The rise in unemployment following the Great Recession would have been larger had wage-setting in the UK been less flexible. That is the central finding of research by Stephen Millard, to be presented at the Royal Economic Society''s annual conference in Brighton in March 2016.
His study notes that the global financial crisis left most economies in recession and hurt trade around the world. Curiously, although the UK saw its GDP fall by 6% peak to trough, its unemployment rate only rose by 3.3 percentage points (from 5.2% to 8.5%). This has often been explained by the willingness of UK workers to see their real wages fall.
Millard''s research examines what would have happened to real wages and unemployment had the UK labour market been less flexible. He finds that the rise in unemployment would have been greater, and the fall in real wages less pronounced, had the UK labour market not been as flexible.
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The Great Recession in the UK was driven by shocks to the financial system and to world trade.
The Great Recession led to a large (6%) fall in UK output and a rise (of 3.3 percentage points) in UK unemployment.
This study suggests that the rise in unemployment would have been larger had wage-setting in the UK been less flexible.
During 2008 and 2009, the world economy was subjected to two large economic shocks that left most economies in recession: the reduction in the ability of the financial system to intermediate between lenders and borrowers, resulting from the sub-prime crisis, and a large fall in world trade, only partly a direct result of the fall in world output.
Although the UK also experienced the Great Recession, with output falling by 6% (peak to trough), the UK unemployment rate only rose by 3.3 percentage points (from 5.2% to 8.5%). This muted response is often attributed to the flexibility of the UK labour market and, in particular, the willingness of UK workers to see their real wages fall.
This study uses an estimated DSGE model of the UK economy to show that shocks to financial intermediation and to world trade drove output and unemployment during the Great Recession and that the effect of these shocks on unemployment would have been worse had the UK labour market responded less flexibly.
More specifically, the research estimates a macroeconomic model – that of Jakab and Konya (2009) – using UK data. It then uses the estimated model to assess the main drivers of the Great Recession in the UK. Given these drivers, the researcher constructs some counterfactual experiments in which he alters some of the features of the UK labour market and asks what would have happened to nominal and real wage growth, employment and unemployment, output and inflation in response to these shocks if the UK labour market had shown less flexibility in different dimensions.
Professor Millard considers in particular shocks to financial intermediation, associated with the impaired ability of the financial sector to allocate savings effectively, world demand, associated with the collapse in world trade in late 2008 and early 2009, and the exchange rate risk premium, associated with the large depreciation of sterling seen in 2007 and 2008.
He finds that these three shocks were particularly important during the financial crisis and that, of these three shocks, it was the financial and world demand shocks that drove the fall in output and rise in unemployment.
Given these shocks, he conducts a simple counterfactual experiment in which he makes wages more ''sticky'' in order to see what would have happened to real wages and unemployment had the UK labour market been less flexible. He finds that the rise in unemployment would have been greater, and the fall in real wages less pronounced, had the UK labour market not been as flexible, though the difference in the unemployment response would not have been that large.
The aim of his future work will be to improve the ability of the model to explain the UK data more generally and to enlarge it by adding a labour market participation choice and a choice over hours worked once employed. That way, the model will become an even more useful tool for thinking about the UK labour market, allowing policy-makers to understand better the drivers of wage, unemployment, hours and participation, in turn, improving their ability to set macroeconomic policy.
The Great Recession and the UK labour market – Professor Stephen Millard
This summary, and the associated paper, represent my views and should not be taken to represent those of the Bank of England or any of its policy committees.
