Wednesday, 25 July 2012

Britain’s productivity conundrum

Note: This article was written for the Adam Smith Institute blog and was published there earlier today. It came as a timely response to today's press release from the Office for National Statistics (ONS) on UK's third consecutive negative growth (-0.7% this time). They seem to blame it on an extra bank holiday due to the Diamond Jubilee (!?). I already covered that fallacy back in May. For all my other ASI writings see here

Also, I had another article published this week, at the IEA blog, which was a combination of my two previous posts on Germany and Sweden. For all my IEA writings see here.


UK unemployment is falling, employment is rising, hours worked are increasing, while output is still stagnant. What does all this mean? How can the private sector create more jobs, while the total output it produces is still stagnating or even decreasing? Some economists seem puzzled by this saying that one set of data in this case is wrong. Even though this might be true as one of the two parameters is misleading, there are deeper explanations for this prevalent occurrence in the past few months.

It is not surprising that the first reaction on the market is a decrease in productivity (see graph) as more people employed are actually producing less. This can partially be explained by an increase of hiring due to the Olympic Games, since none of these people are creating value or growth for the economy (in terms of increasing output), but nonetheless have paying jobs. 

Source: ONS, Labour Market Statistics, July 2012, pg.8
Lower wage growth would suggest that unit labour costs are decreasing which is making workers cheaper and more likely to find work. However, looking at the graph this doesn’t seem to be the case. But the question still remains: what is driving productivity down?


If we turn to statistics, we can blame the faulty data reporting and faulty measures of economic activity such as the GDP, or the way we define employment. However, we always use this data and if it serves as a sort of a benchmark in good times, there is no reason why not use it in bad times. The efficiency and precision of the indicators is a debate for itself, but I leave this for another time. 

As for employment, personally I would always rather look at the employment-population ratio, an indicator that paints a much more precise picture of economic activity since it takes into account people leaving the workforce, which usually biases the unemployment figures downwards. In that perspective, the labour market isn’t improving, it’s still in distress (see graph below). 

Source: St. Louis Fed, FRED database
The second explanation for a temporary drive in employment compiled with a stagnating output can be seen in the manifestation of the government’s job policies. While the British government is going head over heels to try and bring more people into work, their programs of incentivising employers to hire more workers is an example of a severe labour market distortion. No wonder productivity is rapidly falling. Employers hire people only to get the government benefit. There is no economic incentive for an employer, apart from the government subsidy he receives. The additional worker won’t create new value; his or her marginal product is very likely to be diminishing. So what’s the point of the policy? Simple, it shows good numbers and thus relaxes the pressure off the government. The fact is that this is just another ‘Potemkin village’ designed to skew the public opinion into showing that the government is actually doing something to help the economy. But here’s the catch – whatever it does, it only hurts the chances of recovery. 

The public is bemused into thinking that the government must address the market failures created by reckless bankers or the finance industry. That wasn’t the issue at all; market failures were in that particular case created by a series of government initiated policies. Ranging from the distortions on the housing market, the credit market, the banking risk, the overall systemic risk and even the European contagion – all these areas were cramped by excessive risk taking which was supported by the regulatory environment and policy decisions. The market (i.e. the people engaged in interactions and decision-making) simply reacted to the vastly distorted signals sent to them. So the proper way of fixing this can only lie in the market itself, as long as its recovery signals aren’t being distorted. Having the government subsidize employers to hire more people simply to increase head count, or having the government force banks to reach lending targets to SMEs or pre-determined ‘winners’, are exactly the type of wrong and distorted signals that are preventing the recovery. One is leading to rapidly declining productivity, and the other is making banks lend money to businesses which already have enough of it (see the Bank of Dave), thereby completely excluding the ones that actually need it to expand their productive activities. To paraphrase Arnold Kling and Nick Schultz from their excellent book From Poverty to Prosperity: “markets often fail, that’s why we need markets.” 

There is only one way of resolving the issue of declining productivity and competitiveness, and it’s not an employment subsidy, it’s a labour market reform

6 comments:

  1. In a skewed version of Keynesianism Governments are bribing firms with public money to hire unneeded workers.

    The workers have cash but everything they want to purchase bears a premium due to the high taxes.

    When will people learn that real growth comes from productivity increases which comes from real business inputs and investments.

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    1. Indeed! Higher productivity implies higher efficiency, which ultimately leads to higher growth. Britain's low growth numbers can only be explained through their declining productivity - which hasn't even been that great before the crisis. Government hiring policies are pushing productivity further downwards and are only making things worse. And they wonder why growth hasn't started while they are doing everything they can to start-up the economy. That's actually the problem

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    2. Why do you seem to think that Britain's productivity was low even before the crisis? Compared to who? Do you have any evidence to back this up?

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    3. As a matter of fact, yes I do. Check out this paper by John Van Reenen from LSE, or even this one which ties management performance to increasing productivity in an economy. Pretty interesting stuff..

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  2. I agree with the general conclusion regarding the labour market reform, however I'm under the impression that the official data is wrong or at least misleading. I live in the UK and don't think things are bad now as they were a couple of years ago, and everyone seems to be emphasising this "double-dip" recession. I think that even though you're right about productivity being low, the output figures must be better than shown. This just shows how the GDP is a faulty measure of economic activity. The usual example is when a man marries his maid, he decreases the official GDP (something like that).

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    1. As I mention in the text there is reason to be suspicious of the precision of these indicators, but as I also pointed out if we use the same reference in good times, why not use it in bad times either? That implies that the GDP isn't a reliable indicator as sometimes it's precise, sometimes it isn't. Even if that is true and even if it is downward biased during a recession, it still doesn't explain why the productivity of the British economy went down and has been relatively lower compared to US, Germany, France etc. even before the crisis.

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