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Special Topic: The labour market adjustment in recessions

March’s Household Labour Force Survey showed that employment growth resumed in the final quarter of 2009.  Based on the experience of previous recessions it was perhaps surprising that the fall in employment was not larger.  This Special Topic considers whether the adoption of flexible working practices and a moderation in pay growth have helped to limit the fall in employment. 

Employment and output in the recent recession

Output fell by almost 3½% during the recent recession bringing with it a fall in employment, but compared to the recession in 1997/98 it is perhaps surprising that the fall was not larger.  In earlier recessions employment did not decline at all, which suggests that at least some of the fall in employment in the early 1990s represents a structural shift from an unsustainably high level of employment, rather than a response to a cyclical downturn (Table 1). 

Table 1 - Output and employment during recessions
  1970s early 80s early 90s** late 90s 2000s
GDP -4.2% -3.2% -3.4% -1.5% -3.4%
Employment 2.8%* 4.5%* -8.0%** -1.3% -2.5%

*eight quarters after the start of recession

**the GDP peak to trough refers to the fall in the first two quarters of 1991. GDP fluctuated around its 1986q3 level until 1992q4. Employment peaked in 1987q1.

Sources:  Stats NZ, Motu

The smaller falls in employment in the two most recent recessions illustrates the way current economic structures support timely adjustment in wages and employment, which helps ensure that the economy as a whole returns to a sound base for sustained growth.

Why adjustment is necessary

Falls in demand initially reduce firms’ sales and profits.  If the lower level of demand is expected to persist, firms will want to reduce production in order to lower costs and restore the margins between input costs and sales revenue, ie profitability.  For many firms, particularly those providing services, labour costs are a large part of total costs so it is likely that any squeeze on revenues will be offset, in large part, by a squeeze on labour costs.  In the 1970s and early 1980s the fall in output did not flow through to reduced employment largely because government policy provided support to firms that helped offset falls in margins e.g. subsidies on non-labour inputs, and because a large proportion of the labour market was employed in the public sector, which did not have profit related goals.  However, no economy can support large ongoing losses for ever and the eventual adjustment in employment was severe.

Firms can reduce labour costs by reducing the hours worked by employees and by reducing employee pay and benefits.  However, there are likely to be limits to cost savings from this strategy.  Reductions in overtime and bonus payments provide some flexibility but other parts of the wage bill may be less flexible e.g. changes in core hours. In more severe downturns, firms are likely to need to reduce the number of employees.  But redundancy typically entails substantial costs and there is a risk that skilled staff will be hard to replace when demand returns.  Lay-offs will therefore tend to be a last resort.

More flexible work and pay 

The increased use of flexible working practices in 1997/98 and 2008/09, together with a moderation in wage and salary growth, seems to have helped limit the fall in employment.  Average hours worked has fallen roughly in line with the fall in output in the two most recent recessions, which will have been associated with a significant reduction in costs (Fig 8).  Some of the decline in average hours will reflect short-time working arrangements and temporary plant closures. Growth in part-time employment (less than 30 hours per week) has not been an important contributor to falling average hours in these recessions.

Figure 8 - Average hours worked
Figure 8 - Average hours worked.
Source:  Stats NZ - Household Labour Force Survey (HLFS)

Companies have also sought to constrain costs by limiting wage growth.  Both the Quarterly Employment Survey (QES) and the Labour Cost Index show evidence of a sharp moderation in labour input cost growth.  The QES shows annual growth in average hourly wages has moderated from a peak of 5.4% in 2008 to 2.2% in the latest quarter.  However, shifts in industry employment shares suggest the QES may be understating the degree of wage restraint.  Employment in industries with below average wages has been declining as a share of total employment, while the share of employment in industries with above average wages has been increasing (Fig 9).

Figure 9 - Employment shares
Figure 9 - Employment shares.
Source:  HLFS

The Labour Cost Index (LCI) provides a measure of firms’ labour costs that holds constant the composition of employment and the quality of labour.  Growth in the LCI has moderated markedly in recent quarters and from a much higher starting point than in 1997/98 (Fig 10).

Figure 10 - LCI wage inflation (annual % change)
Figure 10 - LCI wage inflation (annual %  change).
Source:  Stats NZ - Labour Cost Index

The moderation in labour costs is reflected in changes to the distribution of annual wage movements.  The LCI shows that 43% of salary and wage rates increased in the year to March 2010, compared with a peak of 62% in the September 2008 year.  Of those salary and wages that increased in the year to March 2010, a quarter rose by over 3%, down from over 50% in 2008.

Supply side influences

The supply of labour has also continued to expand.  The labour force has grown more strongly than the Treasury expected, and more strongly than in earlier downturns (Fig 11). 

Figure 11 - Labour force growth (annual % change)
Figure 11 - Labour force growth (annual %  change).
Source:  HLFS

In the most recent recession the rise in unemployment did not lead to the expected exodus of workers from the labour market.  The greater supply of workers is likely to have been a factor behind the decline in wage growth.

Conclusion

Overall, pay moderation and flexible working practices appear to have limited the adjustment in employment.  Looking forward, earnings growth can be expected to pick up as average hours of work increase and employment growth strengthens.

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