Deloitte’s Ian Stewart ponders the UK productivity puzzle

Ian Stewart, Deloitte’s chief economist, says there is an ongoing puzzle around productivity in the UK, in light of levels of unemployment relative to the state of the economy.

The last five years have seen the worst growth performance by the UK economy since the 1920s. Yet in important respects the economy is faring far better than it did in the late 1920s.

Part of the reasons lies in low interest rates and forbearance on the part of lenders which have helped soften the damage to the economy in this cycle. The UK has also escaped Great Depression levels of unemployment. Indeed, employment has risen for the last three years, as job growth in the private sector has outstripped public sector job losses. Ben Broadbent, a member of the Bank of England’s Monetary Policy Committee, has recently observed that had the normal, pre-recession relationships held, the number of jobs in the UK would have fallen by 8% over the last 5 years. Instead employment has stayed roughly unchanged.

The result is that the UK’s unemployment rate today is well below the peaks seen in the previous, milder recessions of the ’80s and ’90s. This is obviously welcome. But the combination of an expanding workforce and a shrinking economy has meant that productivity, or output per worker, has dropped.

There are plenty of possible explanations for what is going on. GDP growth may be understated and productivity, therefore, stronger than they appear at the moment. Companies could be hanging onto workers in the hope of an upturn in growth. This avoids the cost of firing and hiring workers and is a plausible strategy in an environment, as we are seeing today, of weak wage growth. An alternative explanation is that the recession has permanently depressed productivity by, for instance, disrupting the financial system and weakening consumer activity.

The causes of the UK’s current productivity puzzle remain obscure. But what history does show is that in the long term technology and innovation are two of the main drivers of productivity.

To understand what can make the UK economy grow in the future it is useful to see what has worked in the past. Here are five themes which emerged from a meeting we had last week with the economic historian, Professor Nick Crafts of Warwick University, one of the leading authorities on innovation and economic activity.

First, the application of new technology in an economy is at least as important as innovation. It is not necessarily ground-breaking innovations that matter to an economy as much as the ability to realise the potential of new ideas wherever they come from. Harnessing technology effectively needs a skilled workforce and managers and systems which facilitates the diffusion of new techniques. Within Europe countries vary in their capacity to exploit new technologies. The World Economic Forum ranks Ireland first out of 144 countries on its ability to absorb new technologies through foreign direct investment. By contrast Italy is ranked 122nd.

Second, historically the lag between invention and application has been long. So, for instance, the big impact of electricity on American productivity was in the 1920s, when US factories became organised around electrical power, a full 40 years after the pioneering experiments of Thomas Edison.

Third, the good news is that the lag between invention and exploitation is shortening. It took 150 years for the full effect of steam power to be felt on UK productivity. Professor Crafts believes similar economic effects have been felt in the US from the information, communication and technology revolution in less than four decades. The implication is that today’s innovations are being exploited more quickly, changing patterns of activity and raising growth at a faster pace.

Fourth, markets often find new and unforeseen uses for technologies, creating more pervasive economic effects than were envisaged by their inventors. The original application for radio, one of the transformational technologies of the twentieth century, was for ship to shore communication. Global Positional System (GPS) technology was created for military use but has become a ubiquitous and productivity enhancing civil technology.

Fifth, consumers, rather the inventors or companies, tend to be the principle beneficiaries of innovation. Professor Crafts estimates that only around 2% of the total social gain from the technological process accrue to the innovators. Railways were a revolutionised travel in the nineteenth century but proved a poor investment. Mass air travel has changed the world in the last 40 years but for much of this time the airline sector has faced poor profitability.

Innovation is vital, yet history shows that it is the application of new products and processes in the workplace that boosts growth. Getting inventions to work often requires changes to organisations and working practices. Economies and companies which have this flexibility have an advantage. We should not underestimate the value of being able to put other peoples’ ideas to work.

 

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