Puzzling over productivity: a tough nut to crack

Adam Chester, Head of Economics, Lloyds Bank Commercial Banking, looks at the UK’s poor productivity performance and the how growth has become reliant on rising employment.

Britain’s productivity puzzle is proving particularly tricky to solve. UK productivity fell by 0.5% in Q1 of 2017, leaving output per hour at its lowest since before the financial crisis in 2008.  Our workers are only around three quarters as productive as their equivalents in Germany, who could happily go home early every Thursday afternoon and still produce as much as a British worker who stays on the job until 5pm on Friday.

This is a problem because low productivity constrains prosperity. It means lower output and lower wages, and makes us less competitive internationally. So, what is to blame?

A skills shortage, heightened regulation, impediments to economies of scale and poor infrastructure are all likely to have played their part. But various factors have been blamed for the UK’s flagging productivity, with some more benign than others.

A measured approach

Part of the cause may just be errors in the way productivity is recorded. There are inherent difficulties in measuring the productivity of an economy with large service-sector industries, particularly financial services, like the UK.

As official statistics indicate, productivity in some sectors, including financial services, has been significantly weaker than in other non-financial service sectors in recent years.

While Britain’s success in financial services and other ancillary sectors prior to the financial crash was spectacular, since 2008 additional regulatory demands mean it has had to create many thousands of extra back room jobs, whose productivity is tricky to measure.

But that isn’t the whole picture.

The deterioration in productivity may also be down to changes in the composition of capital and labour.

Since the financial crisis, slow wage growth and elevated economic uncertainty look to have encouraged more companies to shun productivity-enhancing capital investment in favour of hiring new workers to drive output growth.

Indeed, the rise in the UK’s GDP over the past decade has been driven almost exclusively by growth in employment and hours worked rather than productivity.

But with unemployment at its lowest rate for 40 years, what happens when we run out of spare workers?

A major dilemma

The latest labour market data serves to reinforce this point. Employment grew by 175,000 in the three months to May, which was higher than expected, while unemployment fell to a low of just 4.5%, which hasn’t been seen for decades.

Despite growing skills shortages, and with inflation on the rise, so far pay pressures remain mild. Annual growth in overall pay slipped from 2.1% to 1.8% between March and May – the first time it has been below 2% since February 2015.

In the second quarter of 2017 GDP grew by 0.3%, despite shrinking industrial output and a contracting construction sector, while total employment is predicted to have risen by 0.3%. As a result, productivity growth between April and June is projected to be zero.

The combination of a tightening labour market, weak productivity growth and benign pay pressures poses a major headache.

So, where is GDP growth going to come from, unless productivity starts to recover?

Increasing labour shortages may prompt firms to redouble their efforts to boost productivity, not least to justify paying potentially higher wage demands.

If so, business investment and productivity could pick up more sharply.

But, if the causes of the UK’s productivity weakness prove more enduring, the UK economy will face an even more challenging outlook for years to come.