment is primarily the result of fewer people leaving or losing jobs, rather than more people being hired; this suggests that workers are prepared to accept lower pay or fewer hours as an alternative to being laid off. Self-employment is at record levels as well, and – although we don’t know – it may be the case that many of them are “involuntary” as well, that is people who have lost jobs and are trying to make ends meet on a freelance basis. This may sound like an unattractive picture; lower pay and more insecurity. But it is vastly preferable to the alternative, of higher wages for some but mass unemployment, with people dropping out of the labour force entirely and in many cases never returning, as in previous recessions. Shared pain will do less long-run social and economic damage.

Meanwhile, here, again from May 2012, here’s a “Keynesian”, explaining why downward wage rigidities combined with weak demand (the standard Keynesian story for the persistence of “involuntary unemployment”) mean unemployment will remain high:

There is a straightforward reason why unemployment remains so high in Britain. Unit labour costs are rising – hiring someone to produce a set amount of output is becoming more expensive. And higher prices mean reduced demand – in the jobs market as in everything else.  This may come as a bit of a surprise: high inflation combined with weak pay rises are cutting real wages. While terrible for employees, who are becoming poorer, this ought in theory to be helping workers price themselves back into the jobs market. But weak inflation-adjusted wages are not enough. Wages and other labour costs must also weaken relative to productivity to boost jobs – in other words, relative to output per worker. And productivity has been disastrously bad: GDP is falling, yet employment is stagnating, implying that productivity is falling even faster than real wages. The result is a workforce that is becoming less, rather than more, attractive to employers.

Reading both articles in full, it certainly seems like the first economist was broadly correct (“spectacularly right” would be overdoing it), while the second was far too pessimistic. So who were they? Well, as you’ve probably guessed by now, the “Keynesian” was none other than Allister Heath, while the “free market economist” was, er, me.

OK, that was the fun bit.  I don’t think Allister (a good economist, and one who I agree with on a number of issues) was deliberately rewriting history. Rather, he is the victim of his own ideological blindness, in two respects. First, he doesn’t seem to understand that it’s perfectly possible to have a “Keynesian” view of the macroeconomy (although what precisely that means, apart from understanding some basic principles of macroeconomics, is unclear, as I explained here), and at the same time to believe that the supply side matters, and in particular to favour a relatively flexible labour market.  But in fact that is precisely the position of a number of us who comment on both (John Van Reenen, for example).

Second, he is determined to believe that the UK economy is desperately overtaxed and overregulated, and needs deregulation across the board.  In some areas (housing and planning, immigration) he’s at least partly right and we mostly agree. But on the labour market he’s completely wrong: in fact, the reforms introduced by successive governments over the last three decades have left the UK with one of the most flexible labour markets in the developed world.  What many labour economists, including me (regardless of our views on macroeconomic policy) did get wrong in the early stages of the recession was to underestimate just how much of an impact those reforms have had.  As I wrote here:

When I was Chief Economist at the Department for Work and Pensions in the mid-2000s, with unemployment low and record numbers of people in work, Ministers would sometimes ask me: ‘Do you really believe all this stuff you’ve written on how we’ve transformed the UK labour market?’. My response was: ‘I think so. But until we have a proper recession, no one knows.

But, as that article and others show, when the facts changed, we changed our minds.   In that at least we are Keynesians, and Allister is not.