As we enter the year 2012, most developed countries are seeing a positive sign. Their unemployment rates are dropping. To be sure, they are not dropping fast enough and it will still be a very long time before real improvements are made. However, provided you are not living in a country going through IMF restructuring (Greece, Spain, Portugal and Ireland), the future looks better than the past.

With one notable and, to many, surprising exception: The United Kingdom. British unemployment continued to rise throughout 2011 and it now tops 8.3%. 1 I wondered, why is this happening? Of course most news articles and economic analyses blame the Eurozone crisis. Europe is Britain’s largest trading partner and if the EU gets sick, Britain gets sick too. It’s a convenient argument; timely, topical and it sounds good over a few beers.

Unfortunately, it’s dead wrong.

The EU crisis is not the cause of Britain’s unemployment.
There are two easy to spot reasons why this argument is wrong:
1) Britain is a net Importer from the EU, that means that Britain imports more from EU countries than it sells to EU countries. 2 Since the UK buys more than it sells to the EU, the EU crisis should not overwhelm the UK economy. That does not mean there is no effect. There are some effects and they are being seen; according to the latest data, recent British exports to the EU have dropped about 3% 3. However, a 3% drop in the 3^rd Quarter’s exports does not make national unemployment rise for the entire year. Exports do not affect an economy retroactively.

2) Britain in comparison to Germany. Unlike the UK, Germany is a net Exporter to the EU. Germany is not a service economy like Britain, it is an export driven economy and while the Germans sell plenty everywhere, the EU forms the core of Germany’s export machine. Thus, Germany has also been experiencing the effects of reduced exports to the EU. In fact, Germany’s exports to the EU have dropped close to 4%, even more than Britain’s 4.
This makes sense; an ailing EU should have a much more pronounced effect on German exports than British. However, despite this drop in exports, Germany’s unemployment rate has been going down all year, even after the darkest days of the EU crisis. 5

So Germany’s exports go down more but unemployment also goes down? Britain’s exports drop less but unemployment goes up?  This does not add up.
Clearly, the EU crisis is not the reason. It’s not helping of course but facts are facts and these facts are clear and indisputable.

I suspect there something else at work, something in the UK economy itself.

I have been to the UK twice in the last 3 years. I think it’s a charming place and the people are lovely. I really mean that, I like the UK, a lot.  After my second visit though, I started incorporating into some of my lessons a simple little diagram when explaining something that I noticed while in London.  It seemed to me that London had two labor levels, a top level and a bottom level. Those at the top, with higher standards of living worked for, or peripheral to, either government or finance. The rest, the bottom level worked in much lower paying jobs centered on sales (retail or business), service or repair.  To sum this up in a simple way I started drawing a chart that looked similar to this:

Government Employment                                              Financial Services
Government sponsored contracts

Retail + Sales                                                               Services or Repair

The blank box symbolized the middle, the part of the economy that I simply never saw. The part of the economy that actually produced something or was in some way related to the production of something, even if it was an ink pen. Producing a pen requires multiple market segments: chemicals, plastics, metal stamping, paper manufacture, graphic design, printing, packaging, etc. In other words, a company that produces a pen supports other companies that produce other things, such as the package the pen comes in, or the chemical company that makes the ingredients for the ink.

Interestingly, everything I saw in the UK was made somewhere else, the tea boilers, the washing machines, the phones, even the pens and pencils.
(Food is the exception of course, the UK, much like the US, makes a lot of packaged food.)

Over time I discovered that everyone I met in the UK fell into one of the ‘big four’ labor categories I described above. The well off worked in or with government, or in or with big banks. Now, I am not saying no one in the UK makes or supports anything, I am saying I never met anyone who did and I remember that because it really bothered me.

The above graphic became the key to my understanding why the UK unemployment is rising and why I believe it will continue to rise for years. I fear that, for the UK, the struggle with unemployment is only beginning.

Because of its high rate of debt, the UK is undertaking strong government cost-cutting measures. Pensions are being slashed, the retirement age lifted and spending reduced. The UK government is also reducing its large payroll. According to recent estimates, the UK will reduce its public sector by some 700,000 people in the coming years 6. That is a lot of people and a lot of people in the upper part of my diagram who currently are, or will soon be, looking for work. So this begs a question: Where does a formerly well paid government worker (or contact worker for a now cancelled project) go to find a decent job?
Some will of course suggest the other side of the upper part of my diagram, the one occupied by Financial Services. Government workers frequently get jobs at banks right? Well, that used to be true, but it certainly isn’t anymore. Why? The big British Banks (along with many other countries’ largest banks) are laying people off too, lots of people 7.

This begs a question: Where does a formerly well paid bank or investment adviser go to find an equivalent job?

Let’s look at my diagram again.

Government Employment                                              Financial Services
Government sponsored contracts

Retail + Sales                                                               Services or Repair

We can now see that BOTH sides of the top level of Britain’s economy are being squeezed, at the same time. Where are these people going to go to find equivalent work? Some of the most productive, educated and well compensated people are being taken out of the UK economy in the middle a long period of slow growth/recession. This is a terrible kick to any real hope of a rapid recovery.

Unfortunately, it only gets worse because after the squeeze at the top, comes the crunch at the bottom.

Consider: After a few months of unsuccessful job hunting and seeing their severance packages getting smaller, how much less will these formerly well paid people spend? If hundreds of thousands of government workers, former contractors, as well as bankers and investment advisers reduce their spending to conserve cash, what will happen to the bottom level of the UK economy? Upper middle class and middle class wage earners spend a lot on retail, repair, and services. When many of them feel the pinch of income reduced to a still working spouse plus government assistance they will slash spending. This will then put a strain on the lower parts of the UK economy. In fact, it has already started with a gloomy November retail sales figure and expectations of a weak Christmas 8. Some industry analysts are using words like ‘miserable’ and, instead of blaming Europe are correctly highlighting that consumer spending  is the big worry moving forward 9.

Their concerns are well founded. With increasing pressure on the top level earners through layoffs, spending will drop. This will naturally put pressure on stores and service centers to first cut their prices, and then later, cut their own staff. Once the bottom level of the UK economy starts cutting jobs then the damage will cut much closer to the bone. UK Unemployment, spiked with government cuts and bank downsizing will be jolted again when the sales and service sectors contract due to reduced middle class spending.

As of this writing official UK unemployment is 8.3% 10. I take no joy in saying here that I expect that figure to reach double digits within the next 2 years.