The Productivity Puzzle
by Christos Alexandrou
The UK is not producing any more per hour than it did in 2008, meaning that productivity has stagnated in the ten years since the financial crisis. Below, I have discussed possible explanations for the productivity puzzle which include the potential for mismeasurement, the effect of low bank rates and bank forbearance, the substitution of labour over capital, slowing rates of innovation and innovation diffusion, as well as focusing on the manufacturing and financial sectors. This topic has provoked much debate, because productivity, which previously grew by around 2 percent per year,lies at the heart of increasing GDP, earnings and living standards.
Although it is more challenging to accurately measure output in a predominantly service sector economy, it is difficult to explain the productivity stagnation solely from difficulties in quantifying output. This is because such errors would also have occurred before the stagnating trend. A plausible mismeasurement is the unreliability in extrapolating the pre-crisis trend, because the linear increase would not be consistent with the effects of declining sectors in the UK economy, such as the North Sea Oil and gas extraction output has experienced secular decline since 2003. However, even with conservative estimates, mismeasurement may account for approximately one quarter of the shortfall, so more explanations are needed to understand the totality of the productivity puzzle.1
The persistently low bank rates that have hampered the Schumpeterian forces of creative destruction by allowing inefficient firms to have access to cheap credit to fund unproductive activities is a likely contributor to productivity stagnation since 2008. This reasoning is consistent with how the number of companies going into administration was less dramatic than seen in past recessions. One hypothesis which Martin and Rowthorn highlight from an article by Ben Broadbent on “Rebalancing and real exchange rate”,2 is that the dysfunctional finance may have impeded both the start-up of profitable new companies and the demise of old ones. This leads to the slowing of creative destruction both on the destruction of unproductive firms and the creation of more efficient ones.3 Increased levels of bank forbearance is an alternative explanation, which although can help productive companies survive temporary problems, can keep alive firms with more persistent inefficiencies. Despite this, banks have reported that the low interest rate environment has been even more significant for the low rate of company failure. In the years following the crisis, 0.6% of companies had a 50% or more chance of defaulting, with that figure rising to 4.7% if rates had risen by 400 basis points.4
However, it is difficult to see how sustained productivity growth in the long run should be prioritised over smaller crisis-related scarring effects on the labour markets5. The deterioration in human capital that would have resulted from a magnitude of more redundancies during the recession would have been more harmful to the UK economy. The recovery from the crisis a decade ago was unprecedented in terms of record low unemployment rates, now at 4.2%6.
Furthermore, the positive impact of higher interest rates on productivity would be significantly weakened by the bankruptcy of some high leverage, high-productivity companies, which would also suffer the brunt of higher interest rates.7 In the years following 2008, low productivity could have been justified by firms keeping workers due to overhead labour requirements or in expectation of demand recovery. However, increased labour flexibility and the substitution effect between labour and capital are more likely explanations in 2018.
Increased wage flexibility initially began when people were accepting lower wages after the crisis at the same time as output fell (leading to under-utilisation of labour)8. The acceptance of lower wages has been the result of reductions in household wealth and policy changes, such as the recent changes to welfare policy in the UK with more stringent job search conditions attached to unemployment benefits, as well as an increase in the state pension age for women.9 Labour flexibility has also increased due to the dramatic decline in trade union membership and the nominal wage freezes. The resulting decline in cost of labour, combined with smaller sized enterprises being faced with higher capital costs has led to the substitution of capital, which negatively impacts productivity.10
Linked to less investment in capital, slowing rates of innovation may become the norm for future decades, especially with the end of the third part of the industrial revolution- composed of the computer and internet revolution, which is unlikely to dramatically increase productivity any further.
Moreover, other issues such as the end of the demographic dividend, rising inequality and factor price equalisation (which stems from the Internet revolution and globalisation) and consequences of environmental regulations will make growth more difficult to achieve than a century ago11.
Alternatively, it can be argued that competition restraints such as restrictions on patents and intellectual property have prevented the diffusion of innovation by restricting the replication by rival firms.12 Even though new technologies developed on the global frontier diffuse across countries at an increasingly faster rate, they are slow to spread within any economy, remaining unexploited by many firms.13
The 2013 ESSnet project on “Linking of Microdata to Analyse ICT Impact”, identified that productivity spreads rose significantly in countries where industries invest in intangibles. This is consistent with the idea that an industry dominated by intangible innovations will be one in which the top firms will break from the ‘laggards’ due to their ability to achieve economies of scale and because of the difficulty to replicate such advancements by rival firms.14 A related hypothesis is that globalised markets and network economies of scale lead to natural monopolies whereby a small set of players dominate the market share, which slows innovation diffusion.
Contrary to focus on less productive firms, recent research has questioned the performance of frontier firms. Patrick Schneider observes that when the annual change in productivity is illustrated by centile of the productivity level distribution, the post crisis line indicates a fall for the top tail of the distribution, compared to even faster growth in productivity for bottom tail firms. This means we should be focusing on the reasons why the frontier firms are not becoming more efficient.15
Three-quarters of the productivity growth shortfall is accounted for by manufacturing and finance16. A slower growth rate of capital deepening in the manufacturing sector can account for one-third of the slowdown. Growth in capital per hour worked accounted for 1.1pp of productivity growth precrisis, yet none from 2009 to 2015. It is likely that the investment before the crisis was caused by the increased competition from low-cost emerging market producers, such as China. Furthermore, greater offshoring led to TFP growth before the crisis, because import price indexes miss cost-cuts when a cheaper foreign supplier is opted for. Therefore, measured import price inflation is higher and real imports growth is reported as lower than it should be, so productivity gains are overstated.17
However, Tenreyro argues that international trade is a production technology and that productivity improvements coming from domestic TFP and from gains for international trade in the form of cost savings are not dissimilar. The financial sector seems to have had the largest impact on the productivity shortfall, mainly because of the stark contrast before and after the crisis. Pre-crisis productivity growth was aided by increasing financial-sector leverage and unsustainable risk illusion, which sowed the seeds of the subsequent weakness in the economy. When the crisis hit, the channels that led to higher asset prices went into reverse, which lowered spending, output and increased labour supply (due to loss of wealth), which contributed to lower levels of productivity growth.18
Overall, mismeasurement can justify a small fraction of the shortfall, but fundamentally the puzzle consists of several factors all working against productivity growth. It is difficult to blame monetary policy for such a shortfall, because although the persistently low bank rate has kept alive less efficient firms, it has also been vital for high-leverage frontier firms. As well as this, it has prevented the deterioration in human capital that may have resulted from higher unemployment after the crisis. It is the capital shallowing and substitution of capital for labour which has been key in slowing productivity to a halt, because this is what accelerates the efficiency of labour production.
Moreover, this links to the theories that revolve around slowing innovation, because it is the initial investment in capital that allows for this. However, it is equally valid that such innovations have occurred, but the difficulty in rival firms replicating such advancements has kept aggregate productivity low. More specifically, it is the dented performance of the financial sector compared to pre-crisis levels, and the obscurities in measuring manufacturing sector imports growth that can account for a significant proportion of the shortfall.
Word Count: 1451
1 (Bernett, et al. 2014) pg118
2 (Broadbent 2011) pg3
3 (Martin and Rowthorn May 2012) pg53
4 (Arrowsmith and Briffiths 2013) pg300
5 (Haldane 20 March 2017) pg5
6 (Office for National Statistics 2018)
7 (Haldane 20 March 2017) pg17
8 (Martin and Rowthorn May 2012) pg22
9 (Blundell 2014) pg381
10 (Pessoa and Reenen June 2013)
11 (Gordon August 2012) pg2
12 (Haldane 20 March 2017) pg6
13 (Andrews, Criscuolo and Gal 2015) pg6
14 (Jonathan and Stian 2016)
15 (Schneider 2018)
16 (Tenreyro 2018) pg11
17 (Mandel and Houseman 2015) pg8
18 (Tenreyro 2018) pg17
Bibliography
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