The Productivity Puzzle

by in Industry and Markets

Labour productivity growth in the UK has been exceptionally weak since the start of the financial crisis and currently lies around 14-16 percentage points below the level implied by its pre-crisis trend growth rate. This is what is commonly referred to as the UK “productivity puzzle”.

Historically, the productivity of labour in the United Kingdom rises year-by-year, and increases in money wages has reflected this by forging ahead of price increases. Yet despite a rapid recovery in the jobs market, the UK economy has not fully returned to pre-crisis levels of economic output. Such a prolonged period of weakness in labour productivity stands out from international and historical experiences.

Recent firm-level data from the Inter-Departmental Business Register and the Office for National Statistics Annual Business Survey indicates that the whole-economy productivity per capita (i.e. how much economic output a worker generates per hour) of the UK is still below pre-crisis levels, and, worse still, significantly below where it ought to be if the pre-recession trend had continued.

So what is actually going on? On the one hand, a surface-level examination of this “puzzle” may indicate that it may be, in fact, unremarkable. We can even hypothesise that it can be explained away, at least in part, by globalisation and good old fashioned capital transfers. The nature of modern capital is that it is internationally mobile. Given that foreign countries can match the United Kingdom in productive efficiency per unit of capital, productive capital will flow to where capital is scarce and labour abundant. In the times before the recession, a capital drain was augmented by capital formation. Since a recession has an adverse effect on capital formation, leading to net capital flows, labour now has less capital to work with. Marginal product falls and, consequently, so do real wages. The result is that the output gap gradually vanishes, protracting the recovery.

This may begin to make sense. Especially since we know that, given that there is less headroom for expansion, a fiscal stimulus loses its efficacy. At the same time, compared with the high degree of regulation in continental Europe, our relatively flexible market framework has kept unemployment down and fostered employment growth in the private sector despite the cuts in the public sector. As domestic demand picks up in the recovery phase, the owners of capital may choose to invest abroad, earning higher rents. The vital domestic investment response may go missing, again prolonging the recovery. In this context, we should not be surprised to see real wage stagnation, low investment and slower growth. The emerging result is stagnant labour productivity.

On the other hand, the above could fail to provide a complete picture of recent developments. Although higher capital per worker should lift productivity per worker, it is not the exclusive determinant of productivity growth. Also important is the flow of innovations of various kinds which enable more output to be produced from given quantities of capital and labour. So there must be more to this story.

A couple of weeks ago, the Bank of England Governor was asked to give his informed opinion on why the UK economy has not recovered more of its lost productivity. According to his estimates, the productivity gap is around 16 percentage points, approximately 4 percentage points being down to mis-measurement. Mark Carney also provided a number of half-explanations, such as the drop in North Sea oil and gas output, the statistical methodology around how R&D is treated in the national accounts and the performance of the financial sector following the crisis. All of which provide a degree of insight but not quite the full picture. Cyclical factors, such as firms responding to weak demand by keeping people employed even when available work dropped, are also important.

A recent Bank of England working paper, entitled “The productivity puzzle: a firm-level investigation into employment behaviour and resource allocation over the crisis”, provides further and more nuanced details. It also offers two hypotheses (see Table 1) regarding the productivity gap, which have important but very different implications for monetary policy. While it accepts that cyclical factors are likely to be part of the picture, it also argues that: “the protracted weakness in productivity and the strength in employment growth over the past two years suggest that other factors are likely to be having a more persistent impact on the level of productivity”.

These “persistent” factors that the bank of England identifies include reduced business investment, employees being moved to less productive roles within firms, lack of working capital and lack of investment in so-called “intangible capital” – such as intellectual property rights – resulting in fewer new products coming onto the market.

If all else is equal, this suggests that there is more spare capacity than Mr Carney thought. But all else is never equal.

For more information on the United Kingdom labour market, see the latest research: United Kingdom Labour Market

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