A look at wages from the Sunday Times

One of the most surprising features of the economy in recent years has been the behaviour of the labour market. It proved remarkably resilient during the recession, but its behaviour since then has been truly astonishing.

Normally, a recovery in the economy brings an increase in demand for labour, pushing up both wages and employment. But economists have learnt not to use the words “normal” and “recovery” in the same sentence. This time, real wages have fallen further despite a huge rise in employment. Last year, inflation- adjusted earnings were 8% below their value in 2007, the largest fall since records began in the middle of the 19th century. It seems a combination of greater flexibility — both in terms of wages and the nature of employment — and strong growth in the supply of labour have been responsible for this unusual outcome.

Immigration has picked up strongly since the end of the recession in late 2009, helping to hold back wages. The coalition’s payroll and benefit cuts and the welfare-to-work programme have had similar effects. However, the most important factor has been the move from early to late retirement. This has greatly increased the number of older people in the workforce, leading to a rise in what economists call labour force participation.

The number of people over 50 in work, or looking for work, has increased by 1.125m since the end of 2009 — over 90% of the increase in the total workforce. Labour force participation for the 50-64 age group has risen to 71.5%, its highest level since the early 1950s. More than 10% of people aged 65 or over are in some sort of job, higher than at any time since 1973.

These trends reflect legislative changes. Government policies in the 1980s encouraged early retirement to free up jobs for youngsters. Now the theme is “active ageing”. Since October 2011, employers have been unable to insist that workers retire when they reach state pension age. And, since 2010, for women this age has risen from 60 to a planned 65 in 2018.

However, I think the economics of retirement have been more important. The annuity rate — the annual income you can get for a £100,000 pension pot, retiring at 65 — was £11,000 in 1963, rising to £16,700 by 1979. The catch was that inflation was high and volatile, spiking up to 24% in 1975, making retirement a very uncertain financial prospect. At that time, about 70% of those aged 50 to 64 were either in work or looking for work.

This prospect began to improve in the early 1980s when RPI inflation-indexed gilts were issued, allowing pension funds to offer indexed-linked annuities. Moreover, inflation fell back sharply and the government made a commitment to hold it down, eventually adopting an inflation target in 1992. However, it took a long time to convince investors, and gilt yields and annuity returns fell back only gradually, encouraging early retirement. Labour participation fell to just over 61% for the 50-64 group in 1993 and to less than 5% for older people.

Of course, many other influences were at work, including house and share prices. Employers were encouraged by the high annuity rates and a favourable tax treatment to set up company pension plans. These were mainly direct benefit schemes, which gave protection from swings in the stock market and, often, inflation.

These conditions lasted well into the 1990s, until gilt yields caught up with the low rate of inflation and Gordon Brown, the chancellor at the time, removed the tax breaks in 1997. The increase in longevity and, more recently, the financial crisis have reduced annuity rates even further. Direct benefit schemes have become very expensive to provide and few workers have them now.

So it is no surprise people are staying in work much longer than they used to. The jobs market is adjusting to this change smoothly, partly because most of these people are skilled and already in work. Changes in the demand for staff may also have helped. High-skilled occupations (managerial, professional and professional groups) account for 71% of the increase in employment since 2009. At the other end of the pay scale, a quarter of the increase in jobs over the same period was accounted for by low-skilled occupations. However, there has been hardly any growth in middle skill level jobs (typically clerical and manufacturing), leading to the so-called hourglass effect. Technical progress seems to be playing a part in this, too, as computers replace people doing clerical and other routine tasks.

Nevertheless, like immigration, late retirement is having important economic and social effects. It holds back responsibility and remuneration for younger workers and holds back pay in professional and managerial jobs. The labour market also has to cope with people coming off welfare and the public sector payroll. The numbers employed in public administration and defence have fallen by 211,000, or almost 14%, over the past five years, putting further pressure on managerial and clerical pay scales. Besides being flexible on pay, people have had to adapt to new ways of working. Many have moved from full-time to part-time work or become self-employed.

The weakness in wages since the financial crisis also reflects the weakness of labour productivity, particularly the decline of high wage sectors such as North Sea oil. This was an important factor during the recession, which hit financial services as well as the supply of finance and working capital. Employers were generally prepared to keep people on in exchange for greater flexibility, so employment fell back much less than output. However, the link between productivity and pay has arguably worked in reverse during the recovery: the huge increase in the number of workers depressed real wages as they priced themselves into jobs. Employers took on more staff to meet increased demand rather than investing in capital and this has held back labour productivity.

The labour market played the starring role in the upturn in the economy since 2012. The easing of the eurozone crisis has helped, but exports certainly did not trigger this upturn. The classic recovery begins as companies decide they need to hire more workers to increase production as they restock the shelves, but we have seen little stock-building this time. Instead, consumer spending increased because the huge growth in employment offset the weakness of wages. At the same time, people became more confident about their jobs and decided they did not need to save as much for a rainy day.

The employment scene is changing as demand in the economy strengthens, spurred by the fall in world energy and commodity prices. Unemployment has fallen to 5.7% and earnings are at last picking up. What happens now depends on whether the demand for labour outpaces the supply. Public sector employment and welfare budgets will be cut back further after the election no matter what the outcome. Unless there is a strong rebound in the eurozone, immigration is also likely to remain high. The increase in the state pension age will keep more women in the workplace. However, I expect participation by older men to stabilise and the labour market to tighten, allowing real wages to recover. The more flexible pension funding arrangements that come into effect in April should have this effect. And, after all, you can put off retirement for only so long, no matter how dire your finances look.

Peter Spencer is professor of economics and finance at the University of York and chief economic adviser to the EY Item Club