By Lucy O’Carroll, Chief Economist, Aberdeen Asset Management
Productivity matters. As Bank of England Governor Mark Carney recently noted, “Our shared prosperity depends on it”. The level of labour productivity is an important gauge of the economy’s health, as it measures the quantity of output that can be produced with existing resources.
In the longer run, technological progress boosts productivity, helping to determine future living standards. Productivity measures are also important for the Monetary Policy Committee (MPC), as they help it gauge the economy’s ability to grow without generating excessive inflationary pressures. If the MPC gets its productivity growth forecasts wrong, it risks setting interest rates at the wrong level.
Unfortunately, the UK’s productivity performance since the financial crisis has been disappointing: having grown at an annual average rate of 2.1% in the two decades before the financial crisis, growth in output per hour worked has averaged zero in the seven years since. As a result, productivity remains 14.5% below its pre-2008 trend. So what lies behind the UK’s post-crisis productivity weakness? Three explanations come to mind: measurement problems, cyclical trends and more persistent structural factors.
Measurement factors and productivity
Since labour productivity is measured as the amount of output per worker (or per hour worked), if output turns out to be higher than initially estimated, this reduces the size of the estimated productivity ‘shortfall’. Recently, preliminary estimates of UK Gross Domestic Product (GDP) growth have tended to be revised up over time; this is a common statistical phenomenon for economies during growth recovery periods.
The MPC accounts for this possibility in its GDP ‘fan chart’ by not only projecting a range of possible forecast UK growth rates with different probabilities attached, but also by placing similar probabilities on a set of ‘backcasts’ over past official estimates of GDP growth. So while the official estimate of annual GDP growth in 2014 Q4 was 3.0%, the MPC’s backcast indicates that the committee is willing to countenance that ‘true’ GDP growth in that quarter was somewhat lower (as low as 0.5%) or, more likely, higher (as high as 5.0%).
In addition, the trend rate of UK productivity growth may have started slowing before the financial crisis struck – in which case, estimating a productivity shortfall relative to the pre-2008 trend could be misleading, too. The growth of North Sea oil and gas extraction output, for example, has been in decline since around 2003. In total, the Bank of England estimates that these measurement issues could account for around a quarter of the 14.5% shortfall in the UK’s productivity performance relative to its pre-crisis trend – meaningful, but far from providing a complete explanation.
Cyclical factors and productivity
Periods of economic downturn are generally accompanied by a fall in labour productivity, while periods of economic expansion coincide with productivity gains. In the former, firms are typically unable or unwilling to dispose of buildings or machinery, or to lay off workers, either because of minimum staffing levels required to keep the business going or because they believe the weakness in demand is temporary.
As a result, firms are able to maintain capacity levels but will probably be less productive. Other cyclical factors could include firms having to divert resources towards business development or generating custom – which may not count as output, at least in the short run – during downturns. But as the UK economy has picked up speed over the past couple of years, while productivity has continued to disappoint, these explanations have become less convincing.