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Behind the Numbers: Productivity

02 Nov 2017
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Economics is often critiqued for being too opaque for the general public. Indeed, the discipline’s bottom-line focus on numbers, alongside its tendency to ring-fence analysis from social and political issues, is part of the reason why just 1 in 4 people trust economists, according a YouGov survey earlier this year.

But macroeconomic phenomena are just as perplexing to those on the inside. And none more so than the aptly named, and widely reported, ‘productivity puzzle’. For almost a decade, the profession has been spewing out various theories as to why U.K. productivity growth – measured as output per hour worked – has departed from its average growth rate of close to 2.0% from before the 2007/8 financial crisis toward 0.2% over the past 5 years.

So why is productivity growth important? The latest figures, published last month by the Office for Budget Responsibility, the government’s economic watchdog, suggest that, in total, UK business and industry is only able to produce a small amount more each year from its inputs. As such, economic growth becomes harder if the economy cannot incrementally expand its output.

In context, if firms cannot increase their output, they find it harder to raise wages and remain competitive. And regarding the wider economy, “[a] country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker,” said economist Paul Krugman.

And much of this is reflected in today’s political climate. The Government, unable to balance its books when tax revenues are subdued by weak economic growth, has resorted to tightening its spending. Meanwhile, weak wage growth, regional and economic inequality, and mistrust in businesses has come into sharper focus.

Of course weak productivity growth isn’t the only driver behind these trends — but it’s certainly a contributing factor. Indeed, the resultant state of the economy has itself helped to spur a wider debate on the need for more effective and sustainable political, economic, and corporate, governance in the U.K. And those deliberations have largely centred on understanding why the productivity growth figures are subdued.

The causes are manifold, and interlinked. Most directly, productivity has largely languished due to reduced activity in the oil, gas, and finance sectors—traditionally among the most productive sectors prior to the crisis.

Moreover, the U.K. has amongst the lowest public and private investment rates relative to other advanced nations. This impacts the ongoing development of the economy’s productive capacity—across skills, infrastructure, and technology. While unbalanced economic growth nationwide also plays a role in limiting productivity growth. The Government’s Industrial Strategy plans aim to address some of those challenges.

Meanwhile, although Britain is home to among the world’s most productive businesses, it also has a longer tail of low-productivity firms. With the nation’s strong culture of entrepreneurship, part of this is tied to the lack of long-term finance available to grow and invest in businesses, alongside rising costs, and uncertainty in the wider economic climate. These are points we echoed in our response to the Treasury’s recent ‘Financing growth in innovative firms’ consultation.

The Bank of England’s Chief Economist Andy Haldane has also connected the low interest rate environment to allowing low productivity firms to survive, while Bank research shows that weaker management, idea diffusion, and investment in research and development could be making domestic firms less productive than their foreign counterparts.

In our representation document for the Autumn Budget, set for November 22nd, the IoD pushed for cost support, investment reliefs, and wider skills and infrastructure improvements, to help bring out the productive capacity of the business community and build on the UK’s international competitiveness – chiming with members’ greatest concerns.

But of course, there are measurement challenges too. Economist Robert Solow once said; “You can see the computer age everywhere, but in the productivity statistics.” In other words, we may not be able to accurately quantify the value of innovation given its intangible nature. Relatedly, the composition of the economy also plays a role. The manufacturing sector is relatively more efficient than the U.K.’s dominant service sector yet only accounts for around 10 percent of output for example.

Clearly there are a number of potential factors behind the weak data –and none can explain the puzzle in its entirety. As such, unlocking productivity growth for businesses and policymakers is about striving for a holistic, dynamic, and sustainable approach to growth, which in turn requires adopting a long-term mindset toward economic and corporate governance.    

And for economists that means shifting from an obsession on short-term GDP and profit figures, toward keeping a stronger eye on the underlying productive potential of the UK economy. To echo Krugman; “Productivity isn't everything, but in the long run, it is almost everything,”

Tej Parikh, Senior Economist, IoDTej Parikh

Tej holds a Bachelor’s degree in Economics from University College London, and a Master’s degree in International and Development Economics from Yale University. Prior to joining the IoD, he worked as an economic analyst at the Bank of England in roles across monetary and financial policy. Subsequently, he moved to Cambodia where he was a journalist focusing on economic and private sector development for a national newspaper. He has since been a freelance political risk consultant and journalist, covering Europe and Asia in particular. He has published for numerous international media outlets including Foreign Affairs, the Guardian, and The Diplomat, and is currently an active member of London’s Great Debaters Club.

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