Productivity is the holy grail. It drives wages, consumption and general standards of health and welfare. Without productivity growth, living standards might not be that different from what they were in late Victorian times. It is the key to managing an ageing society successfully, and for Brexit Britain, it is the only way to limit the damage caused by leaving the European Union. Productivity, or rather the lack of it, is a fundamental reason for disappointing economic and social conditions since the financial crisis. Yet, there is still no consensus about why productivity is down and out, or how to fix it. Could we be looking around the wrong corner?
In the decade before the financial crisis, UK productivity growth was recorded at 2 per cent per year. Since the ensuing recession, it has been growing sluggishly at about 0.5 per cent per year. To emphasise what this means cumulatively, if productivity had continued to grow on trend after 2007, it would now be about 20 per cent higher than it is. That is the scale of what economists call our “lost decade” since the crisis.
The productivity funk in the UK looks rather curious in the wake of figures published last week by the Office for National Statistics, which show that total investment in the UK grew by 4 per cent in the year to the end of 2017, the best performance among the G7. Much of this investment was in residential and non-residential structures, plans for which were made before the referendum, but business investment, which is over half of the total, rose by about 2.5 per cent. The strongest component has been investment in intellectual property products. This is all welcome news, and you would expect it to boost productivity. And yet the productivity revival has not gained traction. Why not?
In a 2016 paper entitled “The Best v The Rest,” the OECD argued that the main productivity drag could be found in the difference between “frontier firms” and “laggards,” and that public policy should take note. The Bank of England’s Chief Economist Andy Haldane weighed in last year along similar lines, suggesting that among the many reasons for weak recorded productivity, “zombie firms” could be the answer. The thinking here is that inefficient or uncompetitive companies have a tendency to congest markets and divert credit, skills and investment away from more productive peers, start-ups and so on.
This argument seems quite reasonable—except that last week another Bank of England economist, Patrick Schneider, wrote an intriguing piece on the Bank’s blog site arguing precisely the opposite.
“If productivity had continued to grow on trend after 2007, it would now be about 20 per cent higher than it is”He claims that it isn’t so much the firms in the lower regions and tail of the productivity distribution that are to blame for the aggregate productivity droop, but those at the leading edge. Comparing the entire distribution of productivity among firms during 2004-2007 and 2010-2015, he argues that it is the firms in the top quartile of the productivity distribution that have performed much more poorly than the rest, relative to their previous performance. Is he right? Why would the top or frontier firms be dragging overall performance down?
This argument, presented mathematically by the author, is intuitively credible. What’s happened isn't that dull or laggard firms have behaved much more poorly than before, but that the crisis and its consequences have taken the edge off previously dynamic firms. When you consider also that in the UK, at least, the bulk of our productivity slowdown—about three quarters—has been attributed to finance and manufacturing this thinking starts to resonate. The remaining quarter is in information and communications technology, and professional, scientific and technical services. No one can argue these sectors aren’t at the “frontier.”
According to Silvana Tenreyro, external member of the Bank’s Monetary Policy Committee, finance and manufacturing accounted for half of the 2 per cent annual gains in productivity before 2007, but contributed -0.2 per cent to 0.5 per cent overall productivity growth subsequently. That swing in combined contribution accounts for almost all of the slowdown in aggregate performance.
It is easy to see why. In finance, the decade-long process of deleveraging, accompanied by considerably tougher regulation and compliance has unquestionably punctured the productivity contribution of the sector and dulled the impact of finance on output growth. In manufacturing, the relative weakness of investment, alongside economic and commercial uncertainty at home (government policies, and more recently Brexit), the sorry state of the global economic recovery until recently, and the loss or lack of price competition in some areas have also been part of the story of the lost decade.
No one really expects the productivity story to get better any time soon, but the good news is that it probably will eventually. Over time, the drags in finance will lessen, and similarly the shocks that weakened manufacturing. As the consequences of the revolution in advanced manufacturing and robotics become ubiquitous, the UK should be able to leverage some core positive attributes including its geography, respected legal and accounting infrastructure, vibrant SME sector especially in technology, and great educational institutions.
The one thing with which we have to contend that others don’t is Brexit. It’ll help when companies know for sure the environment in which they have to make plans. But we can’t commit to existential change and imagine that the effects will wear off like a sedative. We need a coping strategy, which has yet to be framed.
