The useful Trojan horse of the UK productivity puzzle

Linda Yueh

25 November 2015

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The British government has placed productivity at the centre of its economic growth agenda. The UK economy has recovered to pre-Crisis levels, but productivity has noticeably lagged behind.

Even if the recent decline in output per worker shouldn’t be a huge source of worry, productivity matters for longer-term economic growth.

So, if it helps the government to focus on what does matter – higher wages, greater investment including in infrastructure – then it’s a helpful Trojan horse.

‘Benign neglect’ of the issue prior to, during, and indeed after the banking crisis is a phrase applicable to both parties when they were in power. The Conservatives will hope that their recent heightened focus – in the budget and via their new ‘productivity agenda’ – isn’t too little too late.

Britain’s productivity puzzle

First, by any number of metrics, UK productivity – output per hour – is lower than it should be based on pre-Crisis trends. The annual declines in GDP per worker since the banking crisis are unprecedented.

But, the other way to think about the past few years is that it’s a job-rich recession. Employment recovered a year earlier than output and unemployment never hit the 3 million mark reached during the last two recessions of the early 1980s and 1990s. So, as less output is demanded, including from each worker, output per hour was lower. Real wage flexibility also helped to maintain jobs. As wages declined, it was possible to hold onto workers. It also suggests that the process can be reversed once demand grows (Pessoa and Van Reenen 2013).

Still, employers hoarding workers instead of laying them off doesn’t explain the entire puzzle (Barnett et al. 2014). Part of it may also be due to the structure of the British economy, with a large services sector where both investment and output are poorly measured (Goodridge et al. 2013). But, the US has a large services sector, so mismeasurement is unlikely to be the whole story either.

Indeed, the Bank of England looked at this issue and concluded that there is a productivity puzzle where output per hour is around 16% lower than expected (Barnett et al. 2014). But, of the 16 percentage points, they can explain around only half of the puzzle, or 6-9 percentage points. The Bank attributes 4 percentage points to measurement issues. Nevertheless, that means a chunk of the productivity puzzle that can’t be explained by what they call ‘persistent factors’, e.g. low investment, inefficient allocation of capital, and ‘zombie’ firms.

Government’s renewed focus on growth

That ‘explained’ portion, unsurprisingly, is the focus of government policy. The appointment of Lord Adonis to head a National Infrastructure Commission signals the importance of investment alongside Lord O’Neill’s focus on linking the Northern Powerhouse.

It’ll take more than investing in rail and other ‘hard’ infrastructure. ‘Soft’ infrastructure is just as important to induce business investment. Britain has been somewhat a mixed bag on this issue. Development of the digital economy has been impressive in some parts. For instance, Silicon Roundabout in London has attracted more venture capital than other European cities. But, there are also areas of the country where even getting a mobile signal is challenging, so this can’t be overlooked as a policy priority. The other significant area of investment is skills. Prominent business surveys have pointed to a skills shortage cramping growth.

So, the government’s focus is in the right direction, but somewhat skewed. Perhaps because of the ambition to rebalance the economy towards making things once again, the focus on infrastructure first targets the ‘hard’ investments when ‘soft’ is just as important.

In any case, prompting private investment is also needed, and that’s tricky. Devolution of taxation powers to local governments amounting to an annual £26 billion in business rates is one way of decentralising decision-making authority to encourage more investment. This has proved to work elsewhere such as in Germany and China, where local banks and authorities have better knowledge and can strike deals more efficiently. But, it can also create inefficient competition among localities, with duplicative activities across localities, protected by local vested interests (Yueh 2013).

Aside from tax cuts, which can help boost private investment, clarity about policies and transparent regulations matter too. Some companies are deterred from making big infrastructure investments, which can actually be attractive due to their fixed returns, by regulations over the amount of capital they need to hold as one example. Others worry about Brexit, which adds to uncertainty over Britain’s future access to the EU single market.

Increasing public investment can help there, as it can have a ‘crowding in’ effect. In other words, government investment can make private investment more efficient, e.g. good telecoms infrastructure increases the returns to a pound invested by a private company. Between 2008 and 2011, public investment fell from 3.3% of national output to 1.9%, a decline of some 40%. There is a lot of ground to make up and, more pertinently, will this trend be reversed? A commonly heard argument in the US is over why the US government should take advantage of record low interest rates to borrow and increase public investment. Fiscal constraints should consider excluding investment, which generates future returns, so it’s a distinction worth making.

It’s not just government policy of course that matters for investment. The Bank also identified misallocation of capital, which is a related issue. To invest, businesses need to borrow, and that requires the banks to lend efficiently. It’s less of an issue for large firms, but the vast majority of the country’s businesses are small. A financial system that’s dominated by banks repairing their balance sheets with only a relatively small capital market is also an impediment – one that the US does not face where most of lending doesn’t come from banks. Introducing more competition into the banking system is hard for a relatively small economy. Will the new Capital Markets Union at the EU level help? Lord Hill is leading that development now.

There’s no question that investment is important, but there are also structural issues that underpin the productivity puzzle. Globalisation and the skills upgrading of the economy have affected wages. Cheaper overseas workers plus higher rewards going to those who work in the higher-skill end of the economy have depressed median incomes. Plus, cheaper workers means that companies also substitute workers for capital, which depresses investment, so the issues are all unsurprisingly related.

Raising incomes doesn’t just depend on higher productivity, but raising productivity is the sustainable way to raise incomes rather than relying on debt to grow.

This is why productivity matters even if the recent drop is less of a worry.

The causes of low productivity are not entirely unknown, but the consequences affect our future standards of living. So, if the productivity puzzle has risen higher on the policy agenda due to the crisis, then any reason is a good one to focus on this crucial issue.

References

Barnett, A, S Batten, A Chiu, J Franklin, and M Sebastiá-Barriel (2014), “The UK productivity puzzle”, Bank of England Quarterly Bulletin, 2014 Q2, pp. 114-128.

Goodridge, P, J Haskel, and G Wallis (2013), “Can intangible investment explain the UK productivity puzzle?”, National Institute Economic Review 224: R48–R58.

Pessoa, J P and J Van Reenen (2013), “Decoupling of wage growth and productivity growth? Myth and reality”, CEP Discussion Paper No. 1246.

Yueh, L (2013), China’s Growth: The Making of an Economic Superpower, Oxford: Oxford University Press.

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Topics:  Macroeconomic policy

Tags:  productivity

Fellow in Economics at St Edmund Hall, University of Oxford; Adjunct Professor of Economics, London Business School, and Visiting Professor of Economics, Peking University

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