CIPD - Understanding the economy and labour market

Recruitment and talent management

Revised February 2008

This factsheet gives introductory guidance. It:

establishes why an understanding of the economy is useful for HR practitioners
explains some basic economic and labour market concepts
applies these concepts to the most recent economic and labour market data.

Why understanding the economy matters for HR

Economic conditions provide the background to the everyday business of HR. What happens in the macro economy, or in individual product markets, ultimately determines how many staff organisations need to recruit, retain and develop in order to meet customer demand. Organisations in turn buy the staff they need in the labour market – how many staff they are able to buy, and at what cost, depending mainly on how many people are available and willing to work.

It is therefore important for organisations to keep a weather eye on likely developments in the economy, with HR practitioners monitoring the state of the labour market in particular. The tools available to do this come in the form of official statistics - mostly published by the Office for National Statistics (ONS) - or evidence drawn from independent surveys. Most official statistics indicate how the economy has been doing. Independent surveys, such as those by the Confederation of British Industry, British Chambers of Commerce and the CIPD, also provide an indication of what lies ahead. The CIPD, for example, together with KPMG conducts a quarterly Labour Market Outlook survey. The published results supplement official statistics with the latest experience and expectations of up to 2000 CIPD members.

View the latest edition of Labour Maket Outlook

How big is the UK economy?

‘The economy’ is shorthand for a myriad of market relationships that help allocate human and other 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 determines their price (or market value).

Adding up the market values of all the things produced gives a total measure of the size of the economy known as Gross Domestic Product (GDP). This includes an imputed value for publicly provided services which don’t have a market price. But it excludes the value of other important activities, such as unpaid housework.

This measure of GDP is called the output measure. GDP can also be calculated by adding up total expenditure on all the goods and service produced (the expenditure measure) or adding the income earned by organisations and individuals in producing goods and services (the income measure).

All three measures of GDP are equal in monetary value – they are simply different ways of looking at the economy. This is why GDP is often referred to as national income even though the output measure is that most commonly mentioned.

In 2007, the UK’s GDP was around £1,180 billion – making the UK the fifth largest economy in the world.

The percentage rate of change in GDP over a given period of time – say a year or quarter – is a measure of economic growth. This is a key economic indicator since it shows the rate at which national income is rising or falling.

In the year to the final quarter of 2007, GDP increased by 3.1%. This was a faster rate of economic growth than experienced in either 2005 (1.8%) or 2006 (2.9%).

Economic growth and inflation

There is at any given time a limit to the level of GDP a country can achieve. This achievable level is called potential GDP and 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 ie the rate of inflation will increase. Inflation can also increase regardless of the balance of demand and supply if there is a rise in import prices (as occurred in 2006 and again toward the end of 2007 when the price of imported oil rose sharply).

Potential GDP is determined by a number of factors:

The amount of work people are able and willing to put in, which will depend in turn on human resources: the size of the population, how many people in the population can or want to work, and how many hours they work.
The amount of physical capital people use in their work which enables them to produce more in each hour of work.
The level of skill (‘human capital’) people use in their work which enables them to produce more in each hour of work.
The state of technology and knowledge which improves the quality of the physical capital people use in their work.
The range of techniques, including HR practices and the wider management of human capital, which enables people to produce more in each hour of work.

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

Given a natural limit on population growth and a variety of economic and social factors affecting the willingness or ability of people to work, the trend rate of economic growth depends critically on improvements in physical capital, human capital, technology and techniques. These latter improvements combine to determine the rate of growth of productivity – which over the longer term is the main source of growth in potential GDP.

The economic cycle

Most estimates suggest that the UK has a trend rate of economic growth of 2.5 to 2.75% per annum. But the actual rate of economic growth tends to fluctuate around this trend rate.

The economy can only grow faster than trend without triggering higher inflation if there is spare capacity to be made use of. This develops during periods when demand for goods and services is less than the economy can deliver (ie growth is below trend) and some productive resources remain unused.

Periods when growth is below trend but still positive (as was the case in 2005 and is generally expected to be the case in 2008) are commonly known as economic slowdowns. If growth is below trend but negative (that is, GDP falls) there is said to be a recession (which the UK last suffered between 1990 and 1992).

At some point in a slowdown or recession the economy reaches a trough after which demand picks up again. Organisations can respond to this recovery by making use unused capacity. This enables the economy to grow faster than its long-run trend rate without encountering inflationary pressure until all the spare capacity is finally used up. At this point the economy will be achieving its potential GDP and only capable of sustaining 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.

Economic stability

The amount of spare capacity is measured by the gap at any given time between potential GDP and what is actually being achieved.

The estimated size of this output gap is thus one of several factors the Monetary Policy Committee (MPC) of the Bank of England takes into account when deciding the appropriate level of interest rates.

The MPC makes its decision independently of the government but is required to aim to ensure that the rate of inflation, as measured by the Consumer Price Index (CPI), stays close to 2% per annum. Another way of looking at the MPC’s role is to say that it aims to maintain economic stability – dampening the economic cycle by keeping growth in GDP in line with trend growth.

Human resources and the labour market

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 only be realised 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 wages and salaries (earnings). If demand is high relative to supply, earnings will rise. This will increase the cost of employing people (assuming no change in their productivity) demand for human resources will drop, causing earnings to adjust downward. If, by contrast, supply is high relative to demand, employment costs will fall giving a corresponding boost to demand.

By the end of 2007 there were, according to the ONS’ quarterly Labour Force Survey (LFS)¹, 29.40 million people in paid employment in the UK (74.7 per cent of the population of working age). At the same time there were 677,400 unfilled job vacancies and 1.61 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 lots of jobseekers. In recent years the UK labour market has tended to be quite tight but since 2005 has developed a bit more slack. The level of job vacancies has remained broadly stable while the number of people unemployed was higher at the end of 2007 than at the end of 2005 (when there were 1.58million unemployed). This indicates a rise in labour supply relative to demand (mainly due to an influx of migrant workers from central and eastern Europe). Consequently, the rate of growth of average earnings moderated from 4.4% per annum in January 2005 to 3.7% per annum in December 2007.

Frictional and cyclical unemployment

There will always be an amount of so-called frictional unemployment (commonly estimated at around 3-4% 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 rate of unemployment than this indicates that some human resources are going unused. At the end of 2007 the UK unemployment rate stood at 5.2%.

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 a while (normally about six to nine months) for a slowdown in demand for goods and services to translate into a fall in demand for labour. The unemployment that emerges in this way is called cyclical unemployment, the resulting slack being closely associated with the output gap (as discussed above).

Structural unemployment and labour market flexibility

In principle the existence of cyclical unemployment should cause the rate of growth of earnings to moderate and thereby create renewed demand for any unused human resources. Because of this the MPC closely monitors labour market indicators such as unemployment, vacancies and the rate of pay increases when making decisions on 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. This structural unemployment is more problematic than cyclical unemployment. Because it is 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 a cut in interest rates. The remedy is to make sure the labour market adjusts – that is to improve labour market flexibility.

Full employment

An economy operating at full capacity with no cyclical or structural unemployment is said to be at full employment. This situation was the close to 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 mass unemployment but the UK has since moved closer to full employment once again.

Full employment defined in this way implicitly assumes that everybody who can work or wants to work is participating in the labour market. However, while this might have been a reasonable assumption a generation ago, today there is a much higher number (7.9 million) and greater proportion (more than 1 in 5) of people of working age who don’t participate in the market, a group classified in official statistics as the ‘economically inactive’.

This suggests there is scope to raise the UK’s employment rate. According to the LFS, 2 million economically inactive people of working age wanted to work in 2007, which represents a substantial untapped reservoir of potential labour that organisations might potentially make use of.

Useful contacts

References

OFFICE FOR NATIONAL STATISTICS. Labour force survey. Quarterly. London: ONS. Available at: http://www.statistics.gov.uk/CCI/nscl.asp?ID=5006&x=6&y=8

Understanding the economy and labour market