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UK productivity – puzzle solved?

UK productivity – puzzle solved?

Finally, some good news on UK productivity growth. An expansion of 0.8% in 2017 Q4, coming on the back of a 0.9% pick-up in the previous quarter, topped the strongest six-month growth period since before the Global Financial Crisis (GFC). It has been a long time coming. The UK has lagged its counterparts on productivity for decades, but has fallen further behind since the GFC. So is this a new dawn, or a false one? And why does it matter?

The productivity puzzle outlined

In the three decades before the GFC, annual UK productivity growth averaged 2.3%. By implication, the average UK worker produced twice as much in 2007 as they would have 30 years earlier. However, since the financial crisis, annual productivity growth has averaged only 0.4%, and there has been little sign – until the latest positive news – of the sort of pick-up in productivity growth that would “normally” be expected to follow a recession.

So while the average worker is still twice as productive as they were in 1970, they are currently producing only a little over 1% more than a decade ago.

So while the average worker is still twice as productive as they were in 1970, they are currently producing only a little over 1% more than a decade ago. A cross-country comparison is equally sobering. Labour productivity is, on average, 18% higher in the rest of the G7 major developed economies, and the gap has been widening recently. Since 2007, only Italy’s performance has been weaker. If the UK played “catch-up” with our G7 peers, we could achieve by lunchtime on Thursday what currently takes a full five-day week.

Productivity matters because it is a key determinant of our economic prospects. Bank of England (BoE) research highlights the fact that, over time and across countries, higher productivity is reliably associated with higher wages, enhanced consumption levels and improved health indicators. We spend a lot less time working than our early Victorian ancestors, but productivity is 20 times higher than in the 1830s, while national income has grown 12-fold in per capita terms and consumption has expanded nine-fold. In cross-country studies, higher labour productivity is also associated with longer life expectancy and lower infant mortality rates.

The productivity puzzle explained

The UK’s underwhelming productivity performance since the financial crisis can be interpreted through a sectoral lens. Financial services and manufacturing account for less than 25% of UK economic activity between them, but three-quarters of the shortfall in productivity growth in the post-GFC period has been concentrated in these two sectors. In the case of finance, this is partly a story of apparently impressive productivity advances in the early 2000s turning out to be unsustainable and ultimately damaging – and therefore subject to increased post-crisis regulatory oversight. For manufacturing, the strong pre-crisis performance may have been driven by one-time gains from globalisation, feeding through to stronger competitive pressures and greater incentives to innovate.

But there is also a common thread to this sectoral story. 80% of the drop-off in headline productivity performance is accounted for by a slowdown in Total Factor Productivity (TFP). A disappointing TFP performance could reflect a failure to innovate or improve production processes. In the post-crisis period, concerns over the durability of the recovery may have prompted firms to meet demand by adding to labour resources rather than capital investment – since the former is easier to reverse than the latter, should economic conditions take a turn for the worse.

Similarly, a precautionary approach from existing employees may have increased their willingness to work additional or flexible hours, pushing down real pay growth and further increasing the relative attraction to companies of deploying labour over capital. Arguably the importance of this “uncertainty factor” for both firms and workers may have hit the UK particularly hard because of financial services’ strong showing in economic activity. In addition, Brexit-related uncertainties may have prompted firms to postpone investment that would otherwise have taken place.

The productivity puzzle solved

Given these explanations, should we be surprised by the turnaround in productivity’s fortunes in the second half of 2017? Not really. The contribution of the finance sector to GDP and productivity growth is unlikely to return to pre-crisis boom levels any time soon, but the post-crisis process of deleverage may have run its course. Even if finance’s performance were to move only in line with that of the rest of the economy this would, as the BoE has noted, provide a helpful boost to headline productivity growth. At the aggregate level, there are also tentative signs that business investment is picking up, perhaps reflecting the tightness of the labour market and emerging pay pressures in some sectors. That said, it would be foolish to declare the puzzle solved on the basis of a couple of pieces of data. Productivity growth has serially disappointed over the past decade and is still around 15% below its pre-crisis trend.

Whatever your view of the UK’s productivity prospects, they really matter

For the BoE, they will influence the future path of interest rates. With the unemployment rate already down at 4.4%, the outlook for the UK’s labour supply looks to be relatively subdued - particularly in the context of Brexit. Productivity will be the key determinant for how rapidly the economy can expand without creating inflation. For the UK and other governments, income gains can only really take place in the absence of productivity improvements if the labour force spends more time working. The stagnation of productivity since the GFC has left many electorates facing frozen or deteriorating living standards. In this context, it isn’t much of a leap from weak productivity growth to growing social and political discontent. Solving the productivity puzzle could therefore pay a substantial political dividend, too.

Image credit: Milan Adzic / Alamy Stock Photo