Why are we so unproductive?

What is productivity?

When economists and politicians talk about productivity, they generally mean labour productivity: the value of goods and services produced per hour of labour used. It's normally calculated by dividing GDP by the numbers of hours worked. Strong and growing productivity has always been recognised as being key to a healthy economy.

Many economists believe growth in productivity is the ultimate economic foundation of future growth in wages, living standards and output which is why everyone is so worried about the grim picture in the UK.

What's going on?

Policymakers in the Treasury and the Bank of England increasingly agree low productivity is the core economic challenge faced by Britain. In the UK, unlike some other similar countries, productivity has refused to recover along with improving GDP.

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Currently, output per worker-hour remains 2% below the pre-crisis levels of 2008, whereas in the rest of the G7 group of rich countries it is 5% higher. As The Economist put it recently: "the French could take Friday off and still produce more than Britons do in a week".

Was it ever thus?

No. Normally, productivity recovers along with GDP. And the flatlining of productivity since the crisis sits in stark contrast to a strong performance in the pre-recession years, which makes the issue all the more worrying. In the late 1990s and early 2000s, the UK's record on productivity was on a par with that of the US and rather better than Germany's.

Bank of England calculations suggest if productivity had kept pace with the pre-2008 trend, the UK population might on average be 17% better off than it is today. Even more ominously, Bank governor Mark Carney this month said he thinks there's been permanent damage caused by the recession; he expects growth in productivity to return towards, but remain below, pre-crisis growth rates.

Why this stagnation?

One reason is that, unlike in the US, where firms shed jobs quickly when the financial crisis hit, redundancies were comparatively rare in Britain. Instead, the pain of recession was spread widely, via lower wages, so there's more slack to take up in terms of employment and under-investment in productivity-enhancing technology.

Another reason put forward by the Bank of England is that of "zombie" companies: that low interest rates may have allowed uneconomic businesses to stay alive, slowing "creative destruction" the reallocation of resources to new and more dynamic businesses. Thirdly, as John Redwood argued in the Financial Times, the economy is undergoing substantial structural changes, which help explain the productivity "puzzle".

What are these changes?

A rapid drop in North Sea oil output as fields become less productive "means the loss of very high value-added activity, which will lower the average productivity figures", says Redwood. The slimming of bank balance sheets and a drop in banking and investment activities have had a similar impact, removing what were very high value-added activities.

Also, the UK's heavier balance of services (rather than manufacturing of goods) makes its productivity figures look worse than they really are in services, "labour intensity is often seen as better service rather than as worse productivity".

Put simply, the UK has a more flexible labour market and more entrepreneurial culture, which in recent years has proved adept at creating more jobs and attracting hundreds of thousands of immigrants from Europe. It can also be argued (as, for example, James Ferguson of the MacroStrategy Partnership has) that the UK has an overly generous tax credit system, which encourages less productive part-time jobs, rather than more productive full-time ones.

What is to be done?

There's pretty broad agreement on how the UK needs to tackle this issue but also a recognition that there's no quick wins. First, rebalance the economy away from services (75% of GDP) towards making things (10%). Second, reverse the long-term record of underinvestment in plant and machinery, and physical infrastructure. Third, create a business climate based on innovative products and processes that produce high-productivity jobs. And fourth, improve the quality of the workforce.

Chancellor George Osborne recently noted that "we're one of only three OECD countries where the skills of our 16-to-24-year-olds are no better than our 55-to-65-year-olds". In other words, Britain has too many workers who lack basic skills, aren't receiving sufficient training and are destined for low-productivity jobs. Productivity is a long-term problem the solutions will be, too.

Scrap bonuses; pay salaries

The UK's poor productivity is "readily explicable" and not atall puzzling, argued economist Andrew Smithers in the FTlast year. It is down to a long-term change in "managementincentives". There has been a damaging shift from rewardingsenior managers with salaries which encourage thoserunning firms to think long term to bonuses, whichencourage them to focus on short-term changes in profitmeasures.

Why does that damage productivity? Becausemanagements focused on profit-boosting respond to rising demand by employing more staff rather than long-term capitalinvestment, even in an era of cheap money. So paymentby bonus, intended to align the interests of managers andshareholders, has the opposite effect.