Strategy & economics

Gainfully employed

14/04/2015

Richard Jeffrey

Richard Jeffrey

Chief Economist

Whatever the complexion of the next government, there is one macroeconomic issue that will require continued investigation: the so-called productivity conundrum. If anything, the puzzle presented by recent low growth in productivity has become even harder to resolve, following revisions to investment data which suggest that the post-recession recovery in business investment was significantly stronger than previously thought. Having slumped 14.4% in 2009, the subsequent five years saw a cumulative increase of 29.6%, with both 2013 and 2014 setting new all-time highs for investment spending. Despite this, productivity in 2013 and 2014 improved by a paltry 0.4% and 0.5%, respectively.

Before investigating the numbers further, it is worth taking a step back to look at why productivity growth is so crucial. We are probably all familiar with analysing GDP through examining total output or expenditure within the economy, or for that matter looking at total incomes. However, there is another way to understand GDP, and that is through the input of labour. Broadly, GDP growth requires either an increase in the number of people employed or an improvement in output per employee. It is this analysis that provides us with the concept of the sustainable growth potential of the economy. When applied to the exceptional period between 1997 and 2007 the methodology provides some important insights. The annual average increase in GDP was 3.0%. Supporting this, productivity improved by an average 1.9% per year, fractionally below the 25-year average of 2.0%. Making up the gap, the increase in the employment rate over the period supported another 0.4% growth per annum, and the growing size of the workforce underpinned a further 0.7%.

This provides us with some historical context for recent GDP growth. The latest data show growth last year of 2.8%, but behind this was a gain in productivity of a mere 0.5%. So, it was increased labour input that supported most of the increase in GDP in 2014, with 1.6% coming from the rise in the employment rate and 0.7% from the increase in the size of the workforce.

In the near term, the workforce may continue to expand relatively quickly and may continue to enhance the UK’s growth potential. However, there are political and social pressures to restrict the level of immigration, which is one of the main factors behind the growth in the employable population. At the same time, since the employment rate is already at an all-time high, it is unlikely that further increases in the rate will make similar contributions to the growth potential of the UK. Indeed, rather than facilitating growth, developments in the labour market may begin to become more of a constraint. In this situation, if the economy is to continue to expand by more than 2% per annum, productivity will have to increase at a much faster rate than over the past few years.

What explanations are there for the dire recent trend in output per person? It could be, of course, that GDP has been understated and that the true trend in productivity is appreciably firmer. This would not be without precedent. It may also be that the conjunction of a plentiful supply of labour and low wage inflation has created a situation in which companies feel they do not have to focus so acutely on productivity enhancing investment. If true, this should be self-correcting as the labour market tightens.

We can also delve into the headline numbers a little more deeply. This produces the slightly more reassuring finding that the market sector of the economy (loosely equivalent to the private sector) saw productivity growth improving from 0.3% in 2013 to 0.9% in 2014. In addition, it is evident that productivity growth in the manufacturing sector is close to returning to its long average of 3.5% per annum. This has to be regarded as very important in the context of the UK’s international competitiveness. The obverse of this is true for the services sector and it would appear to be in this area of the economy that the problem lies – in particular within financial and business services. As ever, there are likely to be multiple causes. However, one factor may be that various aspects of the reaction to the recession and financial crisis (including increased regulation) have undermined productivity growth. Whether this is temporary or permanent remains to be seen. If permanent, it will self-evidently damage the growth potential of the wider economy.

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