Economists disagree on lots of things, but on one thing at least there is a consensus. Productivity, or the efficiency of production, is the main driver of human welfare. The data bear this out. Consider that growth in living standards in the UK since the late nineteenth century has been driven entirely by rising productivity. It is not surprising that improving productivity is the Holy Grail of economic policy.
This is why the stagnation in productivity growth since the financial crisis represents such a challenge. Stagnating productivity means stagnating living standards and public services. To some such outcomes calls into question the legitimacy of the economic system.
There are four broad explanations for what has gone wrong.
The first relates to the lingering effects of the global financial crisis. Weak wage growth is likely to have reduced the incentives for firms to undertake productivity-raising investment. Faced with an uncertain world workers are sticking with their jobs for longer, slowing the diffusion of knowledge and skills across the economy. A continuation of very low interest rates has sustained some less productive businesses which, faced with higher rates, would have gone to the wall. In these, and numerous other ways, the financial crisis seems to have cast a long shadow over productivity growth.
The second theory relates to the behaviour of firms. Research by Professor John Van Reenan, of MIT, has found a stark divergence between the UK’s most productive firms and a long tail of low performers. Around 1% of UK firms saw average productivity growth of 6% per year between 2002 and 2014 but a third saw no increase at all. Other research has shown higher levels of productivity among exporting businesses than their domestically-focussed peers and among foreign owned businesses in the UK relative to their UK counterparts. The fact that businesses operating in the same environment and sector perform so differently suggests that management practices play a major role.
The third explanation is that the business environment is to blame. On this account a range of factors, from inadequate transport infrastructure to weaknesses in vocational training and restricted access to risk capital for small firms, are holding back UK productivity.
The fourth and gloomiest theory is that we have entered a new era of permanently low productivity growth. Some argue that we have banked the big inventions – everything from antibiotics, the internal combustion engine and electricity – and we are in an era of less revolutionary technological advance which condemns us to slower productivity growth. Others believe that ageing populations means a less flexible, creative and risk-loving workforce and, as a result, slower productivity growth. Age certainly affects some functions. The US General Aptitude Test shows that motor co-ordination, spatial and finger dexterity skills decline from the early 30s. Yet it is also the case that knowledge and experience increase with age.
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I would love to be able to say that one of these four theories holds the key to low productivity. Frustratingly, it seems more likely that they have all played a part.
Economists have endlessly debated the productivity slowdown. Yet, to paraphrase Marx, the point is to change it. Here we see cause for optimism. Many of the factors cited as being responsible for the UK’s poor productivity performance are, at the least, changeable. Some are reversible. With time and the right policies the effects of the financial crisis should fade. New management, financial and business techniques can be diffused through the economy. The business environment can change for the better – as the Thatcher reforms of the 1980s and 1990s demonstrated.
But what notion of secular stagnation, that we are in an era of irreversibly low productivity growth?
Here I think we should be wary of the very human mistake of extrapolating the recent past – in this case of poor productivity growth – into the indefinite future. In reality productivity comes in waves.
The original idea of secular stagnation came from the US economist, Alvin Hansen, who, in the wake of the Great Depression of the 1930s argued that technology and population-driven growth was played out and the US was entering a new era of low growth. Three decades of unprecedented growth prosperity followed.
The same tendency was apparent in attitudes to the dotcom boom of the late 1990s. It stoked belief in a so-called ‘new paradigm’ of rapid, innovation-driven growth. Just as we were gearing up for a new era of endless prosperity the stock market crashed and the US economy dropped into recession.
With productivity, as with equity investment, the recent past is not necessarily a good guide to the future.
Ian Stewart is Chief Economist at Deloitte