Category: Economics: Ch 10

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Raising the minimum wage: its effects on poverty and employment

The first Budget of the new UK Labour government was announced on 30 October 2024. It contained a number of measures that will help to tackle inequality. These include extra spending on health and education. This will benefit households on lower incomes the most as a percentage of net income. Increases in tax, by contrast, will be paid predominantly by those on higher incomes. The Chart opposite (taken from the Budget Report) illustrates this. It shows that the poorest 10% will benefit from the largest percentage gain, while the richest 10% will be the only decile that loses.

But one of the major ways of tackling inequality and poverty was raising the minimum wage. The so-called ‘National Living Wage (NLW)’, paid to those aged 21 and over, will rise in April by 6.7% – from £11.44 to £12.41 per hour. The minimum wage paid to those aged 18 to 20 will rise 16.3% from £8.60 to £10.00 and for 16 and 17 year-olds and apprentices it will rise £18% from £6.40 to £7.55.

It has been an objective of governments for several years to relate the minimum wage to the median wage. In 2015, the Conservative Government set a target of raising the minimum wage rate to 60 per cent of median hourly earnings by 2020. When that target was hit a new one was set to reach two-thirds of median hourly earnings by 2024.

The Labour government has set a new remit for the minimum wage (NLW). There are two floors. The first is the previously agreed one, that the NLW should be at least two-thirds of median hourly earnings; the second is that it should fully compensate for cost of living rises and for expected inflation up to March 2026. The new rate of £12.41 will meet both criteria. According to the Low Pay Commission, ‘Wages have risen faster than inflation over the past 12 months, and are forecast to continue to do so up to March 2026’. This makes the first floor the dominant one: meeting the first floor automatically meets the second.

How effective is the minimum wage in reducing poverty and inequality?

Figure 1 shows the growth in minimum wage rates since their introduction in 1999. The figures are real figures (i.e. after taking into account CPI inflation) and are expressed as an index, with 1999 = 100. The chart also shows the growth in real median hourly pay. (Click here for a Powerpoint.)

As you can see, the growth in real minimum wage rates has considerably exceeded the growth in real median hourly pay. This has had a substantial effect on raising the incomes of the poorest workers and thereby has helped to reduce poverty and inequality.

The UK minimum wage compares relatively favourably with other high-income economies. Figure 2 shows minimum wage rates in 12 high-income countries in 2023 – the latest year for which data are available. (Click here for a PowerPoint.) The red bars (striped) show hourly minimum wage rates in US dollars at purchasing-power parity (PPP) rates. PPP rates correct current exchange rates to reflect the purchasing power of each country’s currency. The blue bars (plain) show minimum wage rates as a percentage of the median wage rate. In 2023 the UK had the fourth highest minimum wage of the 12 countries on this measure (59.6%). As we have seen above, the 2025 rate is expected to be 2/3 of the median rate.

Minimum wages are just one mechanism for reducing poverty and inequality. Others include the use of the tax and benefit system to redistribute incomes. The direct provision of services, such as health, education and housing at affordable rents can make a significant difference and, as we have seen, have been a major focus of the October 2024 Budget.

The government has been criticised, however, for not removing the two-child limit to extra benefits in Universal Credit (introduced in 2017). The cap clearly disadvantages poor families with more than two children. What is more, for workers on Universal Credit, more than half of the gains from the higher minimum wages will lost because they will result in lower benefit entitlement. Also the freeze in (nominal) personal income tax allowances will mean more poor people will pay tax even with no rise in real incomes.

Effects on employment: analysis

A worry about raising the minimum wage rate is that it could reduce employment in firms already paying the minimum wage and thus facing a wage rise.

In the case of a firm operating in competitive labour and goods markets, the demand for low-skilled workers is relatively wage sensitive. Any rise in wage rates, and hence prices, by this firm alone would lead to a large fall in sales and hence in employment.

This is illustrated in Figure 3 (click here for a PowerPoint). Assume that the minimum wage is initially the equilibrium wage rate We. Now assume that the minimum wage is raised to Wmin. This will cause a surplus of labour (i.e. unemployment) of Q3 – Q2. Labour supply rises from Q1 to Q3 and the demand for labour falls from Q1 to Q2.

But, given that all firms face the minimum wage, individual employers are more able to pass on higher wages in higher prices, knowing that their competitors are doing the same. The quantity of labour demanded in any given market will not fall so much – the demand is less wage elastic; and the quantity of labour supplied in any given market will rise less – the supply is less wage elastic. Any unemployment will be less than that illustrated in Figure 3. If, at the same time, the economy expands so that the demand-for-labour curve shifts to the right, there may be no unemployment at all.

When employers have a degree of monopsony power, it is not even certain that they would want to reduce employment. This is illustrated in Figure 4: click here for a PowerPoint (you can skip this section if you are not familiar with the analysis).

Assume initially that there is no minimum wage. The supply of labour to the monopsony employer is given by curve SL1, which is also the average cost of labour ACL1. A higher employment by the firm will drive up the wage; a lower employment will drive it down. This gives a marginal cost of labour curve of MCL1. Profit-maximising employment will be Q1, where the marginal cost of labour equals the marginal revenue product of labour (MRPL). The wage, given by the SL1 (=ACL1) line will be W1.

Now assume that there is a minimum wage. Assume also that the initial minimum wage is at or below W1. The profit-maximising employment is thus Q1 at a wage rate of W1.

The minimum wage can be be raised as high as W2 and the firm will still want to employ as many workers as at W1. The point is that the firm can no longer drive down the wage rate by employing fewer workers, and so the ACL1 curve becomes horizontal at the new minimum wage and hence will be the same as the MCL curve (MCL2 = ACL2). Profit-maximising employment will be where the MRPL curve equals this horizontal MCL curve. The incentive to cut its workforce, therefore, has been removed.

Again, if we extend the analysis to the whole economy, a rise in the minimum wage will be partly passed on in higher prices or stimulate employers to increase labour productivity. The effect will be to shift the (MRPL) curve upwards to the right, thereby allowing the firm to pass on higher wages and reducing any incentive to reduce employment.

Effects on employment: evidence

There is little evidence that raising the minimum wage in stages will create unemployment, although it may cause some redeployment. In the Low Pay Commission’s 2019 report, 20 years of the National Minimum Wage (see link below), it stated that since 2000 it had commissioned more than 30 research projects looking at the NMW’s effects on hours and employment and had found no strong evidence of negative effects. Employers had adjusted to minimum wages in various ways. These included reducing profits, increasing prices and restructuring their business and workforce.

Along with our commissioned work, other economists have examined the employment effects of the NMW in the UK and have for the most part found no impact. This is consistent with international evidence suggesting that carefully set minimum wages do not have noticeable employment effects. While some jobs may be lost following a minimum wage increase, increasing employment elsewhere offsets this. (p.20)

There is general agreement, however, that a very large increase in minimum wages will impact on employment. This, however, should not be relevant to the rise in the NLW from £11.44 to £12.41 per hour in April 2025, which represents a real rise of around 4.5%. This at worst should have only a modest effect on employment and could be offset by economic growth.

What, however, has concerned commentators more is the rise in employers’ National Insurance contributions (NICs) that were announced in the Budget. In April 2025, the rate will increase from 13.8% to 15%. Employers’ NICs are paid for each employee on all wages above a certain annual threshold. This threshold will fall in April from £9100 to £5000. So the cost to an employer of an employee earning £38 000 per annum in 2024/25 would be £38 000 + ((£38 000 – £9100) × 0.138) = £41 988.20. For the year 2025/26 it will rise to £38 000 + ((£38 000 – £5000) × 0.15) = £42 950. This is a rise of 2.29%. (Note that £38 000 will be approximately the median wage in 2025/26.)

However, for employees on the new minimum wage, the percentage rise in employer NICs will be somewhat higher. A person on the new NLW of £12.41, working 40 hours per week and 52 weeks per year (assuming paid holidays), will earn an annual wage of £25 812.80. Under the old employer NIC rates, the employer would have paid (£25 812.80 + (£25 812.80 – £9100) × 0.138) = £28 119.17. For the year 2025/26, it will rise to £25 812.80 + ((£25 812.80 – £5000) × 0.15) = £28 934.72. This is a rise of 2.90%.

This larger percentage rise in employers’ wage costs for people on minimum wages than those on median wages, when combined with the rise in the NLW, could have an impact on the employment of those on minimum wages. Whether it does or not will depend on how rapid growth is and how much employers can absorb the extra costs through greater productivity and/or passing on the costs to their customers.

Articles

UK Government reports and information

Data

Questions

  1. How is the October 2024 Budget likely to affect the distribution of income?
  2. What are the benefits and limitations of statutory minimum wages in reducing (a) poverty and (b) inequality?
  3. Under what circumstances will a rise in the minimum wage lead or not lead to an increase in unemployment?
  4. Find out what is meant by the UK Real Living Wage (RLW) and distinguish it from the UK National Living Wage (NLW). Why is the RLW higher?
  5. Why is the median wage rather than the mean wage used in setting the NLW?
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Risk aversion in late-cycle slowing economies: the US experience

In recent months there has been growing uncertainty across the global economy as to whether the US economy was going to experience a ‘hard’ or ‘soft landing’ in the current business cycle – the repeated sequences of expansion and contraction in economic activity over time. Announcements of macroeconomic indicators have been keenly anticipated for signals about how quickly the US economy is slowing.

Such heightened uncertainty is a common feature of late-cycle slowing economies, but uncertainty now has been exacerbated because it has been a while since developed economies have experienced a business cycle like the current one. The 21st century has been characterised by low inflation, low interest rates and recessions caused by various types of crises – a stock market crisis (2001), a banking crisis (2008) and a global pandemic (2020). In contrast, the current cycle is a throwback to the 20th century. The high inflation and the ensuing increases in interest rates have produced a business cycle which echoes the 1970s. Therefore, few investors have experience of such economic conditions.

The focus for investors during this stage of the cycle is when the slowing economy will reach the minimum. They will also be concerned with the depth of the slowdown: will there still be some growth in income, albeit low; or will the trough be severe enough to produce a recession, and, if so, how deep? Given uncertainty around the length and magnitude of business cycles, this leads to greater risk aversion among investors. This affects reactions to announcements of leading and lagging macroeconomic indicators.

This blog examines what sort of economic conditions we should expect in a late-cycle economy. It analyses the impact this has had on investor behaviour and the ensuing dynamics observed in financial markets in the USA.

The Business Cycle


The business cycle refers to repeated sequences of expansion and contraction (or slowdown) in economic activity over time. Figure 1 illustrates a typical cycle. Typically, these sequences include four main stages. In each one there are different effects on consumer and business confidence:

  • Expansion: During this stage, the economy experiences growth in GDP, with incomes and consumption spending rising. Business and consumer confidence are high. Unemployment is falling.
  • Peak: This is the point at which the economy reaches its maximum output, but growth has ceased (or slowed). At this stage, inflationary pressures peak as the economy presses against potential output. This tends to result in tighter monetary policy (higher interest rates).
  • Slowdown: The higher interest rates raise the cost of borrowing and reduce consumption and investment spending. Consumption and incomes both slow or fall. (Figure 1 illustrates the severe case of falling GDP (negative growth) in this stage.) Unemployment starts rising.
  • Trough: This is the lowest point of the cycle, where economic activity bottoms out and the economy begins to recover. This can be associated with slow but still rising national income (a soft landing) or national income that has fallen (a hard landing, as shown in Figure 1).

While business cycles are common enough to enable such characterisation of their temporal pattern, their length and magnitude are variable and this produces great uncertainty, particularly when cycles approach peaks and troughs.

As an economy’s cycle approaches a trough, such as US economy’s over the past few months, uncertainty is exacerbated. The high interest rates used to tackle inflation will have increased borrowing costs for businesses and consumers. Access to credit may have become more restricted. Profit margins are reduced, especially for industrial sectors sensitive to the business cycle, reducing expected cash flows.

The combination of these factors can increase the risk of a recession, producing greater volatility in financial markets. This manifests itself in increased risk aversion among investors.

Utility theory suggests that, in general, investors will exhibit loss aversion. This means that they do not like bearing risk, fearing that the return from an investment may be less than expected. In such circumstances, investors need to be compensated for bearing risk. This is normally expressed in terms of expected financial return. To bear more risk, investors require higher levels of return as compensation.

As perceptions of risk change through the business cycle, so this will change the return investors will require from the financial instruments they hold. Perceived higher risk raises the return investors will require as compensation. Conversely, lower perceived risk decreases the return investors expect as compensation.

Investors’ expected rate of return is manifested in the discount rate that they use to value the anticipated cash flows from financial instruments in discounted cash flow (DCF) analysis. Equation 1 is the algebraic expression of the present-value discounted series of cash flows for financial instruments:

 
 
Where:
V = present value
C = anticipated cash flows in each of time periods 1, 2, 3, etc.
r = expected rate of return

For fixed-income debt securities, the cash flow is constant, while for equity securities (shares), expectations regarding cash flows can change.

Slowing economies and risk aversion

In a slowing economy, with great uncertainty about the scale and timing of the bottom of the cycle, investors become more risk averse about the prospects of firms. This this leads to higher risk premia for financial instruments sensitive to a slowdown in economic activity.

This translates into a higher expected return and higher discount rate used in the valuation of these instruments (r in equation 1). This produces decreases in perceived value, decreased demand and decreased prices for these financial instruments. This can be observed in the market dynamics for these instruments.

First, there may be a ‘flight to safety’. Investors attach a higher risk premium to risker financial instruments, such as equities, and seek a ‘safe-haven’ for their wealth. Therefore, we should observe a reorientation from more risky to less risky assets. Demand for equities falls, while demand for safer assets, such as government bonds and gold, rises.

There is some evidence for this behaviour as uncertainty about the US economic outlook has increased. Gold, long seen as a hedge against market decline, is at record highs. US Government bond prices have risen too.

To analyse whether this may be a flight to safety, I analysed the correlation between the daily US government bond price (5-year Treasury Bill) and share prices represented by the two more significant stock market indices in the USA: the S&P 500 and the Nasdaq Composite. I did this for two different time periods. Table 1 shows the results. Panel (a) shows the correlation coefficients for the period between 1 May 2024 and 31 July 2024; Panel (b) shows the correlation coefficients for the period between 1 August 2024 and 9 September 2024.

In the period between May and July 2024, the 5-year Treasury Bill and share price indices had significantly positive correlations. When share prices rose, the Treasury Bill’s price rose; when share prices fell, the bill’s price fell. During that period, expectations about falling interest rates dominated valuations and that effected the valuations of all financial instruments in the same way – lower expected interest rates reduce the opportunity cost of holding instruments and reduces the expected rates of return. Hence, the discount rate applied to cash flows is reduced, and present value rises. The opposite happens when macroeconomic indicators suggest that interest rates will stay high (ceteris paribus).

As the summer proceeded, worries about a ‘hard landing’ began to concern investors. A weak jobs report in early August particularly exercised markets, producing a ‘flight to safety’. Greater risk aversion among investors meant that they expect a higher return from equities. This reduced perceived value, reducing demand and price (ceteris paribus). To insulate themselves from higher risk, investors bought safer assets, like government bonds, thereby pushing up their prices. This behaviour was consistent with the significant negative correlation observed between US government debt prices and the S&P 500 and Nasdaq indices in Panel (b).

Another signal of increased risk aversion among investors is ‘sector rotation’ in their equity portfolios. Increased risk aversion among investors will lead them to divest from ‘cyclical’ companies. Such companies are in industrial sectors which are more sensitive to the changing economic conditions across the business cycle – consumer discretionary and communication services sectors, for example. To reduce their exposure to risk, investors will switch to ‘defensive’ sectors – those less sensitive to the business cycle. Examples include consumer staples and utility sectors.

Cyclical sectors will suffer a greater adverse impact on their cash flows and risk in a slowing economy. Consequently, investors expect higher return as compensation. This reduces the value of those shares. Demand for them falls, depressing their price. In contrast, defensive sectors will be valued more. They will see an increase in demand and price. This sector rotation seems to have happened in August (2024). Figure 2 shows the percentage change between 1 August and 9 September 2024 in the S&P 500 index and four sector indices, comprising companies from the communication services, consumer discretionary, consumer staples and utilities sectors.


Overall, the S&P 500 index was slightly higher, as shown by the first bar in the chart. However, while the cyclical sectors experienced decreases in their share prices, particularly communication services, the defensive companies experienced large price increases – nearly 3% for utilities and over 6% for consumer staples.

Conclusion

Economies experience repeated sequences of expansion and contraction in economic activity over time. At the moment, the US economy is approaching the end of its current slowing phase. Increased uncertainty is a common feature of late-cycle economies and this manifests itself in heightened risk aversion among investors. This produces certain dynamics which have been observable in US debt and equity markets. This includes a ‘flight to safety’, with investors divesting risky financial instruments in favour of safer ones, such as US government debt securities and gold. Also, investors have been reorientating their equity portfolios away from cyclicals and towards defensive securities.

Articles

Data

Questions

  1. What is risk aversion? Sketch an indifference curve for a risk-averse investor, treating expected return and risk as two-characteristics of a financial instrument.
  2. Show what happens to the slope of the indifference curve if the investor becomes more risk averse.
  3. Using demand and supply analysis, illustrate and explain the impact of a flight to safety on the market for (i) company shares and (ii) US government Treasury Bills.
  4. Use economic theory to explain why the consumer discretionary sector may be more sensitive than the consumer staples sector to varying incomes across the economic cycle.
  5. Research the point of the economic cycle that the US economy has reached as you read this blog. What is the relationship between bond and equity prices? Which sectors have performed best in the stock market?
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The economics of ‘greeniums’ in sustainable finance: doing good has a price

Sustainability has become one of the most pressing issues facing society. Patterns of human production and consumption have become unsustainable. On the environmental front, climate change, land-use change, biodiversity loss and depletion of natural resource are destabilising the Earth’s eco-system.

Furthermore, data on poverty, hunger and lack of healthcare show that many people live below minimum social standards. This has led to greater emphasis being placed on sustainable development: ‘development that meets the needs of the present without compromising the ability of future generations to meet their own needs’ (The Brundtland Report, 1987: Ch.2, para. 1).

The financial system has an important role to play in channelling capital in a more sustainable way. Since current models of finance do not consider the welfare of future generations in investment decisions, sustainable finance has been developed to analyse how investment and lending decisions can manage the trade-off inherent in sustainable development: sacrificing return today to enhance the welfare of future generations.

However, some commentators argue that such trade-offs are not required. They suggest that investors can ‘do well by doing good’. In this blog, I will use ‘green’ bonds (debt instruments which finance projects or activities with positive environmental and social impacts) to explain the economics underpinning sustainable finance and show that doing good has a price that sustainable investors need to be prepared to pay.

I will analyse why investors might not be doing so and point to changes which may be required to ensure financial markets channel capital in a way consistent with sustainable development.

The growth of sustainable finance

Sustainable finance has grown rapidly over the past decade as concerns about climate change have intensified. A significant element of this growth has been in global debt markets.

Figure 1 illustrates the rapid growth in the issuance of sustainability-linked debt instruments since 2012. While issuance fell in 2022 due to concerns about rising inflation and interest rates reducing the real return of fixed-income debt securities, it rebounded in 2023 and is on course for record levels in 2024. (Click here for a PowerPoint.)

Green bonds are an asset class within sustainability-linked debt. Such bonds focus on financing projects or activities with positive environmental and social impacts. They are typically classified as ‘use-of-proceeds’ or asset-linked bonds, meaning that the proceeds raised from their issuance are earmarked for green projects, such as renewable energy, clean transportation, and sustainable agriculture. Such bonds should be attractive to investors who want a financial return but also want to finance investments with a positive environmental and/or social impact.

One common complaint from commentators and investors is the ‘greenium’ – the price premium investors pay for green bonds over conventional ones. This premium reduces the borrowing costs of the issuers (the ‘counterparties’) compared to those of conventional counterparties. This produces a yield advantage for issuers of green bonds (price and yield have a negative relationship), reducing their borrowing costs compared to issuers of conventional bonds.

An analysis by Amundi in 2023 using data from Bloomberg estimated that the average difference in yield in developed markets was –2.2 basis points (–0.022 percentage points) and the average in emerging markets was –5.6 basis points (–0.056 percentage points). Commentators and investors suggest that the premium is a scarcity issue and once there are sufficient green bonds, the premium over non-sustainable bonds should disappear.

However, from an economics perspective, such interpretations of the greenium ignore some fundamentals of economic valuation and the incentives and penalties through which financial markets will help facilitate more sustainable development. Without the price premium, investors could buy sustainable debt at the same price as unsustainable debt, earn the same financial return (yield) but also achieve environmental and social benefits for future generations too. Re-read that sentence and if it sounds too good to be true, it’s because it is too good to be true.

‘There is no such thing as a free lunch’

In theory, markets are institutional arrangements where demand and supply decisions produce price signals which show where resources are used most productively. Financial markets involve the allocation of financial capital. Traditional economic models of finance ignore sustainability when appraising investment decisions around the allocation of capital. Consequently, such allocations do not tend to be consistent with sustainable development.

In contrast, economic models of sustainable finance do incorporate such impacts of investment decisions and they will be reflected in the valuation, and hence pricing, of financial instruments. Investors, responding to the pricing signals will reallocate capital in a more sustainable manner.

Let’s trace the process. In models of sustainable finance, financial instruments such as green bonds funding investments with positive environmental impacts (such as renewable energy) should be valued more, while instruments funding investments with negative environmental impacts (such as fossil fuels) should be valued less. The prices of the green bonds financing renewable energy projects should rise while the prices of conventional bonds financing fossil-fuel companies should fall.

As this happens, the yield on the green bonds falls, lowering the cost of capital for renewable-energy projects, while yields on the bonds financing fossil-fuel projects rise, ceteris paribus. As with any market, these differential prices act as signals as to where resources should be allocated. In this case, the signals should result in an allocation consistent with sustainable development.

The fundamental point in this economic valuation is that sustainable investors should accept a trade-off. They should pay a premium and receive a lower rate of financial return (yield) for green bonds compared to conventional ones. The difference in price (the greenium), and hence yield, represents the return investors are prepared to sacrifice to improve future generations’ welfare. Investors cannot expect to have the additional welfare benefit for future generations reflected in the return they receive today. That would be double counting. The benefit will accrue to future generations.

A neat way to trace the sacrifice sustainable investors are prepared to make in order to enhance the welfare of future generations is to plot the differences in yields between green bonds and their comparable conventional counterparts. The German government has issued a series of ‘twin’ bonds in recent years. These twins are identical in every respect (coupon, face value, credit risk) except that the proceeds from one will be used for ‘green’ projects only.

Figure 2 shows the difference in yields on a ‘green bond’ and its conventional counterpart, both maturing on 15/8/2050, between June 2021 and July 2024. The yield on the green bond is lower – on average about 2.2 basis points (0.022 percentage points) over the period. This represents the sacrifice in financial return that investors are prepared to trade off for higher environmental and social welfare in the future. (Click here for a PowerPoint.)

The yield spread fluctuates through time, reflecting changing perceptions of environmental concerns and hence the changing value that sustainable investors attach to future generations. The spread tends to widen when there are heightened environmental concerns and to narrow when such concerns are not in the news. For example, the spread on the twin German bonds reached a maximum of 0.045 percentage points in November 2021. This coincided with the 26th UN Climate Change Conference of the Parties (COP26) in Glasgow. The spread has narrowed significantly since early 2022 as rising interest rates and falling real rates of return on bonds in the near-term seem to have dominated investors’ concerns.

These data suggest that, rather than being too large, the greeniums are too small. The spreads suggest that markets in debt instruments do not seem to attach much value to future generations. The valuation, price and yield of green bonds are not significantly different from their conventional counterparts. This narrow gap indicates insufficient reward for better sustainability impact and little penalty for worse sustainability impact.

This pattern is repeated across financial markets and does not seem to be stimulating the necessary investment to achieve sustainable development. An estimate of the scale of the deficit in green financing is provided by Bloomberg NEF (2024). While global spending on the green energy transition reached $1.8 trillion in 2023, Bloomberg estimates that $4.8 trillion needs to be invested every year for the remainder of this decade if the world is to remain on track under the ‘net zero’ scenario. Investors do not seem to be prepared to accept the trade-off needed to provide the necessary funds.

Can financial markets deliver sustainable development?

Ultimately, the hope is that all financial instruments will be sustainable. In order to achieve that, access to finance would require all investors to incorporate the welfare of future generations in their investment decisions and accept sacrificing sufficient short-term financial return to ensure long-term sustainable development. Unfortunately, the pricing of green bonds suggests that investors are not prepared to accept the trade-off. This restricts the ability of financial markets to deliver an allocation of resources consistent with sustainable development.

There are several reasons why financial markets may not be valuing the welfare of future generations fully.

  • Bounded rationality means that it is difficult for sustainable investors to assign precise values to future and distant benefits.
  • There are no standardised sustainability metrics available. This produces great uncertainty in the valuation of future welfare.
  • Investors also exhibit cognitive biases, which means they may not value the welfare of future generations properly. These include present bias (favouring immediate rewards) and hyperbolic discounting (valuing the near future more than the distant future).
  • Economic models of financial valuation use discount rates to assess the value of future benefits. Higher discount rates reduce the perceived value of benefits occurring in the distant future. As a result, long-term impacts (such as environmental conservation) may be undervalued.
  • There may be large numbers of investors who are only interested in financial returns and so do not consider the welfare of future generations in their investment decisions.

Consequently, investors need to be educated about the extent of trade-offs required to achieve the necessary investments in sustainable development. Furthermore, practical models which better reflect the welfare of future generations in investment decisions need to be employed. However, challenges persist in fully accounting for future generations and it may need regulatory frameworks to provide appropriate incentives for effective sustainable investment.

Articles

Report

Data

Questions

  1. Using demand and supply analysis, illustrate and explain the impact of sustainable investing on the markets for (i) green bonds and (ii) conventional bonds. Highlight how this should produce an allocation of finance capital consistent with sustainable development.
  2. Research the yields on the twin bonds issued by Germany since this blog was published. Can you identify any association between heightened environmental concerns and the spread between the ‘green’ and conventional bond?
  3. Analyse the issues which prevent financial markets from producing the pricing signals which produce an allocation of resources consistent with sustainable development.
  4. Research some potential regulatory policies which may provide appropriate incentives for sustainable investment.
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Getting real with pay

In the first of a series of updated blogs focusing on the importance of the distinction between nominal and real values we look at the issue of earnings. Here we update the blog Getting Real with Pay written back in February 2019. Then, we noted how the macroeconomic environment since the financial crisis of the late 2000s had continued to affect people’s pay. Specifically, we observed that there had been no growth in real or inflation-adjusted pay. In other words, people were no better off in 2019 than in 2008.

In this updated blog, we consider to what extent the picture has changed five years down the line. While we do not consider the distributional impact on pay, the aggregate picture nonetheless continues to paint a very stark picture, with consequences for living standards and financial wellbeing.

While the distinction between nominal and real values is perhaps best known in relation to GDP and economic growth, the distinction is also applied frequently to analyse the movement of one price relative to prices in general. One example is that of movements in pay (earnings) relative to consumer prices.

Pay reflects the price of labour. The value of our actual pay is our nominal pay. If our pay rises more quickly than consumer prices, then our real pay increases. This means that our purchasing power rises and so the volume of goods and services we can afford increases. On the other hand, if our actual pay rises less quickly than consumer prices then our real pay falls. When real pay falls, purchasing power falls and the volume of goods and services we can afford falls.

Figures from the Office for National Statistics show that in January 2000 regular weekly pay (excluding bonuses and before taxes and other deductions from pay) was £293. By April 2024 this had risen to £640. This is an increase of 118 per cent. Over the same period, the consumer prices index known as the CPIH, which, unlike the better-known CPI, includes owner-occupied housing costs and council tax, rose by 82 per cent. Therefore, the figures are consistent with a rise both in nominal and real pay between January 2000 to April 2024. However, this masks a rather different picture that has emerged since the global financial crisis of the late 2000s.

Chart 1 shows the annual percentage changes in actual (nominal) regular weekly pay and the CPIH since January 2001. Each value is simply the percentage change from 12 months earlier. The period up to June 2008 saw the annual growth of weekly pay outstrip the growth of consumer prices – the blue line in the chart is above the red dashed line. Therefore, the real value of pay rose. However, from June 2008 to August 2014 pay growth consistently fell short of the rate of consumer price inflation – the blue line is below the red dashed line. The result was that average real weekly pay fell. (Click here to download a PowerPoint copy of the chart.)

Chart 2 show the average levels of nominal and real weekly pay. The real series is adjusted for inflation. It is calculated by deflating the nominal pay values by the CPIH. Since the CPIH is a price index whose value averages 100 across 2015, the real pay values are at constant 2015 consumer prices. From the chart, we can see that the real value of weekly pay peaked in April 2008 at £473 at 2015 prices. The subsequent period saw rates of pay increases that were lower than rates of consumer price inflation. This meant that by March 2014 the real value of weekly pay had fallen by 6.3 per cent to £443 at 2015 prices. (Click here to download a PowerPoint copy of the chart.)

Although real (inflation-adjusted) pay recovered a little after 2014, 2017 again saw consumer price inflation rates greater than those of pay inflation (see Chart 1). This meant that at the start of 2018 real earnings were 3.2 per cent lower than their 2008-peak (see Chart 2). Real earnings then began to recover, buoyed by the economic rebound following the relaxation of COVID lockdown measures and increasing staffing pressures. Real earnings finally passed their 2008-peak in August 2020. By April 2021 regular weekly pay reached £491 at 2015 prices which was 3.8 per cent above the pre-global financial crisis peak.

However, the boost to real wages was to be short-lived as inflationary pressures rose markedly. While some of this was attributable to the same pressures that were driving up wages, inflationary pressures were fuelled further by the commodity price shock arising from Russia’s invasion of Ukraine and, in particular, its impact on energy prices. This saw the CPIH inflation rate rise to 9.6 per cent in October 2022 (while the CPI inflation rate peaked in the same month at 11.1 per cent). The result was that real weekly earnings fell by 2.7 per cent between January and October 2022 to stand at £471 at 2015 consumer prices. Consequently, average pay was once again below its pre-global financial crisis level.

Although inflationary pressures have recently weakened and real earnings have begun to recover, real regular weekly earnings in April 20024 (£486 at 2015 prices) were a mere 2.7 per cent higher than back in the first half of 2008. This compares to a nominal increase of around 58 per cent over the same period thereby demonstrating the importance of the distinction between nominal and real values in understanding what developments in pay mean for the purchasing power of households.

Chart 3 reinforces the importance of the nominal-real distinction. It shows nicely the sustained period of real pay deflation (negative rates of pay inflation) that followed the financial crisis, and the significant rates of real pay deflation associated with the recent inflation shock.

The result is that since June 2008 the average annual rate of growth of real regular weekly pay has been 0.1 per cent, despite nominal pay increasing at an annual rate of 2.9 per cent. In contrast, the period from January 2001 to May 2008 saw real regular weekly pay grow at an annual rate of 2.1 per cent with nominal pay growing at an annual rate of 4.0 per cent. (Click here to download a PowerPoint copy of the chart.)

If we think about the growth of nominal earnings, we can identify two important determinants.

The first is the expected rate of inflation. Workers will understandably want wage growth at least to match the growth in prices so as to maintain their purchasing power.

The second factor is the growth in labour productivity. Firms will be more willing to grant pay increases if workers are more productive, since productivity helps to offset pay increases and maintain firms’ profit margins. Consequently, since over time the actual rate of inflation will tend to mirror the expected rate, the growth of real pay is closely related to the growth of labour productivity. This is significant because, as John discusses in his blog The Productivity Puzzle (14 April 2024), labour productivity growth in the UK, as measured by national output per worker hour, has stalled since the global financial crisis.

Understanding the stagnation of real earnings therefore nicely highlights the interconnectedness of economic variables. In this case, it highlights the connections between productivity, levels of investment and people’s purchasing power. It is not surprising, therefore, that the stagnation of both real earnings and productivity growth since the global financial crisis have become two of the most keenly debated macroeconomic issues of recent times. Indeed, it is likely that their behaviour will continue to shape macroeconomic debates and broader conversations around government policy for some time.

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Questions

  1. Using the examples of both GDP and earnings, explain how the distinction between nominal and real relates to the distinction between values and volumes.
  2. In what circumstances would an increase in actual pay translate into a reduction in real pay?
  3. In what circumstances would a decrease in actual pay translate into an increase in real pay?
  4. What factors might explain the reduction in real rates of pay seen in the UK following the financial crisis of 2007–8?
  5. Of what importance might the growth in real rates of pay be for consumption and aggregate demand?
  6. Why is the growth of real pay an indicator of financial well-being? What other indicators might be included in measuring financial well-being?
  7. Assume that you have been asked to undertake a distributional analysis of real earnings since the financial crisis. What might be the focus of your analysis? What information would you therefore need to collect?