Economic outlook: Missing workers create further recruitment challenges as economy tightens
While the UK’s economic performance has been lacklustre since 2020, the labour market has been quite tight. The pandemic and Brexit have led to a drop in the UK’s workforce, which is affecting all sectors of the economy. The Bank of England recently revised their long-run growth rate forecast down, citing the decline in the labour force as the main reason. The service sector is missing some 350,000 workers due to Brexit and economic inactivity has increased because of long-term health issues, early retirement, and a broken housing market.
GDP is far below trend, but the UK labour market remains strong
The Covid-19 pandemic has led to a massive economic shock and Great Britain’s GDP is still some 6% below pre-Covid trend in early 2023. Unfortunately, the short-term economic outlook is quite bleak. Due to the highest inflation in decades, the Bank of England (BoE) has hiked its policy rate to 4% now in early 2023 and is determined to keep interest rates higher for longer to bring inflation down.
This is already stifling domestic consumption and it will also have a significant negative impact on the UK housing market, which is deemed somewhat more fragile than housing markets in other countries (as a large share of mortgages are only fixed on a short-term basis and many borrowers will face higher repayment costs soon).
Most economists are expecting a UK recession in 2023, although whether deep or shallow remains to be seen. As of today, the UK economy is the only large advanced economy that is expected to see an economic contraction in 2023, with forecasts ranging from 0% growth to -1% of GDP.
Given the challenging economic outlook, it is worth asking why the UK labour market has been so tight in 2022 and might remain quite tight even as the economy will fall into recession.
While the BoE’s forecast is assuming a prolonged economic recession, the Office for Budget Responsibility (OBR) is forecasting unemployment to peak at just under 5%. So even with the upcoming economic downturn, unemployment will most likely not rise as much as during previous recession. The BoE also recently revised the country’s growth outlook and is now much more pessimistic about long-term growth, citing the decline in the labour force as the main reason.
With many sectors still missing workers, especially workers in hospitality and transportation, the OBR forecast sounds somewhat more plausible.
The labour market has never been as tight before as it was in 2022 and employers had huge difficulties filling positions. As the following graph shows, vacancies per 100 jobs rose to record levels throughout 2022 and only started to normalise recently.
Vacancies are still way above trend but have now started to come down as the economy is entering a downturn.
The case of missing workers: The labour force decline exceeds 3%
Even though domestic demand has been quite weak and GDP has not even reached its pre-crisis level yet, labour market tightness can be explained by missing workers. The impact of Brexit and the pandemic on the labour force – defined as workers between the age 16 and 64 who are economically active – can be seen in the following graph.
Compared to the pre-pandemic trend, there is about one million workers missing from the UK labour force, a total of more than 3%.
There are three main factors that can explain this widening gap: Brexit, the pandemic, and demographics. The current labour market tightness is contributing to the UK’s precarious macroeconomic situation because wage growth is one of the drivers of inflation. Tight monetary policy is a direct response to the labour market mismatch and shortage of workers across various industries.
It is also worth emphasising that the decline in labour force participation is a problem unique to Great Britain. While participation rates dropped across all advanced economies when the pandemic started and economies went into lockdown, most countries have seen a very strong economic recovery and participation rates across many countries are now higher than before the crisis. It is only the UK that has seen its participation rate stagnate at the same level for almost two years now.
Economic inactivity is on the rise: Health-related issues top the list
There are close to 9 million people between 16 and 64 years old who are not economically active in the UK. More than 7 million of those do not want a job and some 1.6 million inactive do want a job. In comparison, there is only 1.2 million people unemployed right now – people actively looking for work – explaining the low unemployment rate of about 3.7%.
Bringing even a small share of those economically inactive back into the labour force could lead to a massive boost to the labour supply. It would address the UK’s current economic woes where companies in many sectors are suffering from worker shortages even as the country’s economy is stagnating.
Needless to say, the high level of job openings with companies struggling to fill some positions is also contributing to the UK’s poor economic performance and a labour supply boost could alleviate the current economic stagnation.
There are several reasons why inactivity is so high in the UK. First and foremost, the pandemic turned out to be a massive shock to the UK labour market.
Economic inactivity by reason shows that early retirement played a small role, but especially emphasises the huge part that long-term economic sickness is playing. The number of early retirees rose by about 100.000 throughout 2021, but this number has reversed since then. Arguably, the cost-of-living crisis is pulling some of them back into the labour force.
More shockingly, the number of long-term sick increased by about half a million since early 2020. There is no doubt that the Covid-19 pandemic played a major role here together with a completely overburdened public health care system as NHS waiting times for specialist appointments, operations, and treatments have gone through the roof. Fixing the health care system should be top priority on policy makers’ list as health issues are actively discouraging workers from coming back to the labour market.
As the following chart shows, the percentage of people on the diagnostic waiting list with a waiting time longer than six weeks has surged to more than 25% and is far above its pre-pandemic levels. The total amount of people on the waiting list has increased as well and now stands at about 1.6 million while the pre-pandemic value was at about a million.
NHS services are facing a perfect storm of surging demand due to the pandemic while being capacity constraint. The lack of access to healthcare for some people is already feeding back into a lower participation rate as economic inactivity due to health reasons is going up.
Economic inactivity by region: levelling up, and a broken housing market
Just as there are wide economic discrepancies in terms of wages and the cost of living between different region in the UK, economic inactivity rates are also differing widely. This reflects the fact that labour market opportunities are unevenly distributed across the country.
The UK’s government initiative of “levelling up“, while applaudable, is unlikely to provide a substantial economic boost to all regions. Germany is a good case in point of how region-based policies have their limits. Even 30 years later, and with more than two trillion euros of transfers from West Germany to East Germany, the latter is still significantly poorer than the rest of the country. Unemployment rates are also higher and East Germany generally scores less well on a variety of social metrics. Since 1990, several million inhabitants have left the East for West Germany for better employment opportunities.
Levelling up in the UK will face similar challenges. Even as the pandemic has led to an increase in jobs that can work remote, research shows that the highest share of remote jobs are actually located in Greater London and other large metropolitan areas where the majority of skilled workers are living.
Infrastructure investments in large key cities in the UK are worth undertaking to ensure that they do not lag behind London significantly. However, more sparsely populated regions will have more trouble catching up because agglomeration effects have led to clustering of the most high-paying jobs in a few metropolitan areas – a phenomenon that Richard Florida has dubbed winner-takes-all urbanism.
Rapidly rising house prices in large growing cities are presenting an obstacle for workers to move where the jobs are and this a significant drag on GDP growth. Fixing the broken housing market and allow freer movement of workers into large metropolitan areas would be one way to raise economic inactivity levels and bring workers back into the labour force.
Demographic decline and migration
Another factor weighing on the growth of the labour force is the long-run demographic outlook. While the UK’s demographic projection look less scary than the ones for other advanced economies, the working age population is expected to stop growing in the coming years and will stagnate from then onwards. This is mostly due to the baby boomer generation starting to retire and subsequent cohort sizes being smaller in size as fertility rates had been going down for decades. Brexit is only aggravating the problem as it has led to a decline in workers from abroad.
According to the UN’s population forecast, the UK’s prime age population will peak in a few years at around 40 million and then stagnate while countries like Germany will see a significant fall in the decades ahead.
With Brexit, it will be even more difficult to reverse this dynamic with immigration. While the number of skilled worker visas has recently increased, this is catered to high-wage occupations as visas are costly to employers and because there is a wage threshold.
The problem of a worker shortage in manual labour occupations will not be solved any time soon. While long-term, the UK would need a higher rate of immigration, the political appetite for this is extremely low. After all, Brexit was a vote against immigration.
Demand vs supply: A lack of workers is holding back the UK economy
The following chart shows to what extent the labour market woes in the UK are a result of missing supply. The labour force plus discouraged workers can be seen as the labour supply in the economy, the pool of available workers. Total employment plus vacancies together are a proxy for total labour demand.
The gap between the two series has narrowed over time, especially since the Brexit vote in 2016. Labour market dynamics have obviously changed a lot since 2020.
For the first time ever, the demand for workers has exceeded the available supply, showing how tight the post-pandemic labour market in the UK has been despite stagnating GDP.
This together with elevated vacancies across all sectors shows that the UK labour supply issue will not go away any time soon even as the country is falling into a recession this year. As previously outlined, there is a good chance that this downturn will not lead to a significant rise in the unemployment rate. With layoffs in the tech sector, we might see a white-collar recession whereas shortages in hospitality, transportation, and the service sector in general might mean that manual workers will not suffer as much as in previous economic downturns.
Steps to solve the talent shortage and economic inactivity
There are no easy solutions to increase inactivity, but some policies might work better than others.
Expanding the pool of available workers domestically should be on top of the list for policy makers, given that a push for more immigration is politically infeasible right now.
According to the ONS, the number of discouraged workers – workers that had been looking for employment but have given up – is currently at an all-time low. With just a little over 30.000 “discouraged workers”, down from more than a hundred thousand at the end of the 1990s, the number is too small to significantly affect the labour force.
However, the number of economically inactive workers with more than 8 million is extremely high. While not all of them want or should work – about 2.4 million are students – there is no doubt that some of the inactive would prefer having some kind of income if a good opportunity came along.
The huge increase in the number of long-term sick must be a key concern for policy makers. We do not yet have a good idea of the long-term costs of the pandemic in terms of people’s health, but losing several hundred thousand potential workers due to long-term illness is a huge negative shock to the available labour pool.
The broken housing market is another huge obstacle to higher employment. Massive price surges in large metropolitan areas are preventing workers from seeking employment in the places where better opportunities exist.
Three policies must take front and centre to address the UK’s long-run labour supply issue:
Health care
Significant investment in the health care system to address the country’s long-term health issues that have increased significantly with the pandemic.
Housing
Fixing the broken housing market: House prices in key metropolitan areas, London in particular, have surged to such an extent that housing has become a luxury good. The working class is being priced out of certain areas and high house prices prevent workers to move to locations where better job opportunities exist.
Infrastructure investment
Building up a better commuter network with more high-speed railways between large UK cities that would allow workers to commute more quickly between key hubs to be able to find work in places other than where they reside. The French TGV network, for example, allows workers to commute into Paris from far away.
All of these proposals require significant upfront investments from the government, but they would ultimately bring large returns by boosting the labour supply and economic growth. As sad as it sounds, “levelling up” and focusing on left-behind regions is more difficult and the payoff might be lower than focusing on key metropolitan areas and “connectivity” between regions instead to improve the flow of workers.