Recruitment And Inflation - is unemployment ever a price worth paying?

On 16th May 1991, Norman Lamont, then UK Chancellor of the Exchequer, stated in parliament that:

"Rising unemployment and the recession have been the price that we have had to pay to get inflation down. That price is well worth paying."

Inflation had indeed fallen from 10.9% to 6.4% and subsequently continued to fall to 1.3%, and a year later John Major’s government was re-elected winning the most votes of any political party in British electoral history. But nonetheless Lamont’s comments were seen as insensitive to those directly affected by unemployment, and ultimately cost him his job. Secretly though, many economists at the time acknowledged that what he’d said was technically correct: unemployment is linked to inflation; but I think it worth exploring how that relationship works in the real world as we experience it as recruiters.

The story starts in 1958 with an academic paper published by a New Zealander based in London by the name of Alban Williams Phillips - known to his friends as Bill.

Phillips observed a negative or inverse correlation between the percentage of people who were unemployed and wage growth, namely that when unemployment was high wages increased slowly, but when unemployment was low wages rose quickly. By doing so he showed that reducing unemployment and slowing inflation were both noble aims for a government to pursue, but as Mr (now Lord) Lamont pointed out, they couldn’t have both.

The logic goes like this: much of economics assumes a simple model of supply and demand. If the demand for a particular product or service (or skillset or job) is greater than supply they become more sought after, and based on the logic that the rarer something is the more people are prepared to pay for it, the price of that item goes up. So if unemployment is low, there are fewer workers available to hire, so those who do get hired can negotiate a higher salary and/or better working conditions. Alternatively you could say that as the labour market shrinks or tightens employers need to offer higher salaries so as to attract or retain suitable candidates. Either way, if people are being paid more they have more disposable cash to spend (and companies need to charge more for their goods and services to pay for the increased salary costs), so consumer demand goes up and so does inflation. As demand for products increases, companies need to hire more workers to produce more goods to meet the increased demand, and so unemployment falls further.

Conversely, when the economy takes a turn for the worse, employers are looking for ways to cut costs and are less likely to be able to afford to hire more staff; so unemployment goes up, and since more people are competing for fewer jobs employers can offer less in wage increases leaving workers with less money to go out and buy stuff with. As people spend less and demand for products drops, manufacturers have to either drop their prices to make their products more affordable or they will go out of business causing a further increase in unemployment. Economists call this Cyclical Unemployment.

By convention this is referred to as a Labour Market whereby employers generate 'demand' by creating job vacancies and pay workers (or candidates) who generate supply of labour. If there are more jobs than there are available/suitable candidates we get a ‘war on talent’ in which candidates can demand better pay and conditions and be more picky about the jobs they take. It is no coincidence that issues such as flexible working come to the fore when the labour market is slowing down and we have the ‘great resignation’. Conversely, when there are more candidates than jobs (usually when unemployment is high and the economy is doing poorly) employers can be more picky about who they hire and on what terms they hire them. The relative control employers have is known as the Employer Market Power.

[I would suggest there is an element of chicken and egg here: does a tight labour market force employers to offer higher salaries, or do employers who offer higher salaries encourage workers to stay put and not enter the labour market, thereby reducing the supply of available candidates and thus driving up demand for labour?]

What Phillips proposed was that the relationship between unemployment and wage growth wasn’t linear, but that it followed a curve, so small reductions in unemployment (ie more people getting back into work) can cause dramatic increases in inflation.

A key factor in defining the Phillips curve is government legal and fiscal policy. Here in the UK, employment law tends to favour employers rather than employees - if you don’t believe me ask an employment lawyer; which could be attributed to the dominance of the Conservative Party in British politics since World War II. We might think our trade unions are quite strong in the UK, but compared to those in continental Europe they’re relatively weak and trade union membership in the UK is in decline. It’s also much easier to hire and fire staff in the UK than it is elsewhere, which consequently gives us a much more flexible labour market, making it much easier for employers to respond to changes in demand for their goods or services.

Government fiscal policy (ie tax policy) affects the decision company owners have as to whether to invest in capital (technology, reducing costs, returns for investors etc) or to invest in its employees. Ideally we want companies to invest equally in both, but how they do this will also affect the shape of the Phillips curve. This is partly because Phillips assumed a steady rate of productivity - the amount of revenue a workforce generates per hour they work. By encouraging investment in training, technology or other initiatives that can give them ‘more bang for the buck’ from their workers, employers (theoretically, at least) are enabled to produce more with fewer workers. This has the effect of reducing demand for labour thus reducing the wages they pay and the price they charge relative to what they produce. Other European countries on the other hand have laws that are more generous to employees (eg Scandinavian parental laws and the proliferation of trade unions across Northern Europe) which make the labour market less responsive/efficient.

An important modification to Phillips’ model was later made by Edmund Phelps and Milton Friedman. They argued that unemployment settles at an equilibrium point - they called it a ‘natural rate of unemployment’, at which point the Phillips curve effectively becomes a vertical line. Basically, we have to accept that there will always be a proportion of the workforce who are unemployed, and trying to push the curve to the left or to the right from that point is going to be incredibly difficult. Over time, this feature of the economy becomes increasingly more difficult to budge and is referred to as ‘hysteresis’. Unfortunately there are communities where being unemployed is seen as a way of life and even pass down generations such that being employed becomes a stigma. Some of the causes of economic hysteresis are easier to resolve than others, but they can be a result of an inability to work due to long-term mental or physical sickness, old age, caring/parental responsibilities etc. At this point, wage growth/inflation equilibriates and becomes more stable in the long term, so they called it the Non-Accelerating Inflation Rate of Unemployment (NAIRU), and many policy makers use this to estimate an optimum rate of inflation (Bank of England set it at 2% and would not raise interest rates until unemployment fell to 7%).

There are some problems with the Phillips model. Firstly, it assumes an ‘efficient market’ ie that if there are job vacancies and there are people who are unemployed, those unemployed people will fill those job vacancies and the two numbers should cancel out. Well, anyone who’s worked in the real world will tell you that not every candidate is suited to the jobs available - hence we have ‘skills gaps’; and even if they are, candidates might not get to find out about all of the suitable jobs available.

There are a whole raft of reasons why people can’t or won’t work, even though it would seemingly be economically detrimental not to do so. Barriers to employment such as high property/rental costs, affordable child/parental care and transport costs mean that the labour market isn’t as responsive (or ‘elastic’ as economists like to say) to changes in demand as we’d like it to be. This is called Frictional Unemployment.

Also keep in mind that the labour market is a finite resource, and will be limited by declining fertility rates, age demographics, long-term sickness and disability etc. The removal of geographical constraints that come from offering remote working and flexible working has sought to counter this by allowing companies to appeal to a broader labour market, but the affect this has on market elasticity and efficiency has yet to be seen. I have anecdotal experience of employers offering hybrid/home-working as an alternative to a pay rise due to the money saved on commuting, but I don't see this being widespread, and there is certainly evidence to suggest home-workers work longer and/or are more productive.

There is also a disconnect between employment and unemployment, and whilst they may seem to be two sides of the same coin, an increase in employment is not always a sign that all is well. People may be underemployed or accepting ‘bad jobs’, temporary/’gig jobs’ or jobs which are prone to automation; and some may be juggling multiple jobs as a way of earning more money. These will all give an unsustainable boost to the employment figures that won’t give a fair reflection of the true health of the economy. This is one reason why economists prefer to look at unemployment rather than employment as an indication of the health of an economy.

Phillips’ model also assumes a closed market with no interference from outside forces affecting inflation. But, communication has moved on quite a lot since 1958 and events on the other side of the world are having ‘butterfly effects’ on the economies in other countries. This means that the supply/demand relationship has become much more complex and the factors affecting inflation (eg bank interest rates) are often independent of the unemployment rate and vice versa. An example of this disconnect is ‘stagflation’ where an outside problem (eg the invasion of Ukraine) pushes prices up causing inflation to increase in a way that is unrelated to bank interest rates. In circumstances like these, unemployment is also negatively affected as companies seek ways to cut costs by reducing the number of workers they employ. So we get an increase in inflation and an increase in unemployment - the worst of both worlds. What subsequent economists have shown is that negative supply shocks like these simply push the Phillips curve to the right, so it still holds true.

Another word of caution: Phillips measured percentage wage increases as a way of tracking inflation, but when we say wage increases drive inflation, that’s a bit of an over-simplification. Research has shown that it is often the top earners who get larger wage increases than the rest of us. It stands to reason that a 10% wage increase for someone earning ￡100k is going to have a more significant effect on the economy than for someone on ￡20k, and it is often the top earners who take much higher percentage salary hikes (often because they are more likely to be in positions of authority to do so) than their underlings.

Let’s not also forget that as salary rises go up, there is the option to save more of the money people earn (or pay off loans) rather than spend it, and if interest rates are high relative to inflation this option becomes more sensible in the long run, if not the most immediately appealing.

As well as not taking into account the many restrictions people have in finding work, the efficient market also assumes employer market power is absolute and that employers are free to offer high or low salaries as they see fit in response to market forces. But this is not always the case, and they are certainly not as responsive. There will often be a time lag between rises in inflation and wage rises because the two operate along different timescales. It is relatively easy for companies to put up their prices (just look at the digital price display on your local petrol station forecourt) whereas negotiating higher wages or hiring more staff isn’t something that happens as quickly.

Whereas salary is often cited as a key reason for people wanting to switch jobs, employers are equally keen to retain their staff without getting caught in a spiral of ever-rising wage bills, and so they can offer intangible benefits like an amenable culture, employer branding etc - we also find they're increasingly reluctant to advertise the salary on offer for a new vacancy and so obtaining realistic salary data isn't always easy. These don’t directly impact inflation and will affect the elasticity of the labour market to changes in demand. If people love where they work they’re less likely to complain that the wages are low or to look to work elsewhere - they're also likely to be more motivated and productive.

On the flip side, employers often include restrictive covenants or 'non-compete' clauses in employment contracts limiting which companies an exiting employee can go on to work for which can inhibit talent mobility and has been shown to have negative affects on innovation and productivity.

I’ve spoken previously about the decision to either recruit or retrain etc, and oftentimes these are commercial decisions relative to the specific circumstances the company faces. In the bigger scheme of things, I hope we’ve shown how these decisions impact the economy as a whole, and that whilst it’s not always easy to make individuals do what’s best ‘for the greater good’ if it has negative consequences for themselves, unfortunately it has to be a price worth paying.