Understanding Britain’s Economy and Labour Market

Some of the words, abbreviations and acronyms used to describe a country’s economic performance may not be familiar to many people in the Armed Forces, and their effects on the economy and therefore on employment may not be understood. The purpose of this article is to explain some basic economic and labour market concepts and then apply them to economic and labour market data.

What happens in the economy as a whole (macro economy), or in individual product markets, ultimately determines how many people organisations need to meet customer demand. Organisations then buy the staff they need in the labour market. How many staff they are able to buy, and at what cost, depends largely on how many people are available and willing to work.

Organisations therefore need to keep an eye on likely economic developments. The tools available are official statistics – mostly published by the Office for National Statistics (ONS) – or evidence drawn from independent surveys. Most official statistics focus on past economic performance, while independent surveys, such as those by the Confederation of British Industry (CBI), British Chambers of Commerce (BCC), and the Chartered Institute of Personnel and Development (CIPD), often provide an indication of what lies ahead.

The UK’s economy consists of many market relationships that help allocate resources to the production and distribution of the various goods and services people want or need. A combination of the relative demand for these goods and services and the relative supply of the resources required to produce them helps to determine their price (or market value). (Gross value added (GVA) refers to the difference between the cost of the resources used to generate these goods and services, and their market value.)

However, adding up the market values of all the things produced gives a total measure of the size of the economy, known as the gross domestic product (GDP) output measure. This is the most common way of calculating GDP and includes an estimated value for publicly provided services that do not have a market price, but excludes the value of such activities as unpaid housework. GDP is often referred to as national income; in 2005, the UK’s GDP was around £1,130 billion, making it the fifth largest economy in the world.

The percentage rate of change in GDP over a given period of time is a measure of economic growth, the rate at which national income is rising or falling. In the year to the final quarter of 2005, Britain’s GDP increased by 1.8 per cent – the slowest annual rate of economic growth since 1992.

At any given time there is a limit to the GDP a country can achieve; this is called potential GDP. This indicates the capacity of the economy to supply goods and services. If the demand for goods and services exceeds this supply capacity there will be upward pressure on costs and prices, increasing the rate of inflation.

Potential GDP is determined by:

• the amount of work people are able and willing to put in, which will depend in turn on human resources
• the amount of physical capital people use in their work, which determines how much they produce
• the level of skill (or ‘human capital’) people use in their work
• the state of technology and knowledge, which improves the quality of the physical capital
• the range of techniques used, including practices and management.

Change in any of these factors will affect potential GDP. Because there is usually underlying change in each factor, potential GDP grows over time. The underlying rate of change is called the trend rate of economic growth.

Given limits on population growth, and economic and social factors affecting the willingness or ability of people to work, the trend rate of economic growth depends on improvements in physical capital, human capital, technology and techniques. These determine the rate of growth of productivity, which is the main source of growth in potential GDP.

The UK has a trend rate of economic growth of 2.5 per cent a year, but the actual rate of economic growth tends to fluctuate around this figure. The economy can grow faster than trend without triggering higher inflation only if there is spare capacity. Periods when growth is below trend but still positive (as was the case in 2005) are known as economic slowdowns. If growth is below trend and negative (i.e. GDP falls) there is a recession.

At some point in a slowdown or recession the economy reaches a trough, after which demand increases. Organisations can respond to this recovery by using hitherto unused capacity. This enables the economy to grow faster than its long-run trend rate without encountering inflationary pressure until all the spare capacity has been used. At this point the economy will be achieving its potential GDP and can only sustain trend growth.

A complete period during which an economy moves from a position of full capacity, experiences an economic slowdown (or recession) and a recovery, and then returns to full capacity is called an economic cycle.

The amount of spare capacity is measured by the gap between potential GDP and what is actually being achieved. This output gap is taken into account when the level of interest rates is decided. This aims to keep the rate of inflation, as measured by the Consumer Price Index, close to 2 per cent a year. This should maintain economic stability and reduce extremes in the economic cycle by keeping growth in GDP in line with trend growth.

The human resources that contribute to GDP are bought and sold in the labour market. The greater the amount or quality of human resources supplied to the market, the higher the potential level of GDP. But this potential will be realised only if there is a sufficient demand for these resources, which is itself derived from the demand for goods and services.

The market demand for labour is measured by the number of people in work (employment), how much they work (hours) plus the number of unfilled job vacancies. Supply is measured by employment plus the number of people who are looking for work (unemployment).

The balance of demand and supply in the labour market is reflected in the level (or rate of change) of earnings. If demand is high relative to supply, earnings will rise. This increases the cost of employing people (assuming no change in their productivity) and demand for human resources will drop, causing earnings to adjust downwards. If, however, supply is high relative to demand, employment costs will fall, giving a corresponding boost to demand.

By the end of 2005 there were, according to the ONS, 28.76 million people in paid employment in the UK (74.5 per cent of the population of working age). At the same time, there were 606,000 unfilled job vacancies and 1.52 million people unemployed.

In periods of relatively high demand the labour market is ‘tight’, unemployment will be low and there will be unfilled job vacancies. When supply is relatively high the market is ‘slack’, with few vacancies and many job-seekers. In recent years the UK labour market has tended to be quite tight, but in 2005 it became more slack. There was a gradual decline in the number of job vacancies and a slight increase the number of people unemployed, so the rate of growth of average earnings moderated from 4.4 per cent a year in January 2005 to 3.8 per cent in November 2005.

There will always be some frictional unemployment (around 3 to 4 per cent of the workforce). This represents the regular movement of people in and out of work (labour turnover) and the speed with which job vacancies are filled. But a higher unemployment rate indicates that some human resources are going unused. At the end of 2005 the UK unemployment rate stood at 5 per cent.

Unemployment tends to rise and fall over the course of the economic cycle and is referred to as a lagging indicator of the economy because it takes around six to nine months for a slowdown in demand for goods and services to translate into a fall in demand for labour. This is called cyclical unemployment, with the resulting slack being closely associated with the output gap.

Cyclical unemployment should cause the rate of growth of earnings to moderate and thereby create renewed demand for unused human resources. Because of this, labour market indicators such as unemployment, vacancies and the rate of pay increases are taken into account when deciding interest rates.

However, even when unemployment is high, the necessary adjustment of earnings may not always occur, leaving some resources unused. As a result, some unemployment persists, caused by inadequacy in the operation of the labour market, rather than a cyclical dip in demand for goods and services. It cannot be corrected by cutting interest rates; the remedy is to improve labour market flexibility.

An economy operating at full capacity with no cyclical or structural unemployment is said to be at full employment. This situation used to be the norm in the UK and most other developed countries in the 1950s, 1960s and much of the 1970s. The 1980s and early 1990s then witnessed a period of unemployment, but the UK has since moved closer to full employment again.

Full employment defined in this way assumes that everybody who can work or wants to work is participating in the labour market. However, 8 million (more than 1 in 5) people of working age do not participate in the market, a group called the ‘economically inactive’. There is therefore scope to raise the UK’s employment rate. Two million economically inactive people of working age wanted to work in 2005, which represents a substantial untapped reservoir of labour.