Economists are perplexed to find that today, in a first in any postwar
recession, productivity is not recovering
British economists are tearing their hair out over the so-called ‘productivity puzzle’ - the fact that, for the first time in any postwar recession, productivity in Britain has not recovered reasonably quickly after the initial downturn. But it isn’t a puzzle at all, and in truth points to deep structural problems in the British economy, argues Phil Mullan in this important new essay
by Phil Mullan
The productivity puzzle
Productivity
growth is the best guide to a country’s future prosperity. As a measure of
economic output relative to employed labour time, productivity gives an
indication of how much wealth can be created for society to live on.
Productivity’s capacity to grow, therefore, underpins durably improving living
standards. In Britain especially, though not uniquely within Europe,
productivity growth since the financial crisis of 2008 has been extremely weak
– in fact, in Britain’s case, it has remained a couple of per cent below its
pre-recession peak.
This has caught
many economists by surprise, prompting a significant amount of debate over why
this has happened and how long it might endure. While the initial fall of
productivity during the recession was in line with everyone’s expectations,
there hasn’t been a subsequent recovery in productivity. Instead, productivity
has remained low and pretty static. This has become known as the British
productivity puzzle (1).
It is perceived as
a ‘puzzle’ because normally after a recession, productivity recovers reasonably
quickly. Economists traditionally attribute recovery to ‘cyclical’ reasons.
Another way of viewing the ‘cyclical’ behaviour of productivity is that it is
the statistical expression of two real-economy measures – output and
employment. These two tend to move at different speeds during the different
stages of the business cycle. Output in a recession usually declines much
faster than businesses reduce their headcount, and the measure of productivity
therefore falls: less output relative to workers.
Then, when the
recession ends and output begins to grow again, the reverse effect is supposed
to kick in: the output recovery makes better use of under-used employees before
employment picks up again, creating a cyclical boost to productivity: more
output relative to workers. This effect is reinforced as output often expands
more quickly than employers recruit.
An important point
about such ‘cyclical’ shifts is that they do not reflect the
impact of the long-term driver of productivity growth: namely, productive
capital investment. It is such investment that generates and spreads the
innovation and the advances in technology and techniques that make people at
work more productive. In contrast to ‘cyclical’ changes, we can call this type
of investment ‘structural’ in its impact on productivity.
The big problem
with the productivity puzzle discussion is that it assumes that what we are
experiencing is primarily some form of business cycle (even if some highlight
more than others its unusual and distinct origins in the West’s financial crash
from 2007). But in fact, we should be looking deeper into our economic troubles
rather than presuming that they are cyclical. Britain’s economic problems – and
those of the rest of the Western world – are structural, and this accounts for
the poor state of British productivity we see today. A long period of
underinvestment in innovation, technology, capital equipment and infrastructure
manifest themselves in low productivity. There is no ‘puzzle’ about the absence
of a productivity recovery, because there is not a high productivity level to
which the economy can recover. Structural British productivity is low.
The only ‘puzzle’ is why productivity seemed to be so strong in the pre-2008 period.
One of the reasons
why many economists limit themselves to a narrow ‘business cycle’ time frame,
when trying to understand low and flat productivity levels today, is that they
remain misled by the apparent strength of the British economy since the 1980s.
This misconception blinds them to the longer historical view, and leaves them
looking only for recent explanations.
For example, in
its recent report Investing for
Prosperity, the LSE Growth Commission claims that from 1980
Britain had started to reverse a century of economic decline. This perspective
misreads successful muddling through - based in Britain’s case on
financialisation, state intervention and the windfall of North Sea oil
production - as genuine economic dynamism (2). To support this idea of a
genuine broad-based economic revival, the Growth Commission claim that Britain’s
booming financial sector cannot account for the rise in productivity and living
standards since 1980. This, though, is a straw man. The key development is not
the direct impact of the financial sector itself, but the way in which the
expansion of financial activities, as expressed, for example, in the explosive
growth of debt levels, has artificially boosted economy-wide output figures.
The Growth
Commission makes the point that the UK financial sector only accounted for
about 0.4 per cent of the 2.8 per cent average annual productivity growth
between 1980 and 2007. It noted, as further evidence, that ‘distribution and
business services were much more important contributors to productivity growth’
between 1997 and 2007. But these were precisely sectors that benefited
significantly from the fruits of financialisation (just as in the US
distribution was a big contributor to the so-called ‘new economy’ productivity
renaissance of the late 1990s and early 2000s; there, personal-credit expansion
boosted sales in Walmart).
In Britain, the
total debt of people, businesses, banks and the government more than doubled
from about 220 per cent of GDP to nearly 500 per cent between 1990 and 2008.
That’s an annual growth rate of around four per cent a year, much higher than
the actual growth rate of GDP over the same period of just over two per cent.
This debt has funded consumption levels by households, businesses and
governments that would not have happened otherwise. This artificial consumption
has helped sustain production within Britain, inflating employment, output and
productivity levels.
In 2010, Cambridge
University economist Bill Martin made a study of the impact of the build-up of
debt over this period and concluded that the ‘asset-price bubbles, and the
fiscal largesse they licensed, may have substantially flattered Britainʼs growth performance between 1995 and 2007. Without
the misvaluation of stock and housing markets, some, perhaps much, of the
decline in unemployment might not have occurred and growth might have stayed
close to its postwar one-two per cent norm, which is significantly below the
three per cent pace of annual expansion which gave credence to the idea of
Britainʼs “new Golden Age.”’ (3) He suggested, therefore, that
the level of activity in 2007 had as a result been raised by 6.5 per cent. This
ispretty much the same as the 6.3
per cent fall in gross domestic product (GDP) in the initial recession from
early 2008 and mid-2009. So the post-financial crisis recession may simply have
cleared away the artificial growth that financialisation had helped produce,
bringing the size of the economy down to a more genuine, un-inflated level.
The financial
crisis, therefore, didn’t just come out of the blue to cause the subsequent
turmoil, trigger a recession and drive the business cycle. The financial crash
was the outcome of the previous period of financialisation and the two-decade
long inflation of a credit bubble. The pre-recession productivity levels were
artificially boosted by financialisation and this created the illusion since
2008 of an unusual, interrupted productivity cycle. The reality is that
productivity was never as high as people thought it was in 2008. So the
productivity drop since 2008 was merely bringing it closer to where it should
be, based on the underlying structural fundamentals. Our attention should not
be on a business cycle that is performing abnormally, but on a real economy
that is structurally defective.
How the productivity puzzle presents itself
The chart below,
from the Office for National Statistics (ONS), shows that the unexpected
behavior of productivity is due to more than a delayed recognition of the
severity of this recession: this is the first postwar cycle where productivity
is still below the pre-recession level four years later and remains, at best,
flat. Even in the very sharp 1973-75 recession that marked the end of the
Postwar Boom and the start of the Long Slump, productivity had recovered after
two years and continued to rise fairly steadily thereafter.
Chart: UK productivity levels, output per hour during UK recessions,
seasonally adjusted
Source: Office for National Statistics.
The position now
is that output per hour in Britain is not just still smaller than before the
recession. In fact, long after any cyclical factors would have usually faded
away, it remains over 12 per cent below where
it would have been if the pre-recession trend had continued. Using a different
comparative view, the ONS puts the shortfall in output
per worker today at a similar level of 15 per cent.
The huge amount of
analysis among economic policy advisers about this productivity conundrum is
understandable. If such a loss of wealth-creating power by the British economy
is mostly permanent and, especially, if the earlier productivity growth trend
is not restored, this would represent a significant blow to social prosperity.
And this would affect the affordability of what we have come to expect as a
continual rise in our living standards. Britain would be a lot poorer and with
weaker prospects than is conventionally assumed. The serious political and
social consequence would be that at some time, and possibly not that long in
the future, this underlying material reality would impose itself and transform
today’s relatively phoney ‘austerity versus growth’ debate into something
rather more urgent and potent.
Unfortunately, as
I’ve noted before, many contributors seem to be trying to find recent,
post-2007 explanatory factors, which could be expected to diminish over time as
demand picks up again. The focus has been on discovering unusual recent forces
at work – to do, for example, with company behaviour, labour-market
flexibility, sectoral shifts in the make-up of the economy, the legacy effects
of the financial crisis, etc – which could have affected the normalcyclical behaviour
in productivity.
There has been
much less thought given to the structural factors which we might see manifest
themselves in lower productivity. This neglect of longer-term forces expresses
the central weakness of Western economic policy discussion these days: its
blend of complacency, conservatism and fatalism. ‘Things are bad – but not that
bad.’ There is therefore no need to look for radical new policy departures – a
tweak on traditional economic management tools is enough. And, anyway, we shouldn’t
expect much to improve economically for quite some time.
The Bank of
England’s recent review of the puzzle summarised this mainstream view that
while ‘productivity is set for a prolonged period of weak growth’, the Bank’s
judgement ‘is that a recovery in productivity and demand occurs in tandem’ (4).
The message is: expect productivity to remain low for a period of time but it
will recover at some point, when demand recovers, supported, presumably, by the
Bank’s easy money policies. The normal cyclical behaviour of productivity will
resume at some point, though maybe in a more muted fashion.
This idea that
when demand eventually recovers so will productivity, legitimates the evasion
of identifying and addressing deeper structural economic challenges. It
justifies the Lib-Con coalition government’s current muddle-through,
state-policy package, which relies primarily on easy monetary policies to get
demand up. And it also justifies what is usually described as the ‘Keynesian’
alternative (though whether John Maynard Keynes would have endorsed it is
another matter), that demand could be boosted more quickly with a slightly
different muddle-through mix incorporating, temporarily, an additional
expansionary fiscal policy.
The common problem
with puzzle explanations that centre on post-2008 economic happenings is that
although they may well be valid when accounting for some of the peculiar
features of the latest recession-recovery cycle, they take as a given what
really needs to be investigated: that the problem is more cyclical than
structural, more down to a passing deficiency of demand than due to a seriously
malfunctioning engine supplying the goods and services that make up our
national output.
They take for
granted that at some stage things will return to normal, even if this means a
‘new normal’ of more lacklustre growth. This discounts the more
straightforward, if politically unsettling, conclusion that low productivity in
Britain is not in fact a ‘puzzle’ at all; it is, rather, an accurate measure of
the weak and anaemic state of British production. Low productivity is
not a statistical ‘cyclical’ consequence of an unusual and sluggish recovery,
but an explanation for the underlying economic feebleness.
The productivity
puzzle discussion has become a case of not seeing the wood for the trees.
Productivity is low and stagnant not because of some peculiarities with this
recent business cycle but primarily because of deep-rooted structural problems
– a long-term failure to invest and innovate for several decades. This
circumstance necessitates instead a big economic restructuring and reset for
Britain.
The most discussed
explanations for today’s low productivity tend either to divert our attention
from this underlying circumstance of productive decay, or, to the extent that
they touch on real features of the economy, tend to view these problems too
narrowly within a post-2007 timeframe. And, as a result, they fail to recognize
the longer established, systemic roots of the anaemia. Sometimes the
discussions even do both of these things at once: both divert and also
diminish.
Next we will look
at three prominent aspects of the discussion on the so-called ‘productivity
puzzle’: employment, investment and the role of financial services…
(1) See, for
example, ‘UK productivity puzzle baffles
economists’, BBC News, 18 October 2012, ‘The productivity puzzles’, in the Green
Budget, Richard Disney, Wenchao (Michelle) Jin and Helen Miller, Institute
for Fiscal Studies
(2) See also British
Relative Economic Decline Revisited, Nicholas Crafts, Centre for
Competitive Advantage in the Global Economy, Working Paper No. 42, University
of Warwick, May 2011; and UK Economic Performance since 1997: Growth,
Productivity and Jobs, Dan Corry, Anna Valero, and John Van Reenen Centre
for Economic Performance, November 2011
(3) Rebalancing
the British Economy: a Strategic Assessment, Bill Martin Centre for
Business Research, University of Cambridge, July 2010
(4) Inflation
Report, Bank of England, November 2012, p. 45
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