Mysteries of the middle class
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.”