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Is there a missing link to understanding poor productivity?

Why has UK productivity growth been so weak over the past 5 years?

The latest Forecast Evaluation Report (October 2017) from the Office for Budget Responsibility (OBR) highlights the weakness in UK productivity growth over the past 5 years. Output per hour in the UK has averaged just 0.2% per annum growth. This is one-tenth of its long-term average. According to the OBR, the level of productivity in the UK is now 21% below its pre financial crisis trend.

The OBR has consistently projected an uptick in productivity as ‘temporary’ constraints on productivity growth were expected to ease. But this has been a classic example of ‘waiting for Godot’ with the forecast upturn never turning up.

Temporary factors cited over the years have focused on labour hoarding and the state of the financial system and the need to re-build bank balance sheets, thereby constraining lending. But these arguments don’t cut the mustard a decade on from the financial crisis.

Other explanations would appear to have more going for them. First is the impact of accommodative monetary policy, and record low interest rates which has allowed weak or zombie companies to soldier on. This has 2 effects on productivity. Lower productivity companies lower ‘the batting average’. They also impede the reallocation of resources to more productive uses within the economy. There could be a capital mismatch, with fast growth (high rates of return) firms capital constrained and zombie (low rates of return) companies kept operating. Academic evidence suggests that around one-third of productivity growth is attributable to the entry and exit of firms and this effect could be reduced by QE.

Second is the weakness in business investment, which is only 5% above its pre-crisis peak. Weak business investment reduces the contribution of capital deepening – new more productive equipment - to productivity growth. 10 years on from the 1980s recession business investment was 63% higher than its pre-recession peak. 10 years on from the 1990s recession business investment was 30% above its pre-recession peak. Whilst such disparities would appear to provide an explanation for weak productivity growth, I wonder whether the investment numbers are quite as bad as they appear. My doubt relates to the impact of intangibles, such as investment in software, falling outside of official investment measures and being captured in consumption numbers instead.

A third explanation relates to the growth of lower productivity activities, what I call the costaconomy. A fourth explanation is sectoral, relating to the impact of The Great Recession on the output of the City, and a secular decline in North Sea oil and gas production over the past decade. Another explanation relates to falling rates of innovation and R&D.

I’m sure all these explanations play a part, but I’d like to submit another ‘missing link’, which I fear has been overlooked. In the early 00s HM Treasury published its list of the 5 key positive drivers of productivity: enterprise, innovation, investment, competition and education & skills. When these were published I wrote that there was a ‘missing link’ or 6th influence, namely the negative impact of the growing size of the state. This remains the case. Total public spending, has fallen back from its recession peak to around 40% of GDP, but this is still one of the highest ratios in 30 years. Public sector receipts, at 37% of GDP, are also at the top end when compared with the past 30 years. It’s as if the reforms of the 1980s never happened. But there’s more. Over recent decades, public spending (e.g. benefits) has been replaced by regulation (e.g. the minimum wage), or there has been a surge in regulation full stop. A total intervention index would surely show the dragging anchor of the state has never been higher. Explanations of poor productivity performance need to factor this in.