The end of cheap labour

Unlike previous British recessions, the Global Financial Crisis squeezed wages rather than jobs. Between 2009 and 2014 the UK economy created 1.7m new jobs and the unemployment rate fell from 7.7% to 5.7% of the workforce. At the same time those in work experienced a major squeeze on real incomes.

The recession and its aftermath made people more willing to accept cuts to pay or changes to working patterns. Lower-paid part-time work and self-employment acted as a "shock absorber" for labour. In 2014, 4.6 million people were self-employed in the UK, accounting for 15% of those in work – the highest level in the 40 years since data have been collected. Self-employment has accounted for almost a third of the growth in jobs since the end of 2009. Over the same period, more than half a million part-time jobs have been created.

Wage moderation allowed firms to hold onto more staff in the downturn in the hope of better times ahead. The period of cheap labour coincided with shortages of credit and a need to cut costs. This set up incentives for firms to shelve investment and get by using plentiful and relatively cheap labour.

That worked well during the downturn, but times have changed. The era of cheap labour is coming to an end.

Big falls in unemployment have stoked skill shortages and are putting upward pressure on wages. In the three months to May average weekly earnings rose by 3.2% on a year earlier for the whole economy and by 3.8% in the private sector. That is the fastest growth since April 2010. Forecasts from the Office of Budget Responsibility (OBR) predict that real earnings, after inflation, will grow by more than 2.0% every year until 2020.

Government is playing a part too. In his Summer Budget, Chancellor George Osborne declared that "Britain deserves a pay rise" and unveiled a substantial rise in the national minimum wage. Workers will earn a minimum of £7.20 an hour from next April and £9.00 an hour from 2020.

Higher labour costs are likely to change the composition of employment, just as the cheap labour period did. With wages picking up, the incentives for business to use labour more efficiently are growing.

Such pressures are probably behind the recent shift to full time work – which has relatively high levels of productivity – and away from part-time working and self-employment.

Rising labour costs creates new incentives for businesses to undertake productivity-enhancing investment. Stronger, steadier growth should also raise productivity among many in work who were under-employed and or working below potential during the downturn.

The wage squeeze helped preserve jobs during the recession. That period was associated with low levels of productivity growth and weak investment. These trends are reversing. The challenge for the private and public sectors now is to use labour more efficiently. If they can get that right the UK will be heading towards a self-sustaining cycle of growth in wages, investment and productivity.