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The darker side of flexible labour

June 29th, 2013 · No Comments

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Globe and Mail Report on Business June 28, 2013
The darker side of flexible labour


NEW YORK — 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 labour markets. In theory, flexible labour 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

In practice, though, some economists who once championed flexible labour
markets without reservation, like Daron Acemoglu of the Massachusetts
Institute of Technology, have begun to have second thoughts. Mr. Acemoglu
doesn’t doubt the positive economic effects of flexible labour markets, but
he has begun to be concerned about their political and distributional
consequences. They might help the economy grow over all, 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 Centre for Economic Performance at the London School of Economics,
makes such fascinating reading. Mr. Van Reenen and Mr. 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

“The big story in the U.K. is that the economy has shrunk by 2.5 per cent
since the pre-crisis period,” Mr. 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, Mr. 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-per-cent lower in productivity today than we would expect,” Mr.
Van Reenen said. “That is the puzzle. Why has this happened? Have we gotten
more stupid?” Mr. Van Reenen and Mr. Pessoa propose a single answer to
these two mysteries – flexible labour markets. In contrast with previous
economic downturns, the British economy today has a much less sheltered
work force. 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 labour
market has been in wages, which have shrunk even more than the economy as a

“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,” Mr. Van Reenen said. “The labour 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 Mr. Van Reenen’s labour 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 labour 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, Mr. Van Reenen argues, “instead of investing in machines, firms are
keeping on workers.” That means each hour of human work is less productive.

Mr. Van Reenen and Mr. 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

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
labour 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 labour markets that Mr. 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,” Mr. 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.”

*Chrystia Freeland is editor, Thomson Reuters Digital.*

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