The productivity puzzle is one of the toughest economic challenges facing British policymakers today. In essence, the puzzle is the lack of understanding over why the UK’s productivity growth has not recovered to its pre-crisis trend following the recession. With no current consensus on a suitable solution, perhaps we need to go back to the drawing board to revisit the causes, since understanding the source of the puzzle is paramount to solving it.
The stagnation in productivity growth can be seen by the divergence in trend and actual productivity growth; this becomes starkly evident in graphical form.
such relationships run counter to standard economic theory
Another facet of the puzzle is its unusual phases. The first phase, circa quarter 1 of 2008 to quarter 2 of 2009, bore a decline in both output and employment, but with employment declining by proportionally less than expected. The second phase from quarter 3 of 2011 to quarter 2 of 2012 displayed increases in employment with decreases in output. Such relationships run counter to standard economic theory – in a recession with declining output, one would expect proportionality similar declines in employment. Yet with robust employment, the UK’s current productivity puzzle casts yet another question for the government to answer: why did the 2008 recession not follow typical trends?
With a difference between trend and actual productivity of around 18%, the productivity puzzle has baffled economists and policymakers. Yet this aside, some have proffered a few explanations.
Firstly, analysis of the labour market offers up a possible explanation. This explanation suggests that the cause of the puzzle is due to a temporary opening up of spare capacity within firms following the crisis and ensuing recession. This suggests that spare capacity leads to firms ‘hoarding’ labour throughout the downturn and the retention of more workers than is necessary then leads to productivity decline through the following process. If the costs of firing in a recession and hiring in a boom outweigh the costs of retaining workers, then hoarding in a recession could be a rational response for employers. With real wages falling from mid 2008, hoarding became affordable and desirable. Yet with excess labour in times of spare capacity, we may expect employers to begin to cut back the working hours offered to employees. If labour hoarding is indeed a significant cause of the productivity puzzle, we’d expect the decline in output per hour to be less than the fall in output per worker. When comparing the two measures, this suggestion appears to hold: output per hour currently sits at approximately 98% of its pre-crisis level, while output per worker has fallen to 94% of what it was before the recession. Thus, the data does provide support for the labour hoarding cause, albeit at a marginal level.
changes in input cost ratios incentivised employers to increase their labour intake while scaling back their investment projects
In addition to this cyclical explanation, there exist underlying structural causes of the British productivity puzzle. One such cause is known as capital shallowing, which refers to the process by which the capital-labour ratio declines. This lowers productivity because when there are fewer machines available to each worker, workers produce less. During the UK’s Great Recession, this theoretical prediction manifested itself. The decline in the capital-labour ratio primarily arises when there are substantial shifts in the relative price of factor inputs. This shift firstly occurred with a stagnation of real wages in the UK – hourly labour costs were static through 2008 to 2013. Turning to capital in the pre-crisis years, the ease of access to credit meant that firms could afford to cheaply invest in capital projects, many of which could be non-productive due to the inexpensive nature of credit. Compounding this, the post-crisis credit crunch increased the cost of capital due to the banks reluctance to lend. Such high costs in the post-crisis years caused firms to scale back on their capital investment operations. These changes in input cost ratios incentivised employers to increase their labour intake while scaling back their investment projects. Thus, as the capital-labour ratio has declined in the years following the recession due to capital shallowing, so has productivity growth.
While capital shallowing does appear to account for at least part of the explanation of the puzzle – approximately 5 percentage points of the divergence – a further, persistent explanation lies in the unusually high firm survival rate throughout the recession. With credit drying up in the recession years, banks showed leniency to indebted firms. With the number of liquidations falling throughout the bulk of the Great Recession, it seems that banks were reluctant to call in debts – better to receive late payment than suffer a default on a loan. Consequently, highly unproductive ‘zombie’ firms could survive. The ‘cleansing hypothesis’ predicts that productivity growth should accelerate in the recession through the death of the least productive firms. The liquidation of these firms should raise aggregate productivity, albeit at the expense of rising unemployment, via a more efficient allocation of resources. However, with increasing employment in late 2008 into 2009, and declining liquidation statistics, it is evident that such a cleansing of unproductive firms did not take place in the UK following the financial crisis. As a result, ‘zombie’ firms could continue in their unproductive manner and in turn contribute to the stagnation of productivity growth experienced by the UK economy.
After considering these damaging causes, one is encouraged to seek to find government policies to address the puzzle. In order to overcome the issue of spare capacity within firms, the government should intend to implement public works schemes. Increased spending on infrastructure projects will allow firms to utilise their spare capacity; increasing the output aspect of productivity. This policy could then be combined with the Funding for Lending Scheme (FLS) to combat the lack of capital deepening. Through lending to commercial banks at rates lower than markets rates, the government can incentivise banks to lend to firms. Firms can then utilise this availability of cheap credit to reverse their current capital shallowing and instead engage in capital deepening to increase investment and thus productivity growth. Finally, to address the issue of ‘zombie’ firms hampering productivity growth, the government should address their Small Business Rates Relief. This relief is distributed indiscriminately to all new firms or SMEs. Such support is likely to exacerbate the problem of low productivity firms entering the market or remaining in the market and dragging down average productivity. Instead, the government should seek to analyse a firm’s productivity before providing them with a portion of the £7 billion tax cut so that only the most productive firms benefit.
the government hits many of the key areas
When comparing the suggested policies above to the policies implemented, the government hits many of the key areas. Through its National Productivity Investment Fund and industrial strategy, the government has targeted spending on key industries to allow them to utilise their spare capacity. However, the government would do well to expand their reach if such policies prove to be fruitful; and if current government budgets permit. Through its so called ‘Productivity Plan’ of 2015, the government committed itself to lowering corporation tax to incentivise investment. While such a policy does address the tax system, it will reduce government revenues for spending in schemes such as public works or the National Productivity Investment Fund, possibly hampering their effectiveness. Finally, while the Bank of England has embarked on flagship unconventional monetary policy initiatives such as Quantitative Easing to ease the credit crunch and increase investment, it should first focus and promote simpler schemes such as FLS before committing to such untested methods.
It is clear that the causes of the productivity puzzle are varied and damaging to the success of the UK economy. While cyclical explanations such as labour hoarding certainly play a part in causing the puzzle, their impact is minor. In contrast, the more persistent, arguably more serious, causes such as capital shallowing and high firm survival rates pose a much greater threat. Accounting for roughly 6 to 9 percentage points of the divergence between actual and trend productivity growth, these factors must be addressed to overcome the puzzle. Therefore, both businesses and the government would do well to revisit the causes above to come together to solve one of Britain’s most pressing economic issues.