Let’s get real about reversing the recession
Britain has profound economic problems that can only be addressed through the wholesale renewal of production and infrastructure.
British economists are tearing their hair out over the so-called ‘productivity puzzle’. In the first part of his essay, published yesterday, Phil Mullan explained why the failure of British productivity to recover in the wake of the current recession is actually not that puzzling. In the second part, published below, he picks apart in more detail three aspects of the ‘productivity puzzle’ debate: employment, investment and the role of financial services.
The unemployment puzzle: why didn’t it rise further?
Probably the most popular conjunctural explanation for the ‘productivity puzzle’ relates to what’s been happening to jobs: employment didn’t fall away as much as it would normally be expected to in the recent recession. It did rise but to a lower level than many anticipated – seven to eight per cent rather than the predicted double-figures percentage. Hence sharply lower output in the recession (by over six per cent) as a ratio to relatively more workers and more working hours expressed itself as reduced productivity. And because unemployment didn’t rise as much as might have been expected during the recession, the normal start of the recovery in the productivity statistics, with firms laying off workers, didn’t happen either.
A common rationalisation for this is that Britain has experienced an increase in ‘labour-market flexibility’ – the economists’ way of saying that people have been prepared to accept lower wages or work fewer hours. As a result, it’s been less costly for employers to keep on more workers than in previous downturns. The fall in real wages since 2008 has made it cheaper for businesses to hold on to labour.
Others add the hypothesis that employers have recently become less short-sighted, more rational and have been holding on to their staff, even when there is not much work for them to do in the economic slowdown. This is supposedly because employers now appreciate better the costs both of laying off workers and then recruiting and training replacement workers when the economy picks up again. In the world of economics, this is termed ‘labour hoarding’, which, depending on one’s interpretation, is due either to indecisiveness or foresight on the part of employers.
The rise in part-time work, the widely reported phenomenon of ‘underemployed’ workers and stagnating wages give anecdotal support to this idea that the unusual productivity pattern may just be a reflection of changing employer practices. A survey by the Chartered Institute of Personnel and Development last summer found that one third of organisations had maintained staff levels higher than required for their existing level of output in the previous year. And two thirds of those said that retaining skills has been the main driver for this (1).
Others, though, have found evidence that disputes the notion of labour being hoarded. Joe Grice, chief economist at the ONS, explains that underneath the relatively stable unemployment levels, flows into and out of employment have remained high. Plenty of people have lost their jobs, but even more have been created.
A key shortcoming with this attention on employer behaviour and labour-market flexibility is that it assesses recent changes away from the context of the long-term decay in productive employment. Employers may well, as the discussion has shown, be finding new ways to cope with a torpid economy, but it’s the causes of this listlessness that really need addressing.
Since the 1970s, the British economy has been unable to provide good durable jobs for increasing numbers of people who want them. For example, even with the benefit of a larger public sector today, simply in quantitative terms, one in three men are not in employment compared with only one in five before the ‘long slump’ began (see chart below). Meanwhile, the quality of those jobs has also deteriorated, with a big shift from secure jobs producing services and goods to relatively less secure jobs in lower-paid service industries, which are often dependent for their continuation on the perpetuation of debt-financed consumption.
Chart: UK employment rate (men)
Source: Federal Reserve Bank of St Louis Economic Research.
Recent employment patterns seem consistent with this deterioration in employment quality. While full-time employment has fallen since 2008, part-time, temporary and self-employed work – often people who have lost their jobs and so have had to set up on their own – have all risen. Part-time employment has increased to reach over one quarter of the workforce, and now many more of these part-time workers say they are ‘involuntary’ part-timers. One in five now say they would prefer full-time work if it were available compared with less than one in 10 before 2008.
Bill Martin and Bob Rowthorn from Cambridge University report that all of the jobs created in the two years from the end of 2009 have been in low-productivity, generally low-paid areas such as recreational and personal services (they mention fitness coaches and undertakers), hotels, restaurants, office cleaning, call centres and retail. The ‘puzzle’ as to why unemployment hasn’t risen more is that more people than ever are putting up with lower-paid, low-quality jobs – a trend consistent with a structurally weak, not a temporarily constrained, economy.
Why low investment will persist for longer than many economists think
Similarly, the productivity-puzzle discussion about the potential role of a lack of investment and innovation is far too narrow. Many analysts home in on the fall in business investment since the financial crisis began. For example, the Institute for Fiscal Studies (IFS) notes that business investment fell by almost a quarter between the end of 2007 and late 2009, and has not expanded by much since. This has been attributed to a mix of ‘uncertainty’ and, especially for smaller and medium-sized companies, financing constraints due to the ongoing weakness of the banks and a high cost of capital (despite low headline interest rates). Advocates of this explanation say that low investment is tending to reduce the amount and quality of capital available for each worker, thereby undermining productivity.
Some people add that the recent dearth of financing also constrains potential start-up businesses. This has further adverse effects for productivity, since these new entrants would tend to be the ones deploying the latest productive technology and techniques, bringing these into the economy and thereby boosting average productivity. A complementary argument often made here is that easy-money conditions are also sustaining the weaker, loss-making firms already in operation. These would often go under in a normal recession, and they of course tend to be on the less productive side, thereby pulling down average productivity.
A combination of these two factors, limiting both the entrance of new high-productivity firms and the exit of old low-productivity ones, is said to be holding capital back from moving around the economy, thereby blunting the ‘creative destruction’ tendencies of capitalism. Such a ‘misallocation of capital’, to use the economic terminology, is perceived as undermining the traditional cleansing effect of recessions in preparing the way for productivity revival. It is keeping low productive businesses operating while holding back new, higher productive businesses to take off in their place.
Empirically, there is evidence that both sides of this conventional, text-book picture of cleansing recessions are quite weak in Britain. The failure of business insolvencies to rise much since 2008 does provide support to the idea that state-backed, bank-lending policies are perpetuating ‘zombie’ companies. These are business that should go under because of cash-flow difficulties but which are being artificially sustained by easy-money policies: low interest rates and banks tolerating bad loans longer than normal. The Bank of England notes that while company liquidations have increased only modestly since the start of the recession, the proportion of loss-making companies has ‘picked up sharply since 2007’. It also notes that the number of company births has been low (2).
This tells us that the cleansing effect of the latest cycle has been more muted than was historically perceived. However, this decline in the scale of destructiveness is not that new to Britain, where the business cycle has become more muted since the early 1980s recession. Moreover, it also applies in the US, which has not appeared to have exhibited anything of the UK’s productivity puzzle (3).
Again, a bit more historical perspective would provide some helpful context to the recent shifts in British investment and innovation. Britain has been under-investing in research, technology and capital equipment, and infrastructure for a long time, not just since 2008. UK gross investment as a share of GDP has both been lower than in other major advanced countries for many decades, and has also fallen from about 20 per cent in the 1960s and 1970s to less than 15 per cent last year, with only a brief interlude above 20 per cent in the late 1980s.
Gross mixed capital formation (% GDP)
When it comes to the inadequate pace of innovation, a long-term failure to devote resources to research and development (R&D) is much more important than recent financing constraints for start-ups. For decades, Britain has been spending less than most of its mature competitors as a share of national output, and this small share has fallen to below two per cent since the early 1990s, standing at about 1.8 per cent today. Countries like Japan and South Korea invest in R&D at about double this level.
A financial crisis – or a crisis that’s become financialised?
The third big area of debate on the productivity shortfall – the impact of the role of financial services – is also usually approached in too limited a way. The ONS and others surmise, reasonably enough, that there is likely to be some relationship between the financial form of the latest economic crisis and the odd behavior of productivity. This encourages an assessment of the direct effects of the demise of financial services, not least because people working in this sector are or, more precisely, were seen to be highly productive workers as they traded and shifted huge volumes and values of financial assets. Now, of course, this ‘high productivity’ industry has hit the rocks, and the implosion of such activity is therefore projected as likely to pull down the productivity levels of the British economy as a whole.
ONS deputy chief economist Peter Patterson notes that the biggest sectoral drop in productivity between the pre- and post-crisis periods was in the finance and insurance sector: ‘Productivity growth of four per cent a year in the pre-recession period compares with annual declines of almost three per cent in the last three years, a drop in annual productivity growth of almost seven percentage points.’ While not claiming that this is a complete solution to the puzzle, Patterson suggests it ‘may have played a role in generating a break in productivity behaviour from past trends’. He reminds us that the make-up of the economy has a direct bearing on the behaviour of productivity at the whole-economy level. He also emphasises that finance is an important sector of the economy ‘in its own right’, with ‘financial and insurance activities accounting for more than 10 per cent of total UK gross value added in 2009’.
Martin and Rowthorn reject this idea, questioning the ‘highly dubious quality’ of some sectoral data – not least for financial services – and conclude that the ‘decomposition of the national productivity shortfall reveals it to be a widespread phenomenon’ and not confined to the banks: ‘The pervasive nature of the sectoral impacts points to a more general explanation [than the contraction of banking].’
The IFS comes to a similar conclusion in this year’s Green Budget analysis. It concludes that there is little evidence that the demise of financial services can explain the overall fall in productivity: ‘The fall in aggregate labour productivity is not the result of a change in the industrial composition of the economy. Instead, the aggregate fall in productivity has resulted entirely from falls in productivity within industries. While a fall in the productivity of the financial sector has played a role in overall levels of productivity, there has been no shift in the workforce away from the financial sector.’ So because the problem of falling productivity is evident across the economy, the IFS argues that it is false to privilege the role of finance in explaining low productivity.
Doug McWilliams, chief executive of the economics consultancy, the Centre for Economic and Business Research (CEBR), takes a slightly different tack in using the financial sector implosion to explain at least part of the productivity shortfall post-2008. He concurs with Martin and Rowthorn that measurement validity for financial services is relevant, but comes to almost the opposite conclusion. McWilliams thinks that at least some of the earlier pre-recession contribution to output and productivity from financial services was overstated, thereby artificially accentuating the size of the apparent fall in productivity since 2008. He argues that the finance sector, therefore, does contribute to explaining what’s happened to the productivity statistics.
McWilliams calculates that ‘the overblown level of City activity in 2007/08 overstated productivity by 2.8 per cent. Some of this was unrenewable business, some profits being accounted for that subsequently had to be written off; some euphoric overcharging.’ This pre-2008 overstatement alone could therefore represent almost a quarter of the subsequent productivity shortfall, leading McWilliams to conclude that ‘we should be less worried about today’s level of productivity than we might otherwise have been’.
There are good grounds to be sympathetic to the views of McWilliams and others that official economic statistics do overstate the direct contribution of the financial sector to total national output (4). However, whether sympathetic to, or critical of, this third explanation for the ‘puzzle’, looking at the financial sector in its own terms, as a standalone part of the economy, tends to distort an understanding of the course of Britain’s economic performance in recent decades.
The tendency to emphasise the direct role of the financial sector to the economy, whether to highlight it or to belittle it, coexists with a common underestimation of the way other parts of the economy were artificially boosted by the effects of all those financial shenanigans that the banking sector helped to facilitate. The value actually produced within the financial services industry is – as Martin, Rowthorn, McWilliams and others argue – overstated, either significantly or even completely. But that is very different to dismissing the crucial effects of financialisation, of financial activities of all sorts, in helping to keep the British economy moving ahead over recent decades.
Discussion around this third possible explanation for the productivity shortfall, or puzzle, therefore falls into the same trap as the other two – employment and productive investment. Viewing the British productivity issue predominantly as a post-financial-crisis phenomenon screens the discussion from the longer-term causes of low productivity.
McWilliams’ point about the previous overstated level of productivity within financial services is only part of the British story. How much of the output and productivity growth in the rest of the economy – outside financial services – would have happened without the stimulating benefits of financialisation? Credit-fuelled spending has boosted output, and therefore productivity, in business services, in consumer services, and in firms dependent on government contracts, all of which saw their customers – business and personal – purchase more. And these customers couldn’t have done that without the help of debt expansion.
British household debt grew by 40 per cent of national output between 1990 and 2008. If, say, only half of that went into buying things that sustained British output and productivity, about one per cent of national output a year, that would have made a significant contribution to sustaining output and productivity growth in the two-to-three per cent a year range over this period. Output and productivity were therefore being overstated during the froth of the credit bubble. We are now seeing better how weak the fundamentals really were, and are.
This is the key point in understanding Britain’s economic prospects that the ‘productivity puzzle’ discussion has missed: productivity earned is not the same as productivity borrowed. Productivity which is the result of sustained productive investment in research, development, technology and innovation is very different to productivity which is the statistical by-product of a society living off debt, effectively borrowing wealth from the future. We are still living in a debt-supported world – paying down debt, ‘deleveraging’ as it’s called, has not gone that far yet. So no doubt even today’s reduced UK productivity levels remain artificially inflated. Nevertheless, the financial crisis and its aftermath are a reminder that repaying this borrowing from the future, which has artificially supported wealth and productivity in the past and present, cannot be put off forever.
The net effect of the ‘productivity puzzle’ discussion is to minimise the need for more decisive policy action to drive the long overdue renewal of production of both services and goods. The complacent economic mindset that much of this discussion expresses evades addressing the real issues. Britain has deep structural economic problems that can only be addressed by significant and sustained investment in the wholesale renewal of production and infrastructure. Only this can reignite innovation and durable ‘earned’ productivity growth.
Paradoxically, the most extreme form of complacency in this debate comes not from those endorsing the mainstream government position – despite their wishful thinking that some form of recovery is on its way – but from its oppositional critics. Under the banner of challenging ‘productivity pessimism’, government critics like Martin and Rowthorn refute the claim that structural causes account for low UK productivity. In their view, low productivity is an ‘effective demand failure’. As they see it, the supply side, or the productive capacity, of the economy is not permanently impaired. The productivity shortfall is temporary and due to demand deficiency, which expansionary monetary and fiscal policies would, they claim, be enough to reverse.
However, consistent with the prevailing low horizons of our times, even Martin and Rowthorn are reluctant to advocate a ‘large-scale fiscal stimulus, or a “Plan B”’, at this stage, due to ‘Britain’s still vulnerable banking system represent[ing] a potentially important constraint on fiscal policy’. But the main message from this ‘anti-pessimistic’, anti-structural perspective is that we can relax a bit, the productivity slump is temporary not permanent.
Instead of this spurious ‘puzzle’, the real story that economic commentators in Britain and other Western countries should be trying to get to grips with is the peculiar sluggishness of the post-financial crisis economy. This is both expressed in, and is the product of, low productivity. The productivity shortfall is not the result simply of forces at play during the post-financial crisis and the recession. It is much more the comeuppance, the deflation from the fake expansion and exaggerated productivity levels before the financial crisis. The resumption of lower British productivity levels today should tear away some of the veil created by the sham boom of the 1990s and 2000s.
Low productivity today is not a puzzle; it just expresses the real weakness of the economy. The anaemic economic recovery is a reality that demands digging deep into, in order to discover its root causes. Recognising this as the way things really are would help to open up a more valuable discussion about the system’s defects that are constraining economic activity. Getting to grips with the deep-rooted barriers holding back the production of goods and services would help a lot in establishing what we need to do to get businesses investing once more, to get innovation moving again, and to get quality, well-paying jobs for the millions of unemployed and underemployed.