By Lucy O’Carroll, Chief Economist, Aberdeen Asset Management
Productivity matters. As Bank of England Governor Mark Carney recently noted, “Our shared prosperity depends on it”. The level of labour productivity is an important gauge of the economy’s health, as it measures the quantity of output that can be produced with existing resources.
In the longer run, technological progress boosts productivity, helping to determine future living standards. Productivity measures are also important for the Monetary Policy Committee (MPC), as they help it gauge the economy’s ability to grow without generating excessive inflationary pressures. If the MPC gets its productivity growth forecasts wrong, it risks setting interest rates at the wrong level.
Unfortunately, the UK’s productivity performance since the financial crisis has been disappointing: having grown at an annual average rate of 2.1% in the two decades before the financial crisis, growth in output per hour worked has averaged zero in the seven years since. As a result, productivity remains 14.5% below its pre-2008 trend. So what lies behind the UK’s post-crisis productivity weakness? Three explanations come to mind: measurement problems, cyclical trends and more persistent structural factors.
Measurement factors and productivity
Since labour productivity is measured as the amount of output per worker (or per hour worked), if output turns out to be higher than initially estimated, this reduces the size of the estimated productivity ‘shortfall’. Recently, preliminary estimates of UK Gross Domestic Product (GDP) growth have tended to be revised up over time; this is a common statistical phenomenon for economies during growth recovery periods.
The MPC accounts for this possibility in its GDP ‘fan chart’ by not only projecting a range of possible forecast UK growth rates with different probabilities attached, but also by placing similar probabilities on a set of ‘backcasts’ over past official estimates of GDP growth. So while the official estimate of annual GDP growth in 2014 Q4 was 3.0%, the MPC’s backcast indicates that the committee is willing to countenance that ‘true’ GDP growth in that quarter was somewhat lower (as low as 0.5%) or, more likely, higher (as high as 5.0%).
In addition, the trend rate of UK productivity growth may have started slowing before the financial crisis struck – in which case, estimating a productivity shortfall relative to the pre-2008 trend could be misleading, too. The growth of North Sea oil and gas extraction output, for example, has been in decline since around 2003. In total, the Bank of England estimates that these measurement issues could account for around a quarter of the 14.5% shortfall in the UK’s productivity performance relative to its pre-crisis trend – meaningful, but far from providing a complete explanation.
Cyclical factors and productivity
Periods of economic downturn are generally accompanied by a fall in labour productivity, while periods of economic expansion coincide with productivity gains. In the former, firms are typically unable or unwilling to dispose of buildings or machinery, or to lay off workers, either because of minimum staffing levels required to keep the business going or because they believe the weakness in demand is temporary.
As a result, firms are able to maintain capacity levels but will probably be less productive. Other cyclical factors could include firms having to divert resources towards business development or generating custom – which may not count as output, at least in the short run – during downturns. But as the UK economy has picked up speed over the past couple of years, while productivity has continued to disappoint, these explanations have become less convincing.
Since 2012 Q1, more than 1.5 million new jobs have been created, and the unemployment rate has fallen from 8.2% to 5.5%. There is clearly far more to this than short-term ‘hoarding’ of labour resources.
Mark Carney has suggested that cyclical labour market factors may still be having an impact on productivity, but in two rather longer-term ways. First, there may have been a ‘compositional effect’ on productivity in recent years, as large numbers of jobs have been created in lower-productivity sectors. Second, a pick-up in the supply of older workers and inward migration (and the resulting downward pressure on wage growth) may have made firms less concerned about efficiency than in the past. Even so, the Governor expects these effects to dissipate over time. Given recent signs of a slower pace of workforce expansion and stronger growth in pay, this judgement appears reasonable.
Structural factors and productivity
The strength in hiring in recent years, and the very persistent nature of the weakness in productivity, suggests that cyclical factors alone are unlikely fully to explain the disappointing performance. Low levels of investment in the post-crisis period – not only in buildings and equipment but also in ‘intangibles’ such as employees’ skills – may have reduced the pace of innovation in firms. Furthermore, the level of company liquidations since 2008 has remained low, while the proportion of loss-making firms has increased significantly.
Banks may have been forbearing on loans, and low interest rates have helped keep down borrowing costs. Lower rates of business failure, and the accompanying lower rates of unemployment, are likely to have meant that the loss to GDP, and general welfare loss associated with the financial crisis, was smaller than otherwise – but have probably suppressed productivity growth over an extended period.
The Bank of England has made its view clear: “the lessening of compositional effects, a pick-up in the reallocation of resources to new and more dynamic firms, and the effects of the investment recovery coming through” should all boost productivity growth – to an estimated 0.5% pace this year and 1.25% next. This could allow demand in the economy to expand at around its trend rate without triggering inflationary pressures, enabling the MPC to maintain interest rates at current levels into early 2016.
We broadly agree with this view, but we would strike a note of caution. The committee’s track record on forecasting productivity trends is not impressive: it has expected productivity to recover, and has subsequently been disappointed, in each of its past 30 quarterly Inflation Reports. With a forecasting record like that, the chances of the committee misjudging the outlook for productivity growth remain high.