This article was first published on  ConservativeHome following the original version on IEA Insider

The existing economic framework of the United Kingdom begs an important question.

Does it comply with critical criteria laid down in the seminal 1960s work of Robert Mundell on optimal currency areas (OCAs). Mundell’s suggested that if shocks, both endogenous and exogenous, emerged at a regional level, differentials in the market price of factors of production (labour, raw materials etc) should emerge. Price differentials encourage factor movement into or out of the region concerned, thus gradually re-equilibrating the overall economy of a common currency area.

Superficially, the UK appears to comply with the tenents of an OCA, (arguably more so than in the European currency union where a single market allowing free trade in services has yet to be fully implemented).

Throughout the UK, labour, capital, goods and services are permitted to flow freely. Despite this, contrary to theoretical expectations, there are (very) long standing regional economic imbalances. Before, and particularly in the decades following WW2, governments of all persuasions, sought to respond to the problem with often elaborate regional policies. These policies, usually transient, were hugely varied and at different times involved extreme restrictions even limiting office development in south east England, and payroll tax-subsidy scheme that discriminated in favour of regional manufacturing (the Selective Employment Tax). There were also many mundane, run-of-the-mill type measures including subsidising the provision of factories and providing generous transport infrastructure in the lagging regions.

Regional assistance policies, in their varied forms with varying emphasis, have been applied for well over 75 years, and have had some success in equilibrating core rates of economic activity.

However, for good reason, the ‘levelling up’ agenda remains a strong policy goal in Westminster. Economic activity rates continue to lag significantly the national average in Wales, Northeast England, and in N.I. Scotland, on the other hand, once considered a markedly lagging regional economy, was boosted particularly by the discovery and development of a natural resource, hydrocarbons in the 1960s onwards. Its activity rates converged on the English average albeit after substantial fiscal transfers, largely through a block grant, that started in the late 1970s.

The continuation of regional imbalances elsewhere should not come as a surprise, however. There is a basic flaw in the design of policy, indeed, a fundamental contradiction, taking with one hand whilst giving with the other. Although economic agents are permitted to flow freely throughout the UK, the essential control mechanism directing this flow, the spatially differentiated level of prices, is severely compromised and distorted, particularly by state intervention in labour markets. The State confuses and confounds the system of price signals that are essential for the efficient working of the equilibrating process.

It does this, for example by setting public sector pay nationally thus in some regions renumerating employees to an extent that is in excess of broadly private sector equivalents, and vice versa as shown in a recent carefully considered analysis of hourly pay rates undertaken by the Institute for Fiscal studies (see Figure 1). Although the public/private wage disparity is much reduced compared with two decades ago, the differences remain marked, being more than 5 per cent higher in Scotland and the North East region. In addition, there are other job attributes, such as pensions and job security, to consider which also tend to favour public sector employment.



Figure 1: Public sector pay differential conditional on workers’ characteristics, by UK region and nation

Source: IFS Report 334

Note: The differential is calculated controlling for age, education, experience and region, all interacted with sex, and interactions between education and experience. Figures are for hourly pay and exclude pension contributions.

Given that public employment accounts for a sizeable proportion of regional totals, generally between one-fifth and a quarter in the afore mentioned regions, when public sector wages exceed those in the private sector, the effect is to benchmarks wage rates for the latter. Consequently, private sector renumeration is inflated above its otherwise naturally occurring level. In turn, the overpriced labour market deters inward private investment and thereby reduces regional economic growth. It is an imposed market distortion which cannot be corrected by exchange rate movements in view of the UKs common currency area. Although inflated public sector wages might boost local spending-power and thus regional economies, such an outcome for the same level of expenditure can be achieved more effectively by adding to a block grant leaving wage rates generally at market clearing levels.

Labour market intervention is an important but far from only way the state distorts regional pricing signals, wholesale energy prices are another. But as matters stand the natural resource advantages of the north (in this instance potentially cheaper labour) are nullified by contradictory policies that for the purposes of the ‘levelling up’ agenda resemble trying to push water uphill.

 

David Starkie is an Economist and a member of the Advisory Committee of the IEA. His latest book is ‘Airport Enterprises: An Economic Analysis’.