Ben Broadbent: Compositional shifts in the labour market
Speech by Mr Ben Broadbent, Deputy Governor for Monetary Policy of the Bank of England,
at the "Understanding the Great Recession: from micro to macro" Conference, Bank of
England, London, 23 September 2015.
* * *
Accompanying charts and table can be found at the end of the speech.
I would like to thank Will Abel and Rebecca Burnham for research assistance and I am grateful for helpful
comments from other colleagues. The views expressed are my own and do not necessarily reflect those of the
Bank of England or other members of the Monetary Policy Committee.
I want to begin by thanking the organisers for putting together this excellent conference and
for asking me to come along. I'm honoured to be in such distinguished company. Up front, I
also want to thank Bank economists - especially Matt Corder and Alina Barnett - for their
help. If this were a working paper it would have multiple authors.
Today's tagline - "from micro to macro" - is a sobering one for macroeconomists. We're
used to describing the economy in broad, sweeping terms, using numbers on aggregate
output, total employment, average wages.
Yet, in practice, the modern economy is hugely diverse and, underneath the surface, highly
dynamic. New ideas replace old, businesses fail and are formed and, even when the net
change in employment is small, and the labour market in aggregate looks stable, the gross
flows in the labour market can be huge.
This fact, highlighted many years ago by Steve Davis and John Haltiwanger in the US, was
no less apparent during the great recession in the UK. Employment fell by over half a million
between 2008 and 2010. But even over that period there were over nine million new jobs
created, over ten million if you include job-to-job flows. On average, over the past 10 years,
gross inflows and outflows into and out of employment have run at an annualised rate of
around one sixth of the stock (Chart 1).
As I say, this has been long understood. Nor should it be forgotten that, whatever the
complicated texture underneath, the aggregate economic data still exhibit significant
empirical regularities over the business cycle. Chart 2 is one example. Using annual data
during the inflation targeting period, the black line plots annual growth in average earnings,
less inflation expectations, against the rate of unemployment. At least until the past couple of
years, when AWE growth appeared unusually weak, the fit was pretty good. Higher
unemployment has gone hand-in-hand with lower real wage growth. Uncannily, the
regression line was pretty much exactly the same as that identified by A.W. Phillips, using
data from the classical gold standard period (1870-1913), in the 1958 paper that gave the
relationship its name (that regression line is in blue).
Yet, from time to time, what happens under the surface has material effects and can distort
these aggregate relationships. Today I want to describe one such example, involving
compositional shifts in the labour market. In recent years, these have been significant:
specifically, both the jobs lost in the 2008-09 downturn, and those regained during the
recovery, have been skewed towards the lower-paid end of the spectrum. This has imparted
a bias to average pay and productivity growth - upwards in the recession, downwards in the
past couple of years - over that period.
Chart 3 plots these estimated "compositional effects" on average wage growth against the
change in unemployment. They went up during the recession, boosting average earnings
growth, and fell back sharply in the recovery, when unemployment declined. Last year, on
these estimates, the skew towards low-paid job creation knocked 0.3% off average wages,
relative to those of the median. This compares with a pre-recession average of +0.7% per
year.
One key point I want to make today is that, directionally at least, this isn't at all unusual. It's
true everywhere that employment tends to be more cyclical for the young, the less
experienced and those with fewer qualifications. Chart 4, for example, illustrates a similar
phenomenon in the United States: those without degrees experience much larger swings in
employment than college-educated people. As a result, measures of average earnings
growth in the US are biased upwards in recessions (relative to the experience of people
continuously in employment) and downwards in recoveries. That's why many people pay
more attention to the Employment Cost Index1 of US wages, which adjusts for these
compositional effects, than to the (unadjusted) headline earnings series.
What is a bit different about the recent UK experience, however, is the scale of the effects.
Compared with the cycle of the 1990s, they appear to have been less positive during the
recession - in the more recent downturn job losses weren't as skewed towards the lower
paid - but more negative during the recovery (the skew in net job creation has been bigger).
Overall, taking the 2008-14 period as a whole, the compositional effects added around 3%
less to average wages than in the equivalent six years in the early 1990s. If anything, Chart 3
hints at a break in the series long before the Great Recession, sometime in the late 1990s.
It's not clear why this occurred (I'll later offer some slightly speculative suggestions). But the
recent drag from compositional effects might help to explain a couple of recent puzzles in the
aggregate data.
One is low productivity growth. As we know, output per employee has been particularly weak
in recent years. It fell steeply during the recession and its rate of growth has been pretty
insipid since. Chart 5, plotting three-year growth rates for output and employment, is one way
of expressing that. What this work on compositional effects suggests - somewhat tentatively,
and only if you're prepared to interpret it in this rather crude fashion - is that this may partly
reflect a slower rate of improvement in the average "quality" of the employed workforce.
"Human capital", to use the economists' terminology, has been growing at a slower rate,
particularly compared with the first half of the 1990s.
Note the word "partly". I don't think this can really be seen as the main, or even a major, part
of the productivity puzzle. Even if you're prepared to view these compositional shifts as some
independent phenomenon, unrelated to other things that have depressed productivity growth
- and that is questionable - their scale isn't really big enough to make that much of a dent.
That 3% figure, which is probably a ceiling on the true contribution2, compares with a
productivity shortfall of over 10% since the recession.
The results offer clearer help with a second puzzle, namely the apparent ease with which
real average earnings have adapted to lower productivity growth. The two must match each
other in the end3. But, in the past, it's been hard for the labour market to absorb negative
1
The Employment Cost Index (ECI) measures the change in the cost of labour by excluding the influence of
employment shifts among occupations and industries. More information about the ECI can be found here In
the UK, the ONS has an experimental series - the "Quality-Adjusted Labour Input" - which makes a similar
adjustment: the latest release can be found here.
2
Some of the factors that might have reduced productivity growth might also have affected the skill mix of
employment, so it's not clear whether this can legitimately be seen as independent effect: in the limit, saying
productivity growth is weak "because" the economy has created more low productivity jobs has a slightly
circular flavour to it. Note too that, at least in the short run, a given compositional effect on wages should not
be translated one-for-one into productivity space - you'd expect the latter to be smaller (I explain this point in
footnote 10). So the 3% figure should be viewed as a ceiling for the estimated impact of these shifts on
productivity over the 2008-14 period.
3
Real wages can diverge from productivity either because average profit margins are changing or because the
relative price of what firms produce diverges from the price of what consumers buy. In an open economy, for
example, an improvement in the terms of trade will raise real incomes relative to productivity; the upward trend
in profit margins in the US has depressed wages relative to national income. There has been no such trend in
shocks to real take-home pay - whether from lower productivity, higher taxes or rises in
import prices - without the unfortunate devices of higher inflation and/or higher
unemployment. In other words, such shocks tend to put upward pressure on the NAIRU (at
least initially, they move you rightwards along the Phillips curve in Chart 2, not downwards4).
Yet, for much of the past two years, pay growth was weak even as unemployment declined
sharply. I commented on the striking flexibility of real wages in a speech last summer, from
which Chart 2 is taken.
Suppose, however, that the drop in productivity has had nothing to do with existing jobs but
instead reflects the skew in the creation of new jobs towards relatively less productive, less
well-paid roles. To that extent, there's no real-wage resistance, among existing employees,
to overcome, and the arithmetic impacts on average pay and average productivity are
necessarily immediate and coincident.
This would also help to explain why pay surveys, which track wages of the median employee
(rather than the average), appeared to over-predict wage growth in 2013 and 2014 (Chart 6):
they failed to take account of changes in the mix of employment. You can see from Chart 6
that when the compositional effects were positive, during the recession, the surveys
undermeasured AWE growth.
Finally, these shifts can also shed light on the most recent trends in the aggregate data. The
latest estimates show that the compositional effects have risen during the first half of this
year - the skew towards lower-paid jobs has diminished. This might account for the
acceleration we've seen in average productivity and wages; it could also explain why there's
been a narrowing of the gap between AWE growth and the surveys.
So having summarised the main points let me describe in a little more detail where the data
comes from and how these effects have been estimated. I'll then say something, if only
tentatively, about why they might have differed from the last cycle - why, in particular, the
compositional effects have been more negative during the recovery, and perhaps before that
as well (my hands will be waving slightly at that point). A short final section concludes with
some remarks about policy.
Generating the estimates
To understand the results it helps to know something about where the data come from and
how they're constructed. The first and most important point is that the headline measure of
wages in the UK, the AWE, is what it says it is - an average. Employers are asked simply to
divide their total wage bill by the number of employees. So if - say - a responding firm were
to substitute a less experienced, less well-paid person for someone better paid, its
submission to the AWE would fall even if no individual's wage had changed. It is these
"compositional effects" that we are trying to measure and account for.
We do so using data from a different source - the Labour Force Survey - which is sent out to
households. The main questions in the LFS are about employment status: do you have a job
and, if not, are you looking for one? (If your answer to the second question is "yes" you are
counted as unemployed, if "no", economically "inactive".) As well as these headline numbers,
the ONS's monthly labour market release publishes standard summary statistics about the
duration of unemployment and the reasons for inactivity.
But, at least since 1994, the LFS has also included a host of questions about the
characteristics of employees and their jobs. These are listed in Table 1. Some are easy
enough to answer - your age, where in the country you work and long you've been in your
job. Others, those related to respondents' qualifications, or the sector they work in, offer a
long list of potential answers. There are over eighty sectors from which to choose, hundreds
of detailed occupational descriptions. Table 1
People are also asked about their pay. And, unsurprisingly, there are clear correlations
between wages and characteristics. Pay is higher in some sectors and occupations than
others; it's also higher, at the level of the individual, for people who have better qualifications
and more experience, in terms both of age and job tenure. Overall, if you take the post-1994
sample as a whole, the spread of individuals' characteristics statistically explains around one
half of the variation in their pay.
This distribution can also change over time. Individuals' characteristics can evolve - people
become more experienced, in principle they can also switch occupations or become better
educated. The distribution will also shift if there are differences between the characteristics of
those entering and leaving employment. We've already seen how large those gross flows
can be. So even a relatively modest contrast between the two groups can lead to significant
changes at the aggregate level. The compositional effects, which are simply the fitted values
of a regression of pay on characteristics, attempt to track the effects of these shifts from one
quarter to the next. In aggregate, the estimated effects amount to a "hedonic" adjustment for
labour quality. Chart 7, summarising the results, is a version of a graph we published in the
last two Inflation Reports.
Note that, over time, the effects have tended to be positive. The average age and experience
of the workforce has grown; more people have gone into higher education and higher-paid
occupations.
But on top of that underlying trend, we've seen sharp movements, in both directions, during
the recent cycle. Both the drop in job creation during the Great Recession, and the
corresponding pick-up during the recovery, were skewed towards the less skilled, less well
paid end of the jobs market. Chart 8, which plots the differences in job creation across three
classes of occupational characteristics, depicts one aspect of that pattern5. You can see
similar differences in rates of job creation between young and old, less and more educated.
And as I outlined in the introduction, the effect of these swings was to add materially to the
growth of average earnings during the downturn and to subtract from it in 2013 and 2014.
Unskilled employment generally more cyclical
Before asking why this has happened let me make a few points about the estimates.
First, there are some approximations involved. One involves the mix of surveys: we're
estimating the impact of compositional changes on LFS pay data and assuming the effect
simply carries over to the AWE. That's the most reasonable assumption, but it's an
assumption nonetheless. Also, because of the way we've done this regression - for the sake
of simplicity it's been estimated in one go, using the entire 20-year sample - we're implicitly
assuming that changes in each of the characteristics have constant effects over time6. But
there's a substantial economic literature explicitly devoted to explaining changes in some of
these coefficients, notably the labour-market returns to better qualifications (the "skill
premium"). I'll come back to this point later.
Second, the estimated compositional effects have been driven mainly by changes in the mix
of people, and their individual characteristics, not by shifts in employment across sectors.
Pay clearly differs across industries, even controlling for those characteristics. And on
occasion sectoral shifts can matter for average earnings. In Chart 7 the marginal contribution
of changes in employment across industries is in red. Thanks mainly to disproportionately
large job losses in the financial sector, where pay is higher than average, these were
negative in 2003 and 2009. But in the rest of the sample, they don't do much: the
compositional effects have been predominantly within, not across, sectors. During 2014, for
example, it's the fact that new jobs went to people with below-average qualifications and
experience, and in lower-paid occupations, that depressed average pay growth7.
Third, as I emphasised in the introduction, this cyclical pattern is entirely typical. The fact that
new hires have low job tenure - and that the average experience of the workforce therefore
declines when unemployment falls rapidly - is hardly surprising. That average skill levels
should be counter-cyclical is, perhaps, less obvious. But it is a widely and long observed
empirical fact: it's true in all countries that employment rates are lower and more cyclical
among the young and unskilled.
Why should low skilled employment be more cyclical? Economists have come up with a
number of possible explanations. One likely factor is that skilled jobs tend to be more
specialised. That means they're also more likely to be retained, or "hoarded", in a downturn:
the costlier it is to replace someone the more reluctant will be the employer to let him or her
go.
Another possibility is that low-skilled workers are more easily substituted by new capital and
new technologies. So when firms are relatively thinly capitalised, early on in an economic
expansion, they tend to hire more unskilled people. Later on, as the recovery matures and
investment in new capacity starts to take hold, it's the demand for skilled employment that
starts to grow faster.
These are both things that would tend to boost the relative demand for high-skilled labour
during a downturn. Differences in labour supply might also play a part. For example, some
have argued that those with low wages have less to lose from exiting employment. Their pay
is lower relative to unemployment benefit, especially during downturns. They may also have
fewer options: when vacancies are scarce, skilled people have the capacity to move into
lower-paid jobs while searching for new opportunities (Nickell (1979), Chassamboulli (2011)).
Why have compositional effects been less positive during this cycle?
These factors can help to explain why employment is more variable for the low paid. It's
possible the same factors have been at work in the most recent cycle in the UK. But the last
few years do look distinct, at least compared with the early 1990s cycle - overall, the
compositional effects have been adding less to wage growth. They were less positive during
the downturn, but have been more marked, in a negative direction, during the recovery.
Overall, the "quality" of the workforce looks to have been growing at a somewhat slower rate
since the onset of the 2008 recession - worth around 1⁄2% point a year on average wage
growth - than it did during the equivalent period in the 1990s.
Why might this have occurred? I can think of two possibilities, though there are no doubt
others as well. One is that the financial crisis has depressed the relative demand for
highskilled employees. I mentioned earlier that economists believe high-skilled jobs are probably
complements, rather than substitutes, for capital and new computer technology. This is the
most common explanation for the marked rise in the "skill premium", in the US and
elsewhere, during the 1980s and 1990s: new technologies favoured skilled jobs and their
wages rose faster than those of the unskilled8. So if the incentives to invest in new physical
capital have been depressed since the Great Recession, by things like higher rise premia or
problems in the banking system, perhaps the same applies to investment in human capital.
It's also possible the relative supply of low-skilled labour has risen. We know, for example,
that migration flows have risen significantly over the past fifteen years, and that immigrants
are more likely to take low-skilled jobs than UK-born workers (see, for example, the Report of
the Migration Advisory Committee (2014)). So if easier immigration has made the overall
supply of labour more responsive to economic conditions in this country - if, as if often
argued, it's flattened the Phillips curve (Bean (2006), Bentolila (2008)) - it's probably done so
to a greater extent for low-skilled than high-skilled workers. So when the UK economy grows
faster than its neighbours, as has been the case over the past couple of years, you'd expect
to see greater inward migration and a disproportionate rise in the supply of low-skilled labour
in particular.
I came across a possible example of this on a recent Agency visit. The head of a small
business told me his firm had been looking to hire an accountant. They'd originally wanted
someone very experienced who might in time fill the shoes of the finance director. However,
they soon realised that the only way they could get someone like that was to bid them from
an existing job within the UK - apparently a costly and lengthy process. So they decided
instead to employ two much more junior and less well trained people. One worked for them
already; the other, from outside the UK, they found in relatively short order after advertising
on an EU-wide basis. The firm would end up being less productive than it might have been
(two people are now doing the work of one). But there'd be a compensating fall in its average
wage and, given the relative availability of less experienced employees, it made sense for
them to go down this route.
What I'm suggesting has more to do with relative quantities, not relative wages, and more to
do with the short than the longer run: at a time when the UK has been outgrowing its
neighbours, you'd expect easier immigration to amplify the rise in the relative supply of
lowskilled employment.
Some concluding remarks
Let me sum up and, in doing so, say something about the implications for monetary policy.
As macroeconomists, monetary policymakers like to deal in simple aggregates and
averages. Output is doing this, employment that and wages the other. We know that the
experiences of individual firms and households are extremely diverse but like to think we can
nonetheless lump them all together and treat them as homogenous wholes.
Much of the time that's a reasonable thing to do. But sometimes it matters what's happening
underneath. As we've seen, there was a distinct skew in recent job creation towards the less
well paid in 2013 and 2014, one that has subsided in the first half of this year. While not the
only factor - narrowing slack in the labour market has probably been more important - this
helps to explain why growth of average wages was weak in those two years and has since
picked up a bit.
At least at the margin, these shifts will have had similar effects on productivity. So, in and of
themselves, they have no direct bearing on impact on inflationary pressure9. Indeed,
because the compositional effects are highly counter-cyclical, and tend to go up and down
with unemployment, perhaps it doesn't matter much if you never took them into account and
stuck with Phillips curves estimated on unadjusted wage data.
The problem is that, although they're qualitatively similar in different cycles, the
compositional effects do appear to vary in scale. This means it's worth allowing for them:
changes in the mix of employment may not affect inflationary pressure but they can have an
impact on the aggregates we normally use to assess that pressure. Thus, in general, our
estimated Phillips curves fit better when you use AWE growth adjusted for compositional
effects. In the past two to three years in particular, the extent of the skew towards low skilled
employment helps to explain some of the weakness of average productivity and pay.
That skew might reflect the particular circumstances of today's recovery. Perhaps easier
immigration has made low-skilled labour easier to come by, especially at a time when other
European economies haven't been growing as quickly as the UK. Maybe deterrents to
investment in physical capital, and new technologies, have also reduced the relative demand
for high-skilled labour. If so, then you might expect the compositional effects to improve
further over time: a strengthening of the recovery in the rest of Europe would reduce the
relative supply of low-skilled labour and a fall in risk premia on new investment, in human as
well as physical capital, would raise the demand for high skills.
I guess we shall see.
Thank you!
References
Autor, D., L. Katz and M. Kearney, 2006, "The polarisation of the U.S. labour market",
NBER Working Paper no. 11986.
Bean, C., 2006, "Globalisation and Inflation", Bank of England Quarterly Bulletin, 2006 Q4.
Bentolila, S., D, Juan J. and J. F. Jimeno, 2008, "Does immigration affect the Phillips curve?
Some evidence for Spain" European Economic Review, Elsevier, vol. 52(8),
pages 1398-1423, November.
Bernanke, Ben S. and Powell, L. James, 1986, "The Cyclical Behavior of Industrial Labor
Markets: A Comparison of the Prewar and Postwar in: R.J. Gordon, ed., The
Ears."
American Business Cycle, Chicago: University of Chicago Press
Chassamboulli, A., 2011, "Cyclical Upgrading of Labor and Employment Differences across
Skill Groups", B E Journal of Macroeconomics
Goos, M. and A. Manning, 2007, "Lousy and lovely jobs: the rising polarisation of work in
Britain", The Review of Economics and Statistics
Nickell, S., 1979. "Education and Lifetime Patterns of Unemployment," Journal of Political
Economy, University of Chicago Press, vol. 87(5), pages S117-31, October.
Phillips A. W.,1958, "The Relation Between Unemployment and the Rate of Change of
Money Wage Rates in the United Kingdom, 1861-1957", Economica.
Pissarides, C., 2000, "Equilibrium Unemployment Theory", Massachusetts Institute of
Technology, 2nd edition
Slacalek, J., 2005, "Productivity and the Natural Rate of Unemployment", Department of
Macro Analysis and Forecasting, DIW Berlin
Solon, G, R. Barsky, and J.Parker, 1995, "Measuring the Cyclicality of Real Wages: How
Important is Composition Bias?" Q. J. E. 109 (1994), pp. 3-25.
Staiger, D., J. H. Stock and M. W. Watson, 2001, "Prices, Wages and the U.S. NAIRU in
the 1990s", NBER Working Paper no. 8320.
Chart 1: Large flows into and out of Chart 2: Growth of average wages weak in
employment 2013, 2014 despite low unemployment
Source: Labour Force Survey and own calculations
Source: ONS, Bank of England, NIESR and Hills, Thomas,
Dimsdale (2010)
Note: AEI until 2010 and AWE since; inflation expectations as
implied by indexed gilt market; 2014 diamond is for H1.
Chart 3: Compositional effects currently Chart 4: Low skilled employment more
weak, generally counter-cyclical cyclical in the US
Source: ONS, Labour Force Survey and own calculations Source: U.S. Bureau of Labour Statistics
Chart 5: Productivity growth very weak Chart 6: Pay surveys better match for AWE
in recent years ex compositional effects
Source: ONS, CBI and BCC
Source: ONS
Table 1: Detailed questions in the Labour Force Survey
Characteristics LFS Question
Age How old are you?
Occupation What was your (main) job in the week ending Sunday the [date]?
Tenure In which year did you start working continuously for your current employer? And which month
was that?
Education This next section is about qualifications gained in the UK. Please think about ALL qualifications
you have ever gained [in the UK], even if it was a long time ago or you are not using them now
(please exclude expired qualifications).
Sector/ Industry What did the firm/organisation you worked for mainly make or do (at the place where you
worked)? Enter a title for the industry
Source: Labour Force Survey (user guidance)
Chart 7: Compositional effects driven by Chart 8: Job creation fell further, and has
characteristics of employees, not sectors since recovered faster, for low skilled
Source: Labour Force Survey Source: Labour Force Survey
We can't demonstrate this with the detailed
Chart 9: Over longer sample, shifts in
LFS dataset from 1994, as it includes only one
average qualifications driven compositional
proper cycle. But the positive relationship with
effects
unemployment exists even during the Great
Stability (1994-2008). And, at the cost of a
smaller set of variables - the survey didn't ask
people about their occupation and sectors
before 1994 - we've managed to extend the
estimates back a few years, to the late 1980s.
The aggregate series you've already seen in
Chart 310. The more detailed breakdown is in
Chart 9. You can see clearly the same cyclical
pattern during the last-but-one cycle: steeper
falls in employment for the less well qualified
during the recession, resulting in a positive
compositional effect, the opposite pattern in the
Source: Labour Force Survey
upswing.
One shouldn't exaggerate the labour-market
Chart 10: Rise in employees with degree,
consequences of easier immigration. Whatever
slight fall in degree premium
its impact on the supply of low-skilled labour in
%
%
the short term, it's not been enough over time
40 50
Employees with a degree (lhs)
to have a noticeable impact on relative rates of
35
Degree premium (rhs)
40
pay. Chart 10 plots an estimate of the UK skill
30
premium, specifically the marginal effect on
25
30
wages of having a degree. We've derived this
20
by running the same regression of pay on
20
15
employee characteristics, but on a
10
year-by-year basis rather than across the
10
5
sample as a whole. Perhaps because the
0 0
supply of graduates has steadily risen, the
1995-2007 2008-2012 2013-2015
estimated degree premium has actually fallen
Source: ONS and Bank calculations
slightly over the past twenty years11.
To be sure, you'd tend to under-estimate the
Chart 11: Real pay growth more variable
cyclicality of "underlying" wage growth12 and
when adjusted for compositional effects
the true slope of the Phillips curve. Over the
past few years, as in earlier cycles, real pay
growth for people who stayed in their jobs13
has been more variable than the average
(Chart 11). But if it's a really regular thing - if
the compositional effects always move in lock
step with unemployment - then a Phillips curve
estimated on an unadjusted AWE series would
still take them into account, only implicitly so.
Source: ONS and Bank calculations
12
This point was made by Bernanke (1987) and, in a well-known paper, by Solon et al (1995).
13
To be precise, the red line is pay growth for someone with fixed characteristics - fixed educational
qualifications and occupation, unchanging experience. Since any individual's experience is bound to grow
over time (if only by virtue of getting older) there is no such person in real life! A more accurate description of
the red line is average wage growth for people continuously in employment, adjusted for any the impact of
changes in average age and experience across the workforce.