The UK's Productivity Puzzle - what's the deal

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With the ONS today releasing data on the UK’s productivity performance for 2017q3, we thought it would be a good idea to recap on what we mean by the UK’s productivity puzzle, a phenomenon that has garnered intense media interest over the last few months, and outline some of the reasons posited for it.

The Productivity Puzzle

Since the onset of the recession, productivity growth in the UK has been particularly sluggish.

Indeed, despite solid economic growth and improving labour market conditions, productivity (as measured by output per hour) has flat-lined since its slump in 2009. Even taking into account the most recent data, in which productivity increased by 0.9% (its greatest growth since 2011q2) productivity still remains around 16% below its pre-crisis trend.

Productivity-has-flat-lined 

Furthermore, compared to other post war recessions, the recovery in productivity growth has been particularly weak.

Productivity-post-recessions 

*Productivity levels in the quarters following major post war recessions.


This is clearly a concern given productivity is vital for long-term economic growth and wage growth, which itself has been subdued over the last year.

Improvements in productivity signal the ability of an economy to grow without generating inflationary pressures, and is regularly cited by industry and institutions such as the Bank of England, as one of the UK’s greatest challenges to overcome. Ominously, the OBR recently slashed its forecasts for productivity growth in the autumn budget, illustrating that there is no quick-fix to this longstanding issue.

 

Is it just us though?

Unfortunately, the data also confirm that the UK lags behind its main trading partners – such as the US, France and Germany.

Productivty-v-competitors 

 

What about manufacturing I hear you ask?

It is clear therefore, that at the whole economy level the UK faces a substantial productivity gap – both compared to competitors and its pre-crisis trend. However, the picture becomes less clear when looking at how different sectors of the economy have performed.

Official statistics indicate that the manufacturing sector’s productivity growth outperforms both that of the services sector and the economy as a whole, both before and after the recession. This suggests that manufacturing is not at the centre of the UK’s weak productivity performance.

A crumb of comfort for manufacturers therefore….

Manufacturing-v-whole-economy 

 

What is behind the UK’s overall weak productivity?

The potential causes of the UK’s weak productivity performance have been hotly debated and remain largely inconclusive. The explanations, put forward by the Bank of England, amongst others, can be broadly split into two trains of thought. 

 

1) Cyclical explanations

The first hypothesis suggests that the weakness in productivity is more cyclical in nature and driven principally by weak demand conditions.

  1. Labour hoarding

The mechanism at work here is that firms are unable or unwilling to dispose of capital or lay off workers, either because of minimum staffing levels required to keep the business going, or because they believe the weakness in demand to be temporary, and therefore wish to retain underutilised labour to avoid the cost of firing and subsequent re-hiring when the economy picks up. Holding on to resources (hoarding labour) in this way means that firms are able to maintain their capacity levels. However in the meantime, these firms are not as productive as they might otherwise have been. This is likely to have been more of a contributing factor in the years following the most recent recession, when we saw large contractions in GDP but not the same extent of employment losses compared to previous recessions.

Labour-hoarding

ii) Strong labour market

The UK’s strong labour market, but subdued wage growth, may also have encouraged companies to both hold on to and hire additional staff, resulting in an increase in employment at the expense of labour productivity. Is the trade-off between labour productivity and employment one we should accept…?

 

2) Other more persistent factors

The strength in hiring over the past 5 years and the very persistent nature of the weakness in productivity suggest that cyclical factors alone are unlikely to explain the productivity puzzle fully. Other more persistent reasons put forward include:

 

     i. Under-investment

Under-investment is one of the possible explanations behind sluggish productivity growth. During the crisis, labour costs deteriorated and the cost of capital increased. Assisted by the UK’s flexible labour market, this pushed firms to retain staff and lower capital investment to minimise their costs and maintain production.

Although investment has picked up considerably since the crisis, productivity has not. One explanation is growth in investment has not been fast enough to contribute decisively to productivity growth, given the collapse in 2008. Businesses needs an incentive to invest in high productive (yet expensive equipment), with low labour costs themselves acting as a disincentive. Our own Investment Monitor 2017/18 found that manufacturers are not investing enough in technology to improve their production processes.

 

    ii. Impaired resource allocation and unusually high firm survival rate

Some have contended that productivity may have been held back by the actions of the authorities, in particular regulatory restraint and accommodative monetary policies (low cost of borrowing). By supporting low-productivity companies who would otherwise have failed, policy actions may have prevented the “creative destruction” of firms.

 

    iii. Slowing Innovation

Some economists believe that the type of technological progress behind productivity growth over the past two centuries may not continue at the same pace in the future. Behind this argument is that the current wave of innovation, grounded in ICT, does not have the same potential as past innovations, as well as the fact that it is already quite mature and that future progress is likely to be slower. This would help to explain why most developed nations, despite outperforming the UK, have seen their productivity growth slow.

 

Find out what companies expect to happen to their productivity in the coming year, in our 2018 Executive Survey, published on Monday.
 

 

Author

Economist

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