Productivity growth: The alarming trend that could kill all hope of a budget surplus (and Osborne becoming Prime Minister)

Graeme Leach
Conservative Party Autumn Conference 2015 - Day 2
The debate about the macroeconomic outlook and public finances is based on such forthright views, and yet it is all built on sand, because nobody has a clue as to how productivity will play out (Source: Getty)

For me, the most interesting aspect of the Budget yesterday wasn’t the headline-grabbing sin tax on sugary drinks, but the Office for Budget Responsibility’s (OBR) “highly uncertain judgement call” (in the words of the chancellor) regarding future productivity growth (output per hour worked).

The OBR now projects that UK productivity growth, in the calculation of potential output, will be 1.4 per cent this year, 1.6 per cent in 2017, 1.8 per cent in 2018, and 2 per cent in 2019 and 2020. Compared with its November 2015 projections, the OBR has shaved off 0.2 percentage points from the annual growth rate of productivity over the 2017-20 period, with a smaller 0.1 percentage point reduction this year. This may seem trivial, but it’s not. It’s the continuation of an alarming trend.

Compared with its projection in 2010, the OBR has revised down cumulative productivity growth (over the 2010-20 period) by 7.5 percentage points. The US Congressional Budget Office (CBO) has undertaken a similar reduction of 9 percentage points over the same period for the US.

These are huge numbers, reflecting the very different nature of economic recovery in the wake of the financial crisis. Despite being half a decade into recovery, productivity growth remains anaemic, estimated by the OBR at just 0.8 per cent last year. The fiscal nightmare is that potential output growth fails to increase much beyond last year’s rate of growth. That seems unlikely, but how many unlikely events have we experienced over the past 10 years?

Productivity growth is the major component of long-term potential GDP growth in advanced economies, and yet we don’t really understand exactly why productivity is behaving so differently in this recovery. Theories abound, but it’s difficult to be certain. And into this fog, the chancellor has little choice but to sail the public finances. The public finances, and his future, will depend on whether or not the OBR is correct about productivity and potential output growth.

Potential output growth can be derived from four components: productivity, population, employment rates and hours worked. The big one is productivity.

If productivity bounces back and exceeds expectations, the underlying improvement in the public finances will no doubt put a down-payment on Number 10 for the chancellor. If productivity doesn’t bounce back and instead undershoots the OBR’s projections, the public finances are going to come under immense pressure, with the attainment of a budget surplus an ever more distant prospect.

It would be funny, if it wasn’t so sad, that all the debate about the macroeconomic outlook and public finances is based on such forthright views, and yet it is all built on sand, because nobody has a clue as to how productivity will play out. This isn’t a criticism of the OBR. They’ve done a very sensible analysis. It merely confirms how little economists really know about the future.

One final thought. Without the contribution from population growth, the OBR projects UK potential output growth around 0.6 percentage points lower each year. So indulge me for a moment. What happens if the UK votes to leave the EU? The logic is that the Autumn Statement later in the year would revise down the contribution to potential output from population growth. By then the chancellor will be hoping that the OBR has enough data this year to avoid any further downgrade to productivity. But if the OBR doesn’t, the Autumn Statement could be ugly.

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