Productivity Puzzle Revisited

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1 Productivity Puzzle Revisited UK Productivity across recessions (Output per hour) Productivity Puzzle Revisited The November 2011 State of the Economy publication discussed the possibility of the emergence of a productivity puzzle in the UK the unusual phenomena since the 2008/09 recession of rising employment coupled with a decline in output. As the chart above shows, productivity (as measured by output per hour) in the UK remains much lower than would be expected compared to previous recessions. As this puzzle continues to persist, this chapter looks into possible causes in further detail. Productivity As an economy becomes more productive, greater quantities of goods and services can be produced with a given set of resources, thereby freeing up labour and capital to move to other areas of activity and increasing overall output (or the quality of that output). In the long run, improvements in productivity are the main driver of economic growth. Productivity performance is typically determined by the relative size and direction of changes in output (GDP) compared against changes in labour market performance (reflecting changes in employment and average hours worked).

2 2008 = 100 Productivity since the 2008/09 crisis Output, employment and total hours worked in the UK Since mid-2010 the private sector in the UK has experienced relatively robust growth in employment and hours worked while at the same time experiencing weak growth (and more recently a contraction) in output (see chart). This combination implies a reduction in productivity in the economy. As at Q2 2012, UK output remains around 3.8 per cent below its peak, whilst the employment level has fully recovered (though the employment rate is still below its pre-recession value due to population growth). 1 In Scotland, output remains 4.4 per cent below its peak and employment 2.7 per cent below. As Scotland s labour market has experienced greater adjustment than that in the UK as a whole during the 2008/9 recession, Scotland s productivity puzzle has not been as pronounced as that in the UK, though still exists. Scottish productivity rose to 99.3 per cent of the UK average in 2010, from 94.0 per cent in International comparisons Both the OECD and ONS present comparisons of UK performance to 2011 in an international context. From this data the UK would not appear to be alone in experiencing declining growth in Labour productivity (output per hour worked) output per hour worked. Germany, 115 Norway and Italy have also 110 experienced weak productivity 105 growth France Germany Ireland Italy Norway Spain United Kingdom United States Source: OECD levels in Over the period from 2006 to 2010, the UK actually closed the gap in productivity with traditionally strong performers like Germany. Productivity in the UK increased from 81.8 per cent of German levels in 2006 to 85.5 per cent of German 1 The preliminary release for Q3 GDP indicated an increase of 1.0% over the quarter.

3 GDP per worker (2007 = 100) Therefore, evidence of a similar pattern in declining productivity across some other advanced economies, suggests the possibility of some medium to long term impacts associated with the global financial crisis which are common across advanced economies. Interestingly, measuring productivity on an output per worker basis shows Source: ONS the UK much more of an outlier in terms of productivity. This is because the UK economy has retained employment at a higher level, relative to the fall in output, compared to other countries, which is particularly striking as the UK has one of the more flexible labour markets and therefore its labour market may have been expected to respond to the downturn more sharply. Now we turn to possible reasons for this. What is driving the decline in productivity in the UK? Scottish nominal GVA per hour worked UK = 100 It is not clear but there are three possible explanation for the trends in productivity at the UK level: 1) A temporary demand side shock 2) A temporary supply side shock 3) A permanent supply side shock This section looks at each of these explanations to understand if productivity is expected to recover to pre-recession levels or if there has been permanent damage to productivity of the economy.

4 Temporary demand side shock Full-time and Part-time employment (aged 16 +) This view holds that the current weakness in productivity is primarily demand driven and will reverse once the recovery gains traction. It implies that the current output gap is large. 2 At first glance, the evidence does not appear to support this view as firms continue to report that they are working close to full capacity. This may be misleading however as firms could be working hard in order to try and find new business. As the number of transactions for each hour of effort will be lower than before the crisis, the measured productivity of workers will also be lower. If the weakness in labour productivity is demand-driven, and primarily cyclical, then it implies that labour is being hoarded by companies. A possible explanation for this is that shedding labour can be costly, so firms may have decided to retain underutilised workers in anticipation of a subsequent upturn. Persistently low wage growth since the start of recession, along with low interest rates and forbearance by banks may also have made it easier than otherwise for firms to keep on skilled staff. However, given that stronger labour market performance over the past year has been driven by flows into employment rather than a declining flow into unemployment, labour hoarding is likely to explain only a small part of the puzzle. Part-time and Full-time Employment with GDP 2008 Q1 = 100 Analysis of the labour market shows that the flows into employment however, have been predominately accounted for by increases in part time workers and those classified as self employed who may be working for themselves at less than full capacity. The possible reasons for this rise in 2 Capital Economics estimate, 2 Oct 2012

5 self-employment are discussed on page 43. This has led to a reduction in average hours worked and hence output despite employment being created. This increase in part-time work appears to account for an explanation of part of the productivity puzzle as full-time employment appears to track GDP fairly well indicating no productivity puzzle with respect to full-time employment. Temporary supply side shock A further explanation for the weakness in productivity and one that is more consistent with the reported levels of high capacity utilisation is that the economy s current supply capacity is temporarily weaker. With the crisis causing a fall in productivity and accompanying falling real wages, households may have had to increase their supply of labour to maintain their income, resulting in an increase in labour force participation and employment. Ben Broadbent, an external member of the MPC, offered an explanation for a possible temporary supply side shock in a recent speech. 3 By looking at sectoral data on output, employment and prices he argues that there may have been an increase in capital mismatch in the UK. In particular, historically low interest rates and increased levels of forbearance shown to low-productivity companies may be hampering the allocation of capital to more productive sectors. This potential delay in the reallocation of capital may explain the comparatively low levels of company failures, leading to the creation of so-called zombie companies which may be surviving because of low interest rates even though they are using assets unproductively. This could mean that there is scope for a period of abovetrend catch up at some point in the future but at the cost of insolvencies and job losses. If this is the case, then it suggests a possible difficult adjustment process in the months and years ahead for certain areas of the economy. Permanent supply side shock A possible further explanation for weak productivity growth in the UK is that it may reflect a permanent hit to potential output. As explained in the discussion of the possible size of the output gap in the UK, while output in the UK remains around 14 per cent below pre-recession trend levels, the OBR estimate the amount of spare capacity in the economy could be just 2.6 per cent of GDP A permanent loss of productivity could have been caused by weak growth in the capital stock; high and persistent unemployment resulting in a loss of skills and detachment from the labour market; and the loss of parts of the high value added financial services sector as a result of the crisis. 3 Productivity and the allocation of resources, Speech given by Ben Broadbent, 12 September 2012

6 The productivity puzzle may also reflect to a certain extent measurement error in either output or labour market data. This is understandable given that a true picture of the economy can be especially difficult in periods of uncertainty and relative volatility. According to Goldman Sachs, the average revision to the initial estimate of quarteron-quarter GDP growth has been +0.25% between 1985 and 2010 with the revisions typically taking place two to three years after the initial estimate. The revisions to GDP following the recession could therefore be quite significant lessening the extent of the productivity puzzle. 4 Recent labour market data for the UK may also be overstating the extent of the improvement in employment although this is unlikely to explain much of the puzzle. In summary, it is likely that the current low productivity measures for the UK reflect a combination of the above factors. Conclusion At present, due to the nature and adjustments in employment and output from the current financial crisis, the impact of the recession/recovery phase on productivity performance is difficult to accurately assess. Over the recession, the fall in output has been much larger relative to the fall in employment in both Scotland and the UK prompting concerns that productivity has weakened, with potential implications for long-term growth. This phenomenon has not been restricted to the UK when measured on an output per hour worked basis. Although productivity in the UK is still below the G7 average, the rate of growth since recession has been comparable to that experienced in other major EU economies. However, a divergence emerges when looking at international comparisons on an output per worker basis. The key factors which are likely to influence Scotland s productivity performance in the coming years include the impact of the recession on key growth sectors, the length and depth of the recovery phase, demographic change, the level of research and innovation in the economy, youth unemployment and whether the recent increase in part-time workers is temporary or a more permanent, structural effect. 4 Goldman Sachs Global Economics, Commodities and Strategy Research Deciphering the UK s productivity September 28, 2012

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