Can Intangible Investment Explain the UK Productivity Puzzle?
Between 2007 and 2009 real UK market sector value added fell by 7.4 per cent. Market sector hours worked fell by 3.5 per cent and hence market sector productivity fell by 4 per cent. In 2010, hours started to grow again, but output has grown very slowly. Between 2011 and 2012 Q3, the latest period for which market sector data are available, hours have grown by 3.4 per cent but market sector value added by 0 per cent. Hence productivity has fallen by 3.4 per cent. Market sector output per hour is now around 16 per cent below its pre-crisis trend. Why?
The standard explanation for the initial fall in productivity is labour hoarding. In most previous recessions, firms cut output but kept labour in reserve for the recovery. Productivity, output per worker, falls at first, but then recovers as the firm uses the reserve inputs. Strictly speaking the fall in productivity is mismeasurement since the output per utilised input is the same, but with utilisation typically poorly measured this shows up as a fall, then rise, in productivity.
This explanation seems to carry less and less weight for the post-2008 years, for it seems very unlikely that firms are still carrying underutilised workers four years on. Further, as we document below, during the recession and since, firms have upskilled at a much faster pace (skill- adjusted labour composition rose at 0.5 per cent per annum 2005–8, but at 1.1 per cent after 2008). Thus if firms are holding onto workers, it is the high skilled, not the low skilled.
A number of different explanations of the UK productivity puzzle have been put forward. First, there are the arguments on labour hoarding and labour utilisation noted above. Second, that this recession has come at a time of greater labour market flexibility so that declines in real wages have allowed firms to keep on less productive workers. At the same time the financial crisis may have increased the cost of capital so that at the margin firms are substituting away from capital and towards labour, thus reducing labour productivity. Third, that the financial crisis has impaired the re-allocation of capital and that there is less migration of capital away from low return activity to higher returns (Broadbent, 2012). Fourth, that a greater degree of forbearance and also increased risk aversion on the part of banks has resulted in lessentry and exit since the recession, with ‘zombie firms’ maintained and few high productivity entrants. Fifth, that a decline in business investment has reduced the capital–labour ratio and therefore labour productivity. We consider here a potential sixth explanation to do with the role of intangible investment in terms of both measurement and its impact on growth.
A broad range of intangible assets is included, under three main intangible asset classes, based on the definitions first developed in Corrado, Hulten and Sichel (2005). Firstly, computerised information (mainly software), secondly, innovative property (covering scientific and non-scientific R&D) and finally firm-specific resources (company spending on reputation, human and organisational capital).
To examine the role of intangibles, our starting point is the observation that whilst investment in tangibles, plant/vehicles/buildings has fallen and stayed low, a point perhaps not noticed is that investment in intangibles, specifically Research and Development (R&D) and software has risen since the recession (software fell and has since been rising, R&D was flat and then rose). Consider then a firm which has reduced production but maintained investment in intangibles. Its skill level rises, since intangible investment typically requires high qualified workers. Its measured output falls, since the output of e.g. R&D projects might not manifest itself for a few years. Thus labour productivity falls, in a pattern that looks just like labour hoarding.
There is a second effect. Although intangible investment has been relatively robust over the recession, it fell before 2008. This was because there was a huge surge in intangible investment in the late 1990s around the introduction of the internet, with new software, machinery etc. In addition, as is well known, R&D investment as a share of GDP has been falling for quite some time in the UK. If such investment has spillovers, and they take some time, then it might be that productivity/total factor productivity (TFP) would have fallen in the late 2000s anyway, due to the slowdown in intangible investment in the early 2000s.
This paper (available from NIESR here) then reviews these hypotheses. It therefore attempts to add an additional hypothesis to the literature on the UK productivity puzzle. There is a wide range of commentary and articles written on the productivity puzzle and offering a number of different explanations. For example, the productivity puzzle has been discussed in various speeches by MPC members including Dale (2011), Broadbent (2012) and Weale (2012) and by other commentators such as Martin and Rowthorn (2012). See also Hughes and Saleheen (2012) for the UK productivity puzzle in an historical and international perspective. See ONS (2012a, 2012b) for a measurement perspective on the productivity puzzle and ONS (2013) for a microdata perspective. See Disney et al. (2013) for a review of most of the explanations put forward to explain the productivity puzzle.
Our main conclusions are as follows. First, measured market sector real value added growth since the start of 2008 is understated by 1.6 per cent due to the omission of intangibles. Second, TFP growth would have slowed down anyway by around 0.75 percentage points per annum. The actual slowdown has been much larger than this, since TFP has gone from a pre-recession average of 1.39 per cent per annum (2002–7) to –2.29 per cent per annum (2007–10). Taken together this accounts for around 5 percentage points of the 16 per cent productivity puzzle.