Britain has profound economic problems
that can only be addressed through the wholesale renewal of production and
infrastructure
The unemployment puzzle: why didn’t it rise further?
Probably the most
popular conjunctural explanation for the ‘productivity puzzle’ relates to
what’s been happening to jobs: employment didn’t fall away as much as it would
normally be expected to in the recent recession. It did rise but to a lower
level than many anticipated – seven to eight per cent rather than the predicted
double-figures percentage. Hence sharply lower output in the recession (by over
six per cent) as a ratio to relatively more workers and more working hours
expressed itself as reduced productivity. And because unemployment didn’t rise
as much as might have been expected during the recession, the normal start of
the recovery in the productivity statistics, with firms laying off workers,
didn’t happen either.
A common
rationalisation for this is that Britain has experienced an increase in
‘labour-market flexibility’ - the economists’ way of saying that people have
been prepared to accept lower wages or work fewer hours. As a result, it’s been
less costly for employers to keep on more workers than in previous downturns.
The fall in real wages since 2008 has made it cheaper for businesses
to hold on to labour.
Others add the
hypothesis that employers have recently become less short-sighted, more
rational and have been holding on to their staff, even when there is not much
work for them to do in the economic slowdown. This is supposedly because
employers now appreciate better the costs both of laying off workers and then
recruiting and training replacement workers when the economy picks up again. In
the world of economics, this is termed ‘labour hoarding’, which,depending on one’s interpretation, is due either to
indecisiveness or foresight on the part of employers.
The rise in
part-time work, the widely reported phenomenon of ‘underemployed’ workers and
stagnating wages give anecdotal support to this idea that the unusual
productivity pattern may just be a reflection of changing employer practices. A
survey by the Chartered Institute of Personnel and Development last summer
found that one third of organisations had maintained staff levels higher than
required for their existing level of output in the previous year. And two
thirds of those said that retaining skills has been the main driver for this
(1).
Others, though,
have found evidence that dispute the notion of labour being hoarded. Joe Grice,
chief economist at the ONS, explains that
underneath the relatively stable unemployment levels, flows into and out of
employment have remained high. Plenty of people have lost their jobs, but even
more have been created.
A key shortcoming
with this attention on employer behaviour and labour-market flexibility is that
it assesses recent changes away from the context of the long-term decay in
productive employment. Employers may well, as the discussion has shown, be
finding new ways to cope with a torpid economy, but it’s the causes of this
listlessness that really need addressing.
Since the 1970s,
the British economy has been unable to provide good durable jobs for increasing
numbers of people who want them. For example, even with the benefit of a larger
public sector today, simply in quantitative terms, one in three men are not in
employment compared with only one in five before the ‘long slump’ began (see
chart below). Meanwhile, the quality of those jobs has also deteriorated, with
a big shift from secure jobs producing services and goods to relatively less
secure jobs in lower-paid service industries, which are often dependent for
their continuation on the perpetuation of debt-financed consumption.
Chart: UK employment rate (men)
Chart: UK employment rate (men)
Recent employment
patterns seem consistent with this deterioration in employment quality. While
full-time employment has fallen since 2008, part-time, temporary and
self-employed work - often people who have lost their jobs and so have had to
set up on their own - have all risen. Part-time employment has increased to
reach over one quarter of the workforce, and now many more of these part-time
workers say they are ‘involuntary’ part-timers. One in five now say they would
prefer full-time work if it were available compared with less than
one in 10 before 2008.
Bill Martin and
Bob Rowthorn from Cambridge University report that all of
the jobs created in the two years from the end of 2009 have been in
low-productivity, generally low-paid areas such as recreational and personal
services (they mention fitness coaches and undertakers), hotels, restaurants,
office cleaning, call centres and retail. The ‘puzzle’ as to why unemployment
hasn’t risen more is that more people than ever are putting up with lower-paid,
low-quality jobs – a trend consistent with a structurally weak, not a
temporarily constrained, economy.
Why low investment will persist for longer than many economists think
Similarly, the
productivity-puzzle discussion about the potential role of a lack of investment
and innovation is far too narrow. Many analysts home in on the fall in business
investment since the financial crisis began. For example, the Institute for
Fiscal Studies (IFS) notes that
business investment fell by almost a quarter between the end of 2007 and late
2009, and has not expanded by much since. This has been attributed to a mix of
‘uncertainty’ and, especially for smaller and medium-sized companies, financing
constraints due to the ongoing weakness of the banks and a high cost of capital
(despite low headline interest rates). Advocates of this explanation say that
low investment is tending to reduce the amount and quality of capital available
for each worker, thereby undermining productivity.
Some people add
that the recent dearth of financing also constrains potential start-up
businesses. This has further adverse effects for productivity, since these new
entrants would tend to be the ones deploying the latest productive technology
and techniques, bringing these into the economy and thereby boosting average
productivity. A complementary argument often made here is that easy-money
conditions are also sustaining the weaker, loss-making firms already in
operation. These would often go under in a normal recession, and they of course
tend to be on the less productive side, thereby pulling down average
productivity.
A combination of
these two factors, limiting both the entrance of new high-productivity firms
and the exit of old low-productivity ones, is said to be holding capital back
from moving around the economy, thereby blunting the ‘creative destruction’
tendencies of capitalism. Such a ‘misallocation of capital’, to use the
economic terminology, is perceived as undermining the traditional cleansing
effect of recessions in preparing the way for productivity revival. It is
keeping low productive businesses operating while holding back new, higher
productive businesses to take off in their place.
Empirically, there
is evidence that both sides of this conventional, text-book picture of
cleansing recessions are quite weak in Britain. The failure of business
insolvencies to rise much since 2008 does provide support to the idea that
state-backed, bank-lending policies are perpetuating ‘zombie’ companies. These
are business that should go under because of cash-flow difficulties but which
are being artificially sustained by easy-money policies: low interest rates and
banks tolerating bad loans longer than normal. The Bank of England notes that
while company liquidations have increased only modestly since the start of the
recession, the proportion of loss-making companies has ‘picked up sharply since
2007’. It also notes that the number of company births has been low (2).
This tells us that
the cleansing effect of the latest cycle has been more muted than was
historically perceived. However, this decline in the scale of destructiveness
is not that new to Britain, where the business cycle has become more muted
since the early 1980s recession. Moreover, it also applies in the US, which has
not appeared to have exhibited anything of the UK’s productivity puzzle
(3).
Again, a bit more historical
perspective would provide some helpful context to the recent shifts in British
investment and innovation. Britain has been under-investing in research,
technology and capital equipment, and infrastructure for a long time, not just
since 2008. UK gross investment as a share of GDP has both been lower than in
other major advanced countries for many decades, and has also fallen from about
20 per cent in the 1960s and 1970s to less than 15 per cent last year, with
only a brief interlude above 20 per cent in the late 1980s.
Gross mixed capital formation (% GDP)
When it comes to
the inadequate pace of innovation, a long-term failure to devote resources to
research and development (R&D) is much more important than recent financing
constraints for start-ups. For decades, Britain has been spending less than
most of its mature competitors as a share of national output, and this small
share has fallen to below two per cent since the early 1990s, standing at about
1.8 per cent today. Countries like Japan and South Korea invest in R&D at about
double this level.
A financial crisis – or a crisis that’s become financialised?
The third big area
of debate on the productivity shortfall – the impact of the role of financial
services – is also usually approached in too limited a way. The ONS and others surmise,
reasonably enough, that there is likely to be some relationship between the
financial form of the latest economic crisis and the odd behavior of
productivity. This encourages an assessment of the direct effects of the demise
of financial services, not least because people working in this sector are or,
more precisely, were seen to be highly productive workers as they traded and
shifted huge volumes and values of financial assets. Now, of course, this ‘high
productivity’ industry has hit the rocks, and the implosion of such activity is
therefore projected as likely to pull down the total economy productivity
levels.
ONS deputy chief
economist Peter Patterson notes that the
biggest sectoral drop in productivity between the pre- and post-crisis periods
was in the finance and insurance sector: ‘Productivity growth of four per cent
a year in the pre-recession period compares with annual declines of almost
three per cent in the last three years, a drop in annual productivity growth of
almost seven percentage points.’ While not claiming that this is a complete
solution to the puzzle, Patterson suggests it ‘may have played a role in
generating a break in productivity behaviour from past trends’. He reminds us
that the make-up of the economy has a direct bearing on the behaviour of
productivity at the whole-economy level. He also emphasises that finance
is an important sector of the economy ‘in its own right’, with ‘financial and
insurance activities accounting for more than 10 per cent of total UK gross
value added in 2009’.
Martin and
Rowthorn reject this idea,
questioning the ‘highly dubious quality’ of some sectoral data - not least for
financial services - and conclude that the ‘decomposition of the national
productivity shortfall reveals it to be a widespread phenomenon’ and not
confined to the banks: ‘The pervasive nature of the sectoral impacts points to
a more general explanation [than the contraction of banking].’
The IFS comes to a similar conclusion in this
year’s Green Budget analysis. It concludes that there is little evidence that
the demise of financial services can explain the overall fall in productivity:
‘The fall in aggregate labour productivity is not the result of a change in the
industrial composition of the economy. Instead, the aggregate fall in
productivity has resulted entirely from falls in productivity within
industries. While a fall in the productivity of the financial sector has played
a role in overall levels of productivity, there has been no shift in the workforce
away from the financial sector.’ So because the problem of falling productivity
is evident across the economy, the IFS argues that it is false to privilege the
role of finance in explaining low productivity.
Doug McWilliams,
chief executive of the economics consultancy, the Centre for Economic and
Business Research (CEBR), takes a slightly different tack in using the
financial sector implosion to explain at least
part of the productivity shortfall post-2008. He concurs with Martin and
Rowthorn that measurement validity for financial services is relevant, but
comes to almost the opposite conclusion. McWilliams thinks that at least some
of the earlier pre-recession contribution to output and productivity from
financial services was overstated, thereby artificially accentuating the size
of the apparent fall in productivity since 2008. He argues that the finance
sector, therefore, does contribute to explaining what’s happened to the productivity
statistics.
McWilliams
calculates that ‘the overblown level of City activity in 2007/08 overstated
productivity by 2.8 per cent. Some of this was unrenewable business, some
profits being accounted for that subsequently had to be written off; some euphoric
overcharging.’ This pre-2008 overstatement alone could therefore represent
almost a quarter of the subsequent productivity shortfall, leading McWilliams
to conclude that ‘we should be less worried about today’s level of productivity
than we might otherwise have been’.
There are good
grounds to be sympathetic to the views of McWilliams and others that official
economic statistics do overstate the direct contribution of the financial
sector to total national output (4). However, whether sympathetic to, or
critical of, this third explanation for the ‘puzzle’, looking at the financial
sector in its own terms, as a standalone part of the economy, tends to distort
an understanding of the course of Britain’s economic performance in recent
decades.
The tendency to
emphasise the direct role of the financial sector to the
economy, whether to highlight it or to belittle it, coexists with a common underestimation of
the way other parts of the economy were artificially boosted by the effects of
all those financial shenanigans that the banking sector helped to facilitate.
The value actually produced within the financial services industry is – as
Martin, Rowthorn, McWilliams and others argue – overstated, either
significantly or even completely. But that is very different to dismissing the
crucial effects of financialisation, of financial activities of all
sorts, in helping to keep the British economy moving ahead over recent
decades.
Discussion around
this third possible explanation for the productivity shortfall, or puzzle,
therefore falls into the same trap as the other two - employment and productive
investment. Viewing the British productivity issue predominantly as a
post-financial-crisis phenomenon screens the discussion from the longer-term
causes of low productivity.
McWilliams’ point
about the previous overstated level of productivity within financial services
is only part of the British story. How much of the output and productivity
growth in the rest of the economy – outside financial services – would have
happened without the stimulating benefits of financialisation? Credit-fuelled
spending has boosted output, and therefore productivity, in business services,
in consumer services, and in firms dependent on government contracts, all of
which saw their customers – business and personal - purchase more. And these
customers couldn’t have done that without the help of debt expansion.
British household
debt grew by 40 per
cent of national output between 1990 and 2008. If, say, only half of that went
into buying things that sustained British output and productivity, about one
per cent of national output a year, that would have made a significant
contribution to sustaining output and productivity growth in the two-to-three
per cent a year range over this period. Output and productivity were therefore
being overstated during the froth of the credit bubble. We are now seeing
better how weak the fundamentals really were, and are.
This is the key
point in understanding Britain’s economic prospects that the ‘productivity
puzzle’ discussion has missed: productivity earned is not the
same as productivity borrowed. Productivity which is the result of
sustained productive investment in research, development, technology and
innovation is very different to productivity which is the statistical
by-product of a society living off debt, effectively borrowing wealth from the
future. We are still living in a debt-supported world – paying down debt, ‘deleveraging’
as it’s called, has not gone that far yet. So no doubt even today’s reduced UK
productivity levels remain artificially inflated. Nevertheless, the financial
crisis and its aftermath are a reminder that repaying this borrowing from the
future, which has artificially supported wealth and productivity in the past
and present, cannot be put off forever.
The net effect of
the ‘productivity puzzle’ discussion is to minimise the need for more decisive
policy action to drive the long overdue renewal of production of both services
and goods. The complacent economic mindset that much of this discussion expresses
evades addressing the real issues. Britain has deep structural economic
problems that can only be addressed by significant and sustained investment in
the wholesale renewal of production and infrastructure. Only this can reignite
innovation and durable ‘earned’ productivity growth.
Paradoxically, the
most extreme form of complacency in this debate comes not from those endorsing
the mainstream government position – despite their wishful thinking that some
form of recovery is on its way – but from its oppositional critics. Under the banner
of challenging ‘productivity pessimism’, government critics like Martin and
Rowthorn refute the claim
that structural causes account for low UK productivity. In their view, low
productivity is an ‘effective demand failure’. As they see it, the supply side,
or the productive capacity, of the economy is not permanently impaired. The
productivity shortfall is temporary and due to demand deficiency, which
expansionary monetary and fiscal policies would, they claim, be enough to
reverse.
However,
consistent with the prevailing low horizons of our times, even Martin and
Rowthorn are reluctant to advocate a
‘large-scale fiscal stimulus, or a “Plan B”’, at this stage, due to ‘Britain’s
still vulnerable banking system represent[ing] a potentially important
constraint on fiscal policy’. But the main message from this
‘anti-pessimistic’, anti-structural perspective is that we can relax a bit, the
productivity slump is temporary not permanent.
Instead of this
spurious ‘puzzle’, the real story that economic commentators in Britain and
other Western countries should be trying to get to grips with is the peculiar
sluggishness of the post-financial crisis economy. This is both expressed in,
and is the product of, low productivity. The productivity shortfall is not the
result simply of forces at play during the post-financial crisis and the
recession. It is much more the comeuppance, the deflation from the fake
expansion and exaggerated productivity levels before the financial crisis. The
resumption of lower British productivity levels today should tear away some of
the veil created by the sham boom of the 1990s and 2000s.
Low productivity
today is not a puzzle; it just expresses the real weakness of the economy. The
anaemic economic recovery is a reality that demands digging deep into, in order
to discover its root causes. Recognising this as the way things really are
would help to open up a more valuable discussion about the system’s defects
that are constraining economic activity. Getting to grips with the deep-rooted
barriers holding back the production of goods and services would help a lot in
establishing what we need to do to get businesses investing once more, to get
innovation moving again, and to get quality, well-paying jobs for the millions
of unemployed and underemployed.
(1) Labour
Market Outlook, Chartered Institute of Personnel and Development in
partnership with SuccessFactors, Summer 2012, p2
(2) Inflation
Report, Bank of England, November 2012, p31
(3) Entry,
Exit, and Plant-level Dynamics over the Business Cycle, Yoonsoo Lee and
Toshihoko Mukoyama, Federal Reserve Bank of Cleveland, Working Paper
0718, 2008
(4) See ‘Measuring
financial sector output and its contribution to UK GDP’, Stephen Burgess,Quarterly
Bulletin, Bank of England, Q3, 2011
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