Wednesday, 24 July 2013

Carney's Conundrum declining productivity

Understanding the mystery of our terrible productivity performance since 2007 in the UK is at the heart of Mark Carney’s concerns (this is a topic of great interest  to Mr Carney).   His analysis of this productivity fall is important to get right as it will determine whether the Bank of England decides to pursue a looser monetary policy or not.  Many economists believe that, after a brief period of decline at the start of a recession, productivity should pick up pretty quickly as a slimmed down labour force is raises production per head.  Before examining why our productivity has declined so much we should look at some numbers.

On the face of it this is a pretty tragic trajectory for the UK, we have out-performed all major economies in lost productivity by a country mile.  Those who press for a looser monetary approach (more quantitative easing) point to these numbers as proof that we have a massive shortage of aggregate demand and that this imposes a liquidity trap that encourages private capital to sit tight.  This type of liquidity trap is a likely consequence of a major asset bust, Japan since 1990 and the great depression are the most obvious examples of this.  Typically, lack of aggregate demand will be accompanied by deflationary pressure on asset prices and typically governments need to respond by increasing liquidity and money supply to jolt private consumption back to life.  The Ex-Governor of the Bank of England Sir Mervyn King was on this side of the argument when looking at our productivity and we are all agog to see which way his replacement will swing.
Another way of looking at the problem is to presume that the UK economy was in any un-natural productivity trajectory prior to 2007 and that we are in a correction that is necessary, in a sense we are paying off the sins of the boom.  This more hawkish view believes that the economy will naturally turn around when savings ratios and levels of debt have returned to more normal levels, this band of Central Bankers are happy to keep interest rates low but don’t see the need use more creative measures to encourage demand growth
So the debate rages between those Central bankers who believe we should give the economy a further shot in the arm and those who think we have done enough on demand stimulus (after all we pushed £375bn of new money into the economy since 2008).  On the face of it it’s difficult to argue against negative real interest rates and possibly more QE, given that we are now 15% below our long term productivity tend rate, but there are a couple of mitigating circumstances that Mr Carney should consider.
Firstly if you widen the view to look at productivity growth since the mid 1990s the UK is still the best performing major economy in the world and the relative decline since 2008 can be seen in context.
My thanks to Gavyn Davies for the chart and most of the good ideas in this blog post!!

We had further to fall! The great reforms of the Thatcher era allowed us to become the most nibble and sadly most over leveraged economy in the western world and we have paid for this in spades.  Secondly we need to look at our productivity performance through the prism of our Anglo Saxon business model; more people in the UK are on performance related and productivity related pay than in most other economies (particularly those in the EU), this has meant that employers have been able to reduce their costs substantially without reducing their labour force, so the same number of people are producing less and earning less.  This partly explains why employment levels have remained high whilst productivity has declined.  Employers and employees have been forced to cut their cloth to suit lower levels of aggregate demand, without the need to increase unemployment.  The current furor on zero hour contracts (some 1 million UK workers are on these contracts) , demonstrates how far ahead the UK is on labour flexibility compared to our European competitors.
Another contribution to this uniquely British problem is our reliance on Financial Services, which has been and will be our most productive industry.  Banking has taken (quite rightly) an enormous hit since 2008,  ‘000 of staff have been laid off and profits and pay for those left in work are way down as the industry restructures to suit a more highly regulated market.  This has had the effect of reducing total output enormously, whist only reducing the overall UK workforce by a few thousand, this short term decline in Financial Services has had the effect of skewing the productivity figures as well as creating the structural deficit in our public finances (lost tax revenues).
So it quite possible that the weak picture on productivity is not a suitable indicator for an assessment on the need to increase aggregate demand in our economy, time will tell by it seems to me that our highly agile labour market and our strength in Financial Services will soon return us to an up-wards path in productivity that will be the envy of the developed world.  Let's hope Mark Carney believes is us as much as I do!

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