Higher wages key to solving productivity puzzle

21 March 2018 Consultancy.uk 8 min. read

The global economic recovery has been blighted by sluggish productivity over its nine-year duration. The corporate response to this is often to slash wages in the hope that reducing expenditure can enhance profits – and high wages are often blamed for heightened inflation and slow growth. However, as wages remain stagnant, and inflation continues to hamper consumer spending regardless, a new study has suggested that enabling ‘demand’, or increasing wages, may be the key to stronger growth.

A new report from McKinsey & Company has found that stagnating wages are negatively impacting the growth prospects of the global and UK economies. The study, which took in a year-long analysis of seven developed nations and six sectors, finds that nine years into recovery from the Great Recession, labor-productivity-growth rates remain near historic lows across many advanced economies. As a result, the researchers determined that “demand matters for productivity growth and that increasing demand is key to restarting growth across advanced economies.”

In other words, limiting wages among the majority of workers has clipped the wings of the global financial recovery, as spending power has remained limited for almost a decade. This has been particularly harshly felt in the UK over the past two years, as fluctuations in the value of the Pound resulting from tumultuous Brexit negotiations have further hampered the spending power of most consumers – who had already endured years of austerity and wage stagnation – forcing many to tighten their belts with regards to what is often termed ‘luxury spending’.

Britain’s poor productivity performance over the past decade deepened throughout 2017. While the sustained decline was shown by a recent BDO poll-of-polls to have stabilised after April 2017, the overall output of each working hour declined 0.2%. This woeful performance stood in stark contrast with a forecast for productivity growth from the Office for Budget Responsibility (OBR) for 1.5%.

Subsequently, the OBR declared that it had greatly overstated Britain’s economic performance over the past seven years, alongside an announcement by the International Monetary Fund in July that it anticipated the UK economy to grow by 1.7%, compared to a previously anticipated 2%, due to "weaker-than-expected activity" in the first three months of the year. The twin blows all but wiped out a £26 billion budgetary buffer, put aside to soften the UK’s exit from the EU, by Chancellor of the Exchequer Philip Hammond, who since announced a series of new austerity measures in response.

In many countries, exceptionally low productivity-growth post-recession reflects slowing value-added growth with robust growth in hours worked

While the problem may have been troubling Britain’s public and private coffers for some time, for the large part, the response has been limited to doubling down on the same tactics as before; primarily the reduction of expenditure by way of real-terms wage cuts, and via the ‘digitalisation’ of jobs which could be done more efficiently by machines in the long-term. This is something which the UK manufacturing sector has been keen to push the Government for support in, citing it as a key battle ground to fighting Britain’s productivity gap.

Meanwhile, on top of support in a range of digital transformation exercises, the consulting industry has similarly offered clients solutions that tend to skirt around the topic of wages. Workplace stress has become a major talking point with regards to productivity, having been cited as the cause of some $250 billion in lost revenues for US businesses, and a large contributing factor for £77 billion relating to UK sick days. However, the most common cause of workplace stress – inadequate pay – is rarely addressed by firms looking to help clients boost output.

UK stagnation

In a closer examination of six major Western economies, which are experiencing slower than expected productivity growth, it seems that on average, workers are now engaged in more hours of labour – and yet the value added to the economy by their work has declined. The UK is exemplary of this, according to McKinsey’s study, as workers in 2010-16 worked longer hours than their counterparts between 1985-2005 – while adding significantly less value and labour productivity for their efforts. This is not to be confused with the idea workers are simply not producing enough consumables, or to a high enough standard, rather it is that the consumer economy they produce for relies upon them to buy back their labour, and the labour of those like them. As wages have declined in real terms from 2010-16, those workers have comparably poorer spending power when contrasted with those between 1985-2005.

Long-term demand leakages could act as a drag on productivity growth and may be further amplified by digital

McKinsey’s paper therefore suggests that employers across the economy are looking to scale back on wages to improve their profit margins, this may in fact have the opposite effect on companies’ bottom lines, and on the growth of the economy as a whole. According to the study, weak productivity can result from a weakened share of profits that the labour force receives from what it produces, while house and land prices rise, along with the cost of living. Rising inequality impacts this further, meaning a yawning gap appears between a wealthy minority with spending power, and a working majority, who must focus what little resources they have on the bare necessities.

While the UK retail sector was supposedly bullish last year, seeing the fewest high street store closures in seven years, consumer spending was largely bolstered by growing debt rather than healthy wages – echoing the circumstances which resulted in 2007’s credit crunch. Entering into 2018, the UK’s high street has subsequently been stricken with falling demand, as consumers rein in their spending to avoid becoming over-incumbered with debt, while focusing stagnating incomes on essentials. A turbulent start to the year, therefore, saw Toys R Us and Maplin both file for administration within a matter of hours of one another, inevitably drawing comparisons with the retail crash of 2008/9. This was followed by a string of so-called ‘casual dining’ chains opting to enter Company Voluntary Arrangements in order to avoid liquidation, including Prezzo, Carluccio’s, and Jamie’s Italian.

This trend is likely to continue unless something is done to alter the financial situation of the bulk of consumers, but this alone may not be enough. This is because digitalisation could amplify labour share declines and inequality, displacing workers who were once considered skilled labourers into low-wage jobs.

Without a productivity boost, younger generations will experience slower increases in their standard of living

The stagnation of productivity looks likely to have a disproportionate effect on younger generations. While, according to previous McKinsey research, just 5% of jobs could be completely replaced by technology, these tended to be work where Millennials were most commonly involved. As this is likely to compound the continued stagnation of the generation’s wages, meaning that generations born after 1990 will witness markedly lower GDP growth throughout their lifetime – and with it, a lower improvement in the quality of life they experience, proportional to the improvements witnessed by those born in 1960, for example.

The authors conclude that while they expect productivity growth to recover and see the potential for at least 2% growth a year over the next decade – 60% of which could come from digital opportunities – these should not be treated as a magic bullet to long-term drags on demand for goods and services. Indeed, these may persist alongside, and be exacerbated by digitalisation in some aspects. Changing demographics, declining labor shares, rising income inequality, polarization of labor markets, and declining investment rates could well be amplified, on top of the creation of other potential barriers to productivity growth.