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 for spiked - part one of which will be published today, followed by part two tomorrow.
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 manifests itself 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.
Before the financial crisis: the illusion of economic health
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 claims 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 is pretty 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 behaviour 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 normal cyclical 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…
Part two of Phil Mullan’s essay will be published on spiked tomorrow.