What does the future hold for productivity and pay?

The Office for National Statistics recently published figures showing average weekly earnings for full time employees falling in eight of the last 14 years, resulting in them being three per cent lower in 2022 than in 2008. This ‘real terms’ figure, i.e. after adjusting for inflation, highlights the loss of spending power for many UK individuals and households since the Great Recession. In contrast, prior to 2008, real earnings had been growing by over two per cent a year.

Weekly earnings for full time employees fell in eight of the last 14 years

This decline emphasises two things. First, the difficult economic times since 2008, think financial crisis and COVID. Second, the virtual disappearance of productivity gains.

Growth in productivity and wages are intrinsically linked as rises in output per worker essentially allow for similar sized rises in pay. Hence, the drop in productivity growth from around two per cent a year to under a half of a per cent explains a lot.

The fall in earnings seen since 2008 hides considerable variation across the economy, for example, between public and private sector workers.

The Institute for Fiscal Studies (IFS) has looked at how the public vs private sector pay differential has changed since 2007. It illustrates a nuanced picture. The ‘raw’ differential remains positive, in the public sectors favour, at seven per cent, but lower than the 13 per cent differential seen in 2007. However, once adjustments are made for relevant factors like education, age, etc then the gap has fallen from three per cent in 2007 to marginally negative in 2021, the lowest relative position seen in 30 years.

But that is not the end of the story. If pension contributions are added into the calculation - which are effectively deferred wages - then the 'experience adjusted’ differential returns to a fairly healthy six per cent in favour of public sectors workers. So, yes, there has been a relative loss of earnings for public sector workers but they still do better, on a like-for-like basis, than those in the private sector.

There is a further twist, which is that while every other UK region has experienced this relative decline in public sector pay advantage, Scotland has not. Instead the reverse has happened, with the ‘experience adjusted’ differential rising, over the period 2005-07 to 2019-21, from under six per cent to over eight per cent. By way of comparison, the differential for the North West of England fell from over ten per cent to almost five per cent while in the East of England it fell from around 12 per cent to minus two per cent.

The IFS hazard a guess that this might be down to the generosity of the Barnett formula, stating “The fact that relative public sector pay has risen in this period in Scotland could be a result of more generous public sector pay settlements allowed by additional per-person funding the Scottish Government receives via the Barnett formula: the rise in Scotland has been driven by especially strong public sector pay growth.”

Another explanation would be higher productivity but this is difficult to measure for many public services and there is no obvious reason why Scotland should have so dramatically outperformed all other regions over this period.

It remains a moot point whether or not the Scottish Government will be able to remain so, relatively, generous, although the recent - seven per cent average - NHS pay offer suggests they may try to do so, by design or by default.

But the bottom line remains that, with a fixed budget, higher wages leaves less for non wage demand pressures on publics services to be met. So there is always a trade-off.

Of course, households actual wealth and spending power depends on more than just earnings. Taxes paid, benefits received, changes in hours worked, etc will also have an impact, but earnings are the most direct element available for households to affect their own well-being.

Ideally, we would want to see the re-emergence of productivity growth in order for wages to also start growing steadily again. The best route to such an outcome is not the disastrous, ideologically driven, policies of the Truss led UK Government but more patient - public and private sector - investment in capital, infrastructure and skills. And luck.

Productivity tends to emerge and subside in mysterious ways so let’s hope that all the AI and internet advances made over the last 20 years start to show up more clearly in the economy in coming years.

If rising productivity does materialise then there are grounds for thinking that workers will receive more of the benefits than owners or shareholders than of late. A tighter labour market, along with an ageing population, puts workers in a relatively stronger position compared to recent decades.

But that is in the longer term. More immediately we can expect elevated levels of inflation, rising interest rates and higher taxes, all of which will impact negatively on households standard of living.

Furthermore, the longer term has many imponderables attached. Will slowing globalisation affect productivity? Or an ageing population? Or rising taxes? Will COVID return? How will quantitative tightening pan out? Will a new bout of austerity and rising unemployment cool pay demands.

While high inflation should be a temporary issue, as it is clear what caused it and what should bring it back down, the picture remains very cloudy as to what the future holds for productivity and, by extension, for real wages.