Sunday, October 15, 2017
Don't give up the ghost entirely on Britain's productivity
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The biggest UK economic news this week came from an unusual source. When the Office for Budget Responsibility (OBR), reviews its own forecasts, as it does regularly, this is normally one for the nerds and pointy-heads.

But, without wishing to align myself too much with either group, the latest Forecast Evaluation Report from the government’s fiscal watchdog had bite as well as bark. One Treasury official described it as a “bloodbath” for the public finances.

The issue is a straightforward one, which has appeared on many occasions in this column. Productivity is the key to prosperity and living standards. Higher productivity – more output for every worker or hour worked – determines the growth of real wages and the economy’s ability to grow with a given size of workforce. It is, as the economist Paul Krugman once memorably put it, not everything, “but in the long run it is almost everything”.

It is also intimately linked to the state of the public finances; government debt and deficits. Productivity growth has a direct impact on tax revenues and establishes the economy’s “speed limit”. The lower that speed limit, the more difficult it is to grow your way out of a budget deficit. As the OBR puts it: “Other things being equal a downward revision to prospective productivity growth would weaken the medium-term outlook for the public finances.”

The significance of its latest assessment is that the OBR has been dutifully waiting for something to turn up on productivity for many years. Every year since 2010, when it came into being, it has assumed a recovery in productivity growth to its long-run average of around 2% a year. Every time it has been disappointed.

Even when all the ducks have been in a row for a rise in productivity, it has failed to happen. Instead of a 2% annual rise in productivity, the past five years have delivered just 0.2% a year. Productivity is no higher than it was a decade ago, when a normal performance would have delivered a 20% rise.

So, while the OBR has not said precisely what figures it will use to underpin the November 22nd Budget, it has said it will be “significantly reducing” its assumption for productivity, to bring it more into line with the recent disappointing experience.

The story of how it has got to this position reads a little bit like a Whodunnit. Post-crisis productivity weakness is not confined to Britain but the gap with other countries – German output per hour is 36% higher than British, France’s 29% - is embarrassing.

One of the first explanations for the weakness of productivity in Britain was that firms had hoarded labour during the 2008-9 recession, during which employment fell a lot less than feared. With a surplus of workers relative to output, productivity weakness was not surprising.

However, as the OBR notes, that explanation “became less appropriate once firms began hiring again”, so attention turned to other factors.

High on the list of these was that problems in the banking system had prevented the normal process of creative destruction to work. The banks forgave weak businesses which in other circumstances might have failed, and failed to lend enough to new, dynamic, high-productivity firms.

Clearly, there was some truth in that. But, as the OBR again concedes: “The banking system is now much better capitalised and more robust than it was in the immediate aftermath of crisis, so this explanation no longer looks as relevant as it once did.”

That still leaves us with plenty of explanations. One, which I devoted a piece to here a few weeks ago, is that ultra-low interest rates have contributed to productivity weakness. The banks showed forgiveness and near-zero official rates made it easier for them to do so. Zombie firms have stalked the land, driving down productivity.

Sectoral shifts in the economy have also been important. I have yet to come across a business which says it is not making an effort to boost productivity and, in most cases, achieving gains. Yet if there has been a shift from higher to lower productivity activities, as there has been, it is perfectly possible for the majority of firms to be increasing productivity while the performance of the average stagnates.

The single most important explanation for the weakness of productivity, however, jumps out of the OBR report. 10 years on from the start of the financial crisis, business investment is just 5% above its pre-crisis peak. At this stage in the two previous recessions and recoveries, in the 1980s and 1990s, business investment was up by 63% and 30% respectively. This is an enormous contrast.

A couple of years ago Britain appeared to be on the brink of a significant upturn in business investment. Predicted annual growth rates of 8% or 10%, sustained for some time, were not unrealistic. Then came the referendum and, according to the Bank of England, the level of business investment by 2020 will be 20% lower as a result. We should also be concerned about Britain’s ability to attract inward investment in future.

The delayed investment upturn may mean we have to get used to weaker productivity than is healthy for a while yet. But we should not throw in the towel entirely on a productivity revival, and I would not expect the OBR to do so.
For one thing, we have a labour market that is tight, with an unemployment rate of just 4.3%, and a labour supply shock on the horizon. I do not buy the simplistic argument that EU migrants have enabled firms to employ rather than invest. In most cases a decision to employ also means a decision to invest, for example in new outlets.

But migration from the EU to Britain is already falling and, given the tightness of the labour market, we will soon facing the choice of raising productivity or not growing at all.

The shift in the mix of economic activity to lower-productivity sectors, made possible by a good supply of labour may also have run its course. It is hard to expand the number of coffee shops or sandwich bars when there is nobody to staff them. Meanwhile the latest figures for manufacturing, which had a good summer, is outgrowing services and generally has higher productivity. We may be seeing a shift back towards higher-productivity activities, or at least the start of it.

Above all, the idea of permanently stagnant productivity is too depressing to contemplate. Stagnant productivity means stagnant living standards. The OBR is right to adjust its projections in the light of productivity weakness. It would be wrong to give up the ghost entirely.