If you listen to economists, most will tell you that the UK’s productivity puzzle is the biggest problem for the country’s prospects in the next few years. Here’s why I still refuse to accept the pessimists’ case.
This is the most worrying chart for Britain at the moment:
Since 1971 the total amount of hours worked in the UK economy has grown by around 15%, but total size of the economy has increased by over 160%. In other words through the magic of productivity growth, every hour we work as produced more economic output. That’s how we have become richer as a society.
But since 2008 the relationship hasn’t held…[as] hours and output have tracked each other very closely.
In other words, productivity in the UK has stagnated since the crisis.
What this means is that, if the current situation continues, either growth is likely to slow or inflation start to creep up unless British workers start taking on much longer hours or a lot of new people join the workforce. It also suggests that economic growth is so far failing to improve people’s standard of living even though the population as a whole is working harder and longer.
Compounding the problem, sluggish economic growth makes it harder to pay down the government’s rising debt burden and so would necessitate harsher budget cuts than many of Britain’s political parties appear willing to countenance.
So are there any reasons to be cheerful? I think there are.
1. Record levels of employment in the UK and the so-called productivity puzzle may well be connected.
Falling real wages — whereby prices have been rising faster than pay packets — helped to increase the appeal of hiring additional workers, pushing down the unemployment rate. At the same time the banking crisis raised the cost of capital, meaning that firms were more reluctant to borrow to invest in their businesses.
This situation encourages firms to hire more people to meet additional demand for goods and services as a substitute for investing to increase the efficiency of the business, which would allow them to produce more for less. And it can have a big impact on productivity growth. For example, the Office for National Statistics (ONS) estimates that investing
in new technology and equipment accounted for over 40%
of labour productivity growth between 1998 and 2008.
As the economy recovers, wages should rise and the relative cost of capital to firms should fall, which would increase the appeal of investing in productivity-enhancing technology. This, at least, is what Professors Joao Paulo Pessoa and John Van Reenen argue in a paper published in June 2013:
“The fall in the price of labour coupled with the rise in the cost of capital has meant a fall in the capital to labour ratio which means that labour productivity falls substantially…What this means is that the UK economy is not fundamentally the victim of a large supply side shock, but rather a very severe demand side shock.”
Crucially, the gains from this type of investment take time to come through — so we should not necessarily be surprised that we can’t immediately see improvements in the data.
2. Productivity has historically been pro-cyclical, meaning that it picks up as the economy does.
The UK is only just starting to see a modest pick-up in wage growth, with average weekly earnings excluding bonuses rising 1.7% in November compared to a year earlier. Some economists argue that higher wages should encourage people to work harder and attract more capable and productive employees.
A 1992 study of Fortune 500 companies in the US found that the productivity gains of non-unionised workers following pay rises were large enough to effectively pay for the wage increases, while a 2006 survey of New Jersey police found that officers granted a 17% pay rise were 12% more productive in closing cases than their peers who didn’t get a wage hike.
The implication of this is that the lack of wage growth in the UK over recent years may have held back worker productivity by providing a disincentive to work harder and preventing workers finding employment in industries that matched their specific skill-sets. As wages rise both of these problems should start going into reverse.
3. If the productivity problem is structural, where’s the inflation?
If the pessimists are right and we’re stuck in a low-productivity-growth world, with the unemployment rate now at 5.8% we should presumably start to see stresses in the labour market start to push up prices. Instead core inflation in the UK has been falling along with unemployment and is currently 1.3%:
The lack of price pressure is indicative, though not conclusive proof, that the economy is still running substantially below potential. This is bad news in that the longer an economy remains below potential the more likely it becomes that the damage inflicted by the financial crisis becomes permanent — with workers either becoming de-skilled or de-motivated.
However, it also suggests that there is still room for economic growth to move higher without forcing the central bank to raise rates in an effort to tame inflation. Productivity growth is key to how quickly the UK economy can expand, and how much of that growth people will experience through improvements in living standards. I, for one, do not see sufficient evidence in the data to accept the pessimistic argument yet.