Stephen King: Public sector growth is fuelling a pay boom

If there's been a dominant global labour market theme in recent years, it's the mobility of factors of production. Capital hunts out cheaper sources of labour. And labour hunts out higher wages. From the perspective of rich Western countries, there are two visible signs of this process. Offshoring and outsourcing have driven capital out of Western countries. Meanwhile, the prospect of higher wages has brought migrant labour into Western countries.

Attitudes towards this change have, inevitably, been mixed. As shareholders - and I'm thinking here of the broadest category, including those dependent on company or personal pensions - the news appears to be rather good: more profitable capital implies better returns, thereby raising pension incomes to higher levels than might otherwise have been the case. As workers, though, people might look on these economic changes with some degree of apprehension.

The truth of the matter is that more open global labour and capital markets create more competition and, with more competition, the old guarantees of jobs for life, or of jobs associated with a certain level of wages, may no longer hold. Of course, competition also should imply a better allocation of resources so that, in theory, everyone should eventually be better off. Whether this is reflected in people's pay packets or, instead, in falling prices of durable goods, is another matter altogether. And whether everyone really ends up being better off depends a great deal on how the efficiency gains are distributed through society and across countries.

For most Western countries, recent evidence offers support to these new competitive forces. Last Friday's US employment report was a little stronger than expected at the headline level, with a jobs gain of 262,000 in February. But, below the surface, the story looks somewhat different. The average monthly gain in payrolls in the last half-year has been only 182,000, compared with more typical monthly gains during economic recoveries of much more than 300,000. And although February's employment gain was stronger than expected, the same cannot be said about wages: earnings per hour were flat on the month, suggesting that workers are failing to be compensated for either energy price increases or productivity gains. Indeed, unit labour costs have barely changed in recent years, a result without historical precedent: normally, costs rise as the recovery gets under way (see left-hand chart).

The remarkable control of labour costs doubtless owes something to the technology revolution, which has allowed companies to extract more out of their existing workers than, perhaps, has been the case in previous economic cycles, thereby raising productivity growth. Yet the lack of significant wage growth appears to be a feature of countries with good long-term productivity performance (the US) and those that have done less well (Germany).

Why might this be? I suspect it's the combined impact on factor mobility of technology and opportunity. Without technology, it would be difficult for one company to manage factories, offices and call centres in different parts of the world. Equally, though, without the opportunity created by political change - the collapse of the Berlin Wall, China's "free market" communism - the opportunities to exploit new technologies would have been far fewer.

One country that appears to have bucked the trend of wage restraint is the UK. The right-hand chart shows real, inflation-adjusted, wage growth in the UK together with the US and Germany. The US and Germany have had broadly similar experiences, with real wages flat or falling in recent years. The UK, though, has seen persistently strong real wage growth. Indeed, wage growth has accelerated in recent quarters.

Why? The UK's productivity growth has not been greatly different from Germany's and it's been a lot less impressive than America's, so there's no great justification for British workers seeing bigger pay increases than elsewhere.

Sterling may have softened a little against the euro i n recent months - and exchange rate weakness has sometimes been a trigger for compensating wage increases - but sterling's overall level has remained very high, so again there's no obvious case for higher wage increases.

Despite recent political opposition, the UK's policy on immigration has been more open than that of its European neighbours, an attitude that, theoretically, should have eased labour market pressures. And the UK's policy mix - low interest rates by historic standards, accommodating fiscal policy - has been little different from America's, so loose policy alone doesn't seem to offer a particularly satisfactory explanation.

One more compelling reason is, perhaps, the role of the public sector. Whereas America's loose fiscal stance has been associated with tax cuts, Britain's has been associated with higher public spending. Much of that spending has been associated with job creation in the public sector.

Unfortunately, precise data on public sector job creation doesn't come along often. The Office for National Statistics publishes an update only on an annual basis and, even then, the figures are rather out of date. The latest report, for example, was published in July 2004 and refers to 2003 data. However, it shows that public sector job creation in the year to June 2003 was significantly higher than private sector job creation, with an increase of 162,000 compared with a private sector gain of 98,000. Moreover, since 1998, more than 500,000 public sector jobs have been created, an overall increase of 10 per cent.

How does this relate to wage increases? The average earnings data, published monthly, provides the answer. Public sector wage increases have continued to outstrip private sector wage gains. In the three months to December, public sector average earnings rose 4.7 per cent on a year earlier compared with a 4.3 per cent gain in the private sector. Private sector wage increases, though, are catching up. This is hardly surprising: if public sector employment is to expand and unemployment is very low, success will come only by enticing workers away from the private sector or by allowing more immigration. And if the private sector suddenly finds there's competition for its workers, it will simply have to pay more.

Of course, whether or not we have a large or small public sector is ultimately a matter of political rather than economic choice. That choice, though, will carry economic consequences. If the labour market is already tight and public sector demand doesn't slow down, wage inflation will tend to rise and the Bank of England will start to fret. If wage inflation rises, companies may eventually find it more difficult to make profits, hastening the process of outsourcing and offshoring. Higher interest rates may eventually undermine the housing market, leading to higher unemployment and lower tax revenues.

All in all, the risk with continued public sector expansion at a time when the UK has virtually full employment is a persistent increase in real wages. If the rest of the world is busily controlling wages and improving competitiveness, the UK might eventually suffer from a loss of capital and a slowing growth rate. By sticking to ambitious spending plans but, at the same time, finding that tax revenues are coming in lower than expected, the Government would then face the risk of ever-larger public sector borrowing.

There are two ways round this. First, the UK should keep the doors open for immigration, a conclusion that will hardly please the Daily Mail readers of this world. Second, the Government has to demonstrate that its investment in the public sector is adding to the nation's productivity performance - if that were true, higher wages really wouldn't matter. But because public sector services are too often calibrated by quantity of inputs rather than quality of outputs, it's difficult to find any convincing evidence to date that the desired productivity improvements are really coming through.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com