Why we should worry about the middle class

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, these 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 work it doesn’t.

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.

Acemoglu doesn’t doubt their positive economic effects, but he has begun to be concerned about the political and distributional consequences. They might help the economy grow overall, 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. The pair set out to unravel the two big mysteries about Britain’s economic performance in the past five years.

“The big story in the UK is that the economy has shrunk by 2.5% since the pre-crisis period,” Van Reenen told me. “That’s the longest depressed economy in this country for more than a hundred years.”

Given the prolonged recession, economists would normally predict that unemployment would soar. It has risen, but, 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, productivity has plunged.

Van Reenen and 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 workforce. 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 whole.

Van Reenen says: “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.”

He believes weak productivity can also 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, Van Reenen argues, “instead of investing in machines, firms are keeping on workers”. That means each hour of human work is less productive.

There remains, however, a caveat. The relatively benign workings of flexible labour markets that Van Reenen describes are in response to the cyclical shock of a recession. British workers in the middle and across the Western industrialised world more generally are also being pressed by broader structural economic forces.

“I think the squeezed middle class is likely to continue,” 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.”

Chrystia Freeland is the managing director and editor of consumer news at Thomson Reuters


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