Human Capital, Productivity, and Brexit
by George Hatjoullis
On February 27, 2017, the Ogden Rate was cut from 2.5% to -0.75%. This sent a shock wave through the share prices of UK insurance companies. In practical terms it raises the lump sum compensation payments made by insurance companies and other entities with liability for personal injury (e.g. NHS). Lump sum payments assume a life expectancy and a rate at which payments today can be invested on risk free terms. The rate of 2.5% has long been too high. It is debateable that -0.75% is an appropriate long run rate. The outcome will be higher premiums for policies that pay out on personal injury and greater taxpayer costs where public liability for personal injury is involved (NHS). However, this is only of passing interest.
The Ogden rate reminds us of the importance of interest rates in valuing human capital. The latter is a rather unsavoury and dehumanizing term but nevertheless some version of it is analytically necessary. Human beings are more than their productivity but, unless they can live off the productivity of others, their productivity is a necessary condition for being able to continue as humans. With a population of 7.6 billion people living off the bounty of nature is no longer an option for humanity. Their productivity also sets their standard of living. Low interest rates have raised the value of this productivity. They have raised the value of human capital.
If the correct discount rate for the future income stream of a human is -0.75% then a pound tomorrow is worth more than a pound today. To illustrate, if the discount rate was 1% p.a. then £1 in a year is worth 99p today. You can invest 99p at 1% and receive your pound in a year. If the discount rate is -0.75% then a pound in a year is worth £1.0076 today. You would need this today to achieve £1 in a year at -0.75%. Sounds odd but this is now embedded in the valuation of human capital thanks to Liz Truss. What are the other practical implications?
Clearly, a secure job paying a decent wage is more valuable. Any liability to you based on the wage ( a company pension) is more valuable. Any liability to you from the state aka the taxpayer (a state pension) is more valuable. Even job seekers allowance is more valuable. The lowering of the Ogden rate made everyone richer in terms of the present value of their human capital. Low interest rates have not just raised land prices. They have raised the value of human capital. Wages may not have been rising very fast but the value of those wages has risen more than individuals might explicitly grasp. How is labour market behaviour affected?
The first thing to note is that the importance of job security is enhanced. In a world of high interest rates risky job behaviour makes more sense if the pay is commensurate. If you earn a lot over a shorter career it is easier to live off savings if real interest rates are high. In a world of negative real interest rates a secure job is worth more than money in the bank. Perhaps this partly explains the mild labour behaviour that is being observed. In a sense, low-interest rates are reinforcing slow wage growth.
The second thing to note is that investment in human capital looks attractive. Of course bad investment is never attractive. Investment that enhances ones employability, pay, and job security is worth considering. Professional qualifications and training payoff better than general education qualifications. Professionalization of a function usually involves a barrier to entry which enhances the prospects of those admitted. This has always been true but takes on a new significance when real interest rates are negative.
The third thing to note is that the higher value of human capital has it corollary in higher costs of employment. Employees have rights which amount to an employer liability. This liability has gone up in value. It is thus inevitable that employers seek to minimise this contingent liability by changing the contractual relationship between employer and employee. The rise of zero-hour contracts and self-employed contractors, and the demise of defined benefit pension schemes, are all aspects of this changing relationship. Low interest rates are not the only explanatory variable but they are a vital part of the explanation.
One of the conundrums of recent years has been measured low productivity in the UK. The technology to save labour is there but has not yet been integrated sufficiently. One of the reasons has been the new contractual relations between employee and employer. Labour is a flexible cost under these arrangements. Employment can be varied with demand and there is no expensive employment liability attached. Artificial intelligence has a high fixed capital cost. It is a bigger commitment and needs more certainty of demand to justify. There is strong social pressure to end the more flexible contractual arrangements between employer and employee. If this happens then the relative attractiveness of artificial intelligence will be enhanced, especially given the now negative discount rate for human capital. Productivity should jump in the UK simply by banning zero-hour contracts and reintroducing employee rights for all. Of course, this will have consequences for employment.
The timing for acting on zero-hours contracts may be propitious. Brexit seems inevitable and a hard one at that. If there is a labour force shock (which is the primary hope of the leave voters) then abolishing zero-hour working and encouraging the introduction of AI working systems may simultaneously improve employee working conditions and productivity with minimal employment costs. This may be a silver lining in the Brexit cloud. The situation is of course much more complex than I have painted here but there is some validity in this outline.