Mysteries of the middle class

By Chrystia Freeland
June 28, 2013

If you are worried about the Western middle class – and we all should be – you may have started to have some doubts about the virtues of flexible labor markets. In theory, flexible labor markets should make our economies more productive, and all of us richer, by making it easier for people to do the work the economy needs and to stop doing the work it doesn’t.

In practice, though, some economists who once championed flexible labor markets without reservation, like Daron Acemoglu of the Massachusetts Institute of Technology, have begun to have second thoughts. Acemoglu doesn’t doubt the positive economic effects of flexible labor markets, but he has begun to be concerned about their political and distributional consequences. They might help the economy grow overall, but they may also be contributing to the hollowing out of the middle class by weakening its political bargaining power.

That’s why a recent paper by Joao Paulo Pessoa and John Van Reenen, both of the Center for Economic Performance at the London School of Economics, makes such fascinating reading. Van Reenen and Pessoa set out to unravel the two big mysteries about Britain’s economic performance over the past five years. The backdrop to both is the devastation that Britain, with its oversize banking sector, suffered in the wake of the 2008 financial crisis.

“The big story in the UK is that the economy has shrunk by 2.5 percent since the pre-crisis period,” Van Reenen told me. “That’s the longest depressed economy in this country for more than a hundred years.”

Britain’s dismal economic performance certainly helps to explain the grimness of British politics at the moment, and the growing appeal of the nationalist fringe. But the story becomes more mysterious when you start investigating what is happening inside the country’s shrunken economy.

Given the prolonged recession, economists would normally predict that unemployment would soar. It has risen, but, Van Reenen said, “not nearly as much as you would expect, and not as much as in, for example, the United States,” where the economic contraction has not been as prolonged. So, when it comes to jobs, Britain has surprised on the upside.

The second riddle is a less cheerful one: While employment has held up relatively well, given the country’s poor economic performance, productivity has plunged, an unanticipated departure from the pre-crisis trend line.

“We are 12 percent lower in productivity today than we would expect,” Van Reenen said. “That is the puzzle. Why has this happened? Have we gotten more stupid?”

Van Reenen and Pessoa propose a single answer to these two mysteries: flexible labor markets. In contrast with previous economic downturns, the British economy today has a much less sheltered workforce. The result is what classical economic theory would have predicted: The job market has adjusted more successfully to the shrinking economy than it did during previous downturns.

But that good news comes at a price: The flexibility in the British labor market has been in wages, which have shrunk even more than the economy as a whole.

“In this recession, unions are much weaker than they were in the 1980s, and we’ve had welfare to work reform, so there’s a lot more pressure on people to find jobs,” Van Reenen said. “The labor market is much more flexible, which means wages fall. That is bad news for the people whose wages fall, of course, but the positive side is that employment has stayed up. Some pay is better than no pay, at least in a recession.”

It is easy to understand how Van Reenen’s labor market theory explains the combination of falling real wages and relatively strong employment at a time of economic slump. What’s less obvious is how weak productivity fits into the story.

He believes that, too, can be explained by flexible labor markets. Workers have become cheaper in Britain and, despite low central bank interest rates, capital is still expensive for many firms, or hard to come by. As a result, Van Reenen argues, “instead of investing in machines, firms are keeping on workers.” That means each hour of human work is less productive.

Van Reenen and Pessoa’s paper is thought-provoking because it connects the two British economic phenomena that are inspiring a great deal of hand-wringing – falling productivity and falling real wages – with the one bright spot in the British economy: the relatively low increase in unemployment.

As in Germany, where job cuts were avoided thanks to more formal deals to decrease the hours and pay of a wider group of workers, Britain’s flexible labor markets allowed a lot of people to weather the recession by pricing themselves into a shrunken economy.

There remains, however, a significant caveat. The relatively benign workings of flexible labor markets that Van Reenen describes are in response to the cyclical shock of a recession. British workers in the middle and across the Western industrialized world more generally are also being pressed by broader structural economic forces.

“I think the squeezed middle class is likely to continue,” Van Reenen said. “The combination of technological change and outsourcing is going to continue to put pressure on median wages.”

“What to do about it is the question,” he said. “I don’t think the answer is smashing the machines or closing the borders. As we come out of the recession, this is going to be the key question of the next 20 years.”

13 comments

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Still avoiding the D-word. Economists have defined depression for decades as two or more years of recession. So, the UK has been in a depression for six years.

Posted by ptiffany | Report as abusive

Van Reenen said: “What to do about it is the question,” he said. “I don’t think the answer is smashing the machines or closing the borders. As we come out of the recession, this is going to be the key question of the next 20 years.”

Well, no modern nation can indulge in “smashing the machines” and sustain itself given globalization. But modern nations can and should look at closing their borders. Since when has there emerged a national obligation to allow the dregs of unsuccessful societies to sneak in and squat in those societies that DO achieve some measure of improvement in their standard of living?

Posted by OneOfTheSheep | Report as abusive

the only way to make an economy work, when the customer base is earning less……is for prices to fall.

central banks are busy enforcing the opposite………trying to keep prices high.

this is not for the benefit of the economy……..it’s for the benefit of people who have loans……..use leverage…….

Posted by Robertla | Report as abusive

When every item on every store shelf in Europe says “Made in Asia” how can Europe expect to keep its citizens employed?

A protective tariff is the only way for the west to put its hundreds of millions of citizens to useful work.

Same for the USA.

The dogma — the catechism not to be questioned by the faithful — is that protective tariffs are evil. What nonsense.

Alexander Hamilton designed the American system of protective tariffs that were in effect all the way from George Washington’s term until President Bill Clinton signed NAFTA.

Those 200 years, under the protective tariff of Alexander Hamilton and George Washington, saw America rise to become the mightiest economic power in all history.

There is no other way for Europe to keep its people employed than a 20% protective tariff on all manufactured goods.

Anything else will lead to social disaster for the middle class. The goods on the shelves in European stores must say Made in Europe.

There is no other way.

Posted by AdamSmith | Report as abusive

Huh, economists are finally starting to see that globalization is not good for the ordinary worker. Any blue collar worker ten years ago could have told them that while they were watching factory doors close just as walmart so happened to be flooding the country with cheap Asian imports. It always boggles my mind how smart people can use data to blind them to simple and obvious truths! I hope it doesn’t take another decade for our idiot political classes to drop the debate over cyclical measures of economic relief and discuss structural reforms to the labor market.

Posted by wildcat27 | Report as abusive

Good news to read.

Posted by sandrasl | Report as abusive

If British de-unionization means a fall in productivity, why hasn’t the United States suffered a similar fall in productivity besides having even lower unionization rates?

Posted by ThomasPCole | Report as abusive

Another way to put it is that one part of the flexible labor market issue that has been completely ignored is the question of externalities. Company A may be able to increase its profits by moving production to China, but, in doing so, Company A imposes costs of others in the form of lost wages and lost spending by wage earners. It may be that, if transaction costs were zero, a way could have been found to pay Company A not to move production to China; however, transaction costs are not zero, so that didn’t happen. One transaction cost that might be addressed — and this is another way of looking at the point of the article — is the cost of overcoming the dogma that moving production to a low labor cost area is always wealth maximizing. That appears not to be the case. Thus, we know that effects of labor market flexibility may be negative, but we found ourselves in the position of the economist who lies in bed awake at night wondering if what works in practice can be made to work in theory.

Posted by Bob9999 | Report as abusive

chrystia freeland you are a five start journalist,and your work is perhaps the best that i have read,on todays agenda,i thank you and the best wishes to you… ps.i only read top 30 papers in the world.

Posted by michaelwind | Report as abusive

We should be worried about the detrimental effects of Big Government’s influence on the decay of society.

The middle class is fine. The problem is that Big Government’s destruction of the education system prevents people from acquiring the skills to join the middle class.
The problem is that Big Government destroys the dignity and pride of employment by creating inescapable dependency in government programs. The problem is that Big Government prevents people who live irresponsibly from suffering the consequences of their actions by making endless excuses and redistributing precious tax dollars to them.

The Welfare States and its disastrous effeects are preventing people from entering the middle class and nothing else.

Posted by thesafesrufer | Report as abusive

“Closing the borders” as such certainly is not the answer – but perhaps joining all of the first-world economies (i.e. the NATO region + the wealthy Asian nations such as Japan and S. Korea) into a single free trade zone, and controlling imports into that zone *is* part of the answer. This may allow us to reverse some of the more pernicious effects of no-holds-barred globalization without throwing the baby out with the bathwater. It would engender an internationalized labor market that is more “fair” (i.e. where skill, efficiency and quality of work, rather than a low cost of living, are one’s primary competitive assets), and mitigate the overuse of fuel in frivolously shipping items across the globe that could just as easily be procured or manufactured next-door to where they are sold.

Smashing the machines is similarly simplistic and misguided – mechanization/automation has the potential to enrich all of our lives by allowing more leisure time, if we simply organized the distribution of its benefits more intelligently. Let’s consider mandating more vacation time and shorter workdays across all affected industries.

Posted by Belisarius1 | Report as abusive

“Closing the borders” certainly is not the answer. However, joining the first-world economies (i.e. the NATO region + the wealthy Asian nations, such as Japan and S. Korea) into a single free-trade zone, and controlling imports into that zone, would certainly help. This would reverse some of the most pernicious effects of globalization, without throwing out the baby with the bathwater. It would engender an international labour market that is significantly more “fair” (as productivity, efficiency and quality, rather than a low cost of living, would rightly become the primary competitive assets). It would also reduce over-utilization of fossil fuels in frivolously shipping manufactured goods across the globe when they could just as easily have been produced near where they will be sold, while still allowing for a trade in raw materials that are abundant in some regions and scarce in others.

“Smashing the machines” is equally simplistic and misguided. Mechanization/automation has the potential to significantly enrich all of our lives (e.g. by offering more leisure time), if we could only find the political will to distribute its fruits more intelligently. Mandating more vacation time and shorter hours in all affected industries would be a move in the right direction – of course, this kind of thing would have to be done jointly by all advanced countries so as to avoid a flight of investment and jobs from any one economy.

Posted by Belisarius1 | Report as abusive

A single answer, labor market, only applies if all the other factors are eliminated. As I look around the largest factor is the growing service sector, including government and education, from which no productivity is evident. I have a large number of neighbours who are school teachers and get to see them leaving late, get home early, take summers off, endless teacher development days, the stress of rigorous courses such as Canoe Camping and their retirement in their early fifties. With all due respect to Messrs Pessoa and Van Reenen but the fact that global labor markets are allowing us to import cheap socks from China doesn’t seem to have the slightest impact on these individuals productivity.

Posted by dbrown101 | Report as abusive