Analysis

The productivity puzzle: is Britain stuck in a rut?

Growth in output per worker is vital to the wealth of nations. Since the financial crisis, Britain has consistently fallen behind on this score. Why? Stuart Watkins reports

North Sea oil rig © Getty Images
More oil off the coast of Scotland cannot just be magicked up

Growth in output per worker is vital to the wealth of nations. Since the financial crisis, Britain has consistently fallen behind on this score. Why? Stuart Watkins reports.

"Productivity isn't everything, but in the long run it is almost everything. A country's ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker." So said Nobel laureate Paul Krugman, stating succinctly a view universally held among economists. Little wonder, then, that Britain's productivity statistics cause so much hand-wringing. The latest official figures show that Britain has remained stuck in a rut that it first settled into just before the financial crisis of 2008. Output per hour, the most commonly used measure, fell 0.5% over the three months to June compared with the same quarter last year. In every quarter since the one ending in June 2018, the UK's productivity growth has been flat at best. This continues a long losing streak. Productivity has grown by only 2.4% since the pre-crisis peak in 2007 and is about 20% below its pre-crisis trend; before the crisis, productivity grew at about 2% every year.

This is worrying. Producing more with less is the essence of economic growth and the basis for prosperity and improving living standards. In Britain, we are spinning our wheels and doing less with more. With the demographic constraints associated with an ageing population acting as a further long-term drag on our economy, that means Britain will in the future face difficult choices when it comes to national priorities, whether that's spending on the environment and healthcare and other public services, or the ability to raise incomes or cut taxes.

Bringing the pieces together

This phenomenon is known as the "productivity puzzle", an appropriate name given that the problem has many pieces and no one is really very clear about how they might fit together to produce a clear and coherent picture. Perhaps the slump has been caused by companies investing too little in productivity-enhancing machinery (they are still spending less than is typical following an economic slowdown, maybe because they remain nervous about the economic outlook). Perhaps record low interest rates have kept alive failing companies that should have been closed down, meaning highly unproductive zombies lumber on and drag us all down. Or perhaps it is simply a supply and demand issue: the plentiful supply of cheap workers, boosted by high net immigration, has made it more attractive for companies to hire them than to invest in labour-saving machinery. Furthermore, the tax credit system, where the government tops up the pay of low-paid workers, acts as a subsidy for employers, making unproductive part-time work more attractive. The puzzle is further complicated by the fact that the productivity slowdown is partly a global issue (it is crimping almost all advanced economies, including the US), partly a peculiarly British one (Britain lags the laggards) with regional and sectoral dimensions (some of our companies and towns and cities are not prospering and growing as they might).

There are other culprits: the fat cats. A new book by economist Andrew Smithers, Productivity and the Bonus Culture, says the cause lies in the perverse system of incentives that makes it more attractive for managers to line their pockets than invest in growth for the future. As a review of the book by Edward Chancellor on Breakingviews points out, you would expect the ultra-low interest rates and above-average corporate earnings of the past decade to have given investment a boost. That they clearly haven't has been blamed variously on "secular stagnation" (this despite the UK and US enjoying strong growth in employment and consumption) and on a deleveraging private sector paying down its debt (in fact, debt has never grown more rapidly than during the decade since the collapse of Lehman Brothers). The real problem with our weak economies, says Smithers, lies not in insufficient demand, but on the supply side. Productivity growth is determined by how much is invested. If investment is too low, growth stagnates. Falling productivity accounts for the entire decline in trend growth in GDP in the UK, says Smithers, and falling tangible investment preceded the drop in productivity growth. The story is a similar one in the US.

Why, then, has investment fallen off? Perverse incentives. Since the rise to dominance of the theory of "shareholder value" in the 1980s, the idea took hold that the only duty a company had was to boost returns to shareholders. Paying senior executives partly in stock was supposed to align their interests with that of shareholders, which would result in better allocation of capital and higher returns for shareholders. Returns did indeed improve but largely thanks to their gaming the system with share buybacks and other forms of financial engineering that boosted returns but did nothing for productive investment. As The Economist points out, "the proportion of cash paid out to shareholders by non-financial American companies was 40.7% from 2000 to 2017, when share options became popular. Between 1947 and 1999, when they were not, it was 19.6%. As a corollary, the proportion used for investment fell". As did productivity, and hence the pay of those firms' employees. Smithers argues for an overhaul of company reporting rules and the tax system to curb bonuses and give management an incentive to spend more on new investment. But if the problem is that management is gaming a system that was designed to align incentives and boost investment, what's to say that a new system won't be equally cleverly gamed?

More productive doesn't always mean better

Diagnosis of a problem is one thing, prescribing an effective remedy quite another. But even making an accurate diagnosis is a more fraught business than it might at first seem. As Anthony Hilton points out in the Evening Standard, economists urge action or inaction based on quarterly figures for GDP despite the fact that these are inevitably adjusted as more data comes in, often reversing the previously observed trend. Also, the contribution to GDP of new digital technologies has yet to be satisfactorily accounted for in the statistics, many argue the economy may be doing far better than we realise. Imagine how much confidence you would have in evidence-based medicine if the existence of the disease you are being treated for is subject to quarterly updates that might well magic it away. That's probably too cynical a view: an appraisal by the Financial Times, based on a Bank of England study, estimated that measurement issues account for perhaps a quarter of the shortfall in productivity growth since the crisis: "obviously significant", but not enough to "account entirely for the phenomenon".

Where entirely accurate data and scientific cures are found wanting, a dose of common sense may be restorative. The productivity puzzle may not after all be all that much of a puzzle, as John Redwood MP has insisted. One obvious reason for Britain's sharp fall in productivity in recent years is the decline of North Sea oil and the disappearance following the crisis of much high-value output in finance a lot of people in both industries lost high-end, highly productive jobs as a result. This is regrettable, but we can't suddenly magic up more oil in Scotland or high-end banking jobs in the City. The "better reason" for the productivity slowdown though, says Redwood, is that, "in contrast to higher-productivity economies on the continent, Britain has preferred a model that has focused on producing many more lower-paid jobs in the hope that this will in time lead onto higher paid jobs and more output and activity". This is better than simply throwing people out of work. If you sack 10% of the least productive people in the economy, which is in effect what membership of the euro achieved for some countries, "that can be flattering for its productivity figures, because the least productive jobs go, and the productivity of the total country rises, but the country is a lot worse off, because it then has 10% of its workforce out of work who would otherwise have been in less productive jobs".

The result of this model for Britain is not an entirely unhappy one. In manufacturing it is nearly always right to do things faster, better and cheaper, as Redwood says. But in a services business, "better" might mean more staff. In UK public service, the aim is often to lower productivity: many want smaller class sizes, for example, as "lower teaching productivity should bring higher performance". On the way to work we get our coffee from a local cafe rather than a machine because we rather like the less efficient version.

No quick fixes

In short, it's important not to mistake the map for the territory. Panicked by the map, policy makers promise to move heaven and earth to shift the numbers in a direction they prefer. But it's obviously sensible to pause and think about what the numbers are really telling us about the underlying reality. Perhaps they represent reasonable choices. "Financial markets are like the mirror of mankind," says historian Niall Ferguson, "revealing every hour of every working day the way we value ourselves and the resources of the world around us [so that] it is not the fault of the mirror if it reflects our blemishes as clearly as our beauty". Similarly, when we look into the mirror of the productivity statistics, it pays to reflect on what we are really seeing.

To the extent that what we are seeing is something real productivity does, of course, matter after all then we should be concerned about what is to be done. But there are no quick fixes, as Redwood points out in a note for Charles Stanley. It all "hinges on consistent work to raise educational standards, improve skills, speed the rate of new company formation and encourage innovation", "helping people work smarter for better pay" and improving infrastructure. On that last point, the main parties' promised spending splurges may, if the money is spent well, help nudge Britain out of its rut.

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