Low interest rates and high public spending drag down productivity

Graeme Leach
Aerial Views Of Stonehenge
The level of productivity in the UK is now 21 per cent below its pre financial crisis trend (Source: Getty)

The latest Forecast Evaluation Report (October 2017) from the Office for Budget Responsibility (OBR) highlights the weakness in UK productivity growth over the past five years.

Output per hour in the UK has averaged just 0.2 per cent 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 per cent below its pre financial crisis trend.

Read more: How the UK can plug the productivity gap

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, the state of the financial system, and the need to rebuild 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 two effects on productivity. Lower productivity companies reduce “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 quantitative easing.

Second is the weakness in business investment, which is only five per cent above its pre-crisis peak. Weak business investment reduces the contribution of capital deepening – new more productive equipment – to productivity growth. A decade after the 1980s recession, business investment was 63 per cent higher than its pre-recession peak. A decade on from the 1990s recession, business investment was 30 per cent above its pre-recession peak.

While such disparities seem 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 software, falling outside 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 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, which I fear has been overlooked.

In the early twenty-first century, the Treasury published its list of the five key influences on productivity: enterprise, innovation, investment, competition, and education and skills. When these were published, I wrote that there was a “missing link” or sixth driver, namely the growing size of the state.

This remains the case. Public spending has fallen back from its recession peak to around 40 per cent of GDP, but this is still one of the highest ratios in 30 years. Public sector receipts, at 37 per cent of GDP, are also high 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), and 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.

Read more: Data skills will solve Britain’s productivity puzzle

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