The UK productivity puzzle – or is it?

There was a time when it was normal for the productivity of labour in the UK to be rising year by year, and for money wages increases to reflect this by forging ahead of price increases. The last few years, however, seem to have turned these norms upside down. Has the economy hit an iceberg, or just an unusually strong headwind?

The case for believing the latter, and thus for hoping for better things in due course, takes off from the fact that businesses have lately been coming to rely more on the use of labour in their productive processes and rather less on capital equipment of various kinds. This unusual shift in ‘factor proportions’ has occurred partly because, under the pressure of unemployment, money wages have risen less than prices, so that labour has become cheaper in real terms. But at the same time, the upheavals in the banking system since 2008 have made it very hard for businesses to raise funds to invest in capital equipment. Under these two influences, the normal process of increasing capital per worker leading to increasing output per worker, and so to increasing real wages, has evidently ceased to operate.

Or has it just been suspended? It is reasonable to suppose that the effect of the upheavals in the banking system was essentially that of a shock whose impact, with the passage of time and the aid of reforms to the system, will sooner or later fade. As the blockage it applied to the flow of funds for investment turns out to be temporary and diminishing, the normal process of increasing capital per worker should be resumed, and with it the secular growth of labour productivity and real wages. The recent lapse from that would be no more than a good question for examination papers in economic history.

Nevertheless, the above could well fail to provide a complete explanation of recent developments, since increasing capital per worker is not the exclusive determinant of productivity growth. That also depends upon the flow of innovations of various kinds which enable more output to be produced from given quantities of capital and labour.   The American economist Robert J. Gordon has recently assembled evidence for the USA from about 1900 which appears to indicate what he calls ‘faltering innovation’, and his paper poses the question ‘Is U.S. Economic Growth Over?’ Since the influence of the innovations he studies is much wider than the USA alone, his hypothesis implies what has recently been happening to productivity in the UK could be rather more than just an episode.

Contemplating Professor Gordon’s theory alongside the ‘factor proportions’ theory outlined earlier, economists thoroughly in thrall to the ‘dismal science’ may be tempted to opt for the former, and those who have stayed more cheerful for the latter. But it is important to note that the two theories are not mutually exclusive; it is quite possible for both to apply. The capital-labour ratio could return to a normally rising trend in an economy where weaker innovation enabled it to deliver less of a dividend in the shape of rising labour productivity.   

Professor J. R. Sargent examines these questions in greater detail in the June 2013 issue of Economic Affairs.

There is no "productivity puzzle". It is quite unremarkable that there is a fall in labour productivity during a recession. The reason is fairly obvious. Capital is now internationally mobile and developing countries can match us in productive efficiency per unit of capital. It follows there will be a constant drain of productive capital to where capital is scarce and labour is abundant - where rents are high and wages are low. Normally, a capital drain is moderated by capital formation. However, in a downturn, capital formation dries up but the capital drain continues. As labour now has less capital to work with its marginal product falls and, consequently, so do real wages. The capital drain will cause other difficulties as well. Over time, the output gap will slowly evaporate making the recovery somewhat protracted. A fiscal stimulus will then be less effective as it now has less headroom for expansion. Also, as domestic demand picks up in the recovery phase, the owners of capital may choose to invest abroad to meet local demand. The vital domestic investment response may go missing, again prolonging the recovery. There will also be some obvious long term consequences. Slower growth, real wage stagnation, a big increase in income for owners of capital (they are the big winners in this scenario, not only earning higher rents abroad but also earning higher rents at home as capital is now more scarce there), rising inequality as a result of the above, low investment and reduced or stagnant labour productivity. The good news is that this global capital transfer will end when factor prices (wages and rents) have roughly equalized. The bad news is this may not happen in our lifetime!

Post new comment

The content of this field is kept private and will not be shown publicly.
Type the characters you see in this picture. (verify using audio)
Type the characters you see in the picture above; if you can't read them, submit the form and a new image will be generated. Not case sensitive.