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Part 2: Pieria Debate on the UK Productivity Puzzle

Part 2: Pieria Debate on the UK Productivity Puzzle

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Miles Kimball, Jonathan Portes, Frances Coppola and Tomas Hirst discuss the mysterious case of the UK's falling productivity.

Miles Kimball: A big issue that the Bank of England is worried about is that the UK may not be far below the natural level of output at all. They’re very interest in the productivity puzzle and I’m hoping they’ll put out a prize for research into it one of these days.

Tomas Hirst: We’ve had some interesting discussions on Pieria about how we can explain the productivity puzzle – including how it might reflect miscalculations of output and growing problems in the UK labour market. 

Jonathan Portes: Do they really think that we’re not far below the natural level of output at the moment?

Miles Kimball: Well opinions differ. I think it’s safe to say there’s a very active debate on exactly that question.

Tomas Hirst: The minutes of the MPC’s most recent meeting suggest that there’s something of a schism opening up in the committee between those worrying about the risks of further QE purchases (who are currently in the majority) and those worrying about the continued weakness of output. Do you think it reflects this debate?

Miles Kimball: Pieria really ought to talk about this more. For many other economies it seems crystal clear to almost everybody with an ounce of sense that output is below the natural level but I don’t know if it’s true in the UK. It’s not even clear to me, I just don’t know. 

The broadest sphere of the debate should really be trying to get a hold of that productivity puzzle. In addition to measures that could add to aggregate demand for the UK I think a great deal of work needs to be done to assess whether it really is below the natural level of output or not.

Tomas Hirst: I think in the UK people have been too focused on headline figures of inflation and unemployment, for example. What people have missed is the fact that core inflation has been below target throughout the crisis, which might itself justify further stimulus.

Miles Kimball: Well remember that the new remit from the Treasury says that the MPC should look through government-administered prices.

Tomas Hirst: Yes, but could that change in mandate not be a response to this problem of growing doubts in the usefulness of headline figures?

Miles Kimball: What I’m saying is that the remit could suggest that the BoE is being asked to look more at core inflation. It’s actually a little bit of a mixed message as they’re being told that their target should remain linked to headline inflation but are being told to look through the headline numbers at what’s happening to core inflation. Pushing them towards core inflation is important. 

On the productivity puzzle, there are things that can be solved by expansion and things that can’t. In the recession the government is not as willing to let firms go bankrupt so you get a long tail of unproductive firms carrying on. If you convince everybody that you’ve got all the aggregate demand you want you can allow for more bankruptcies, which will mean some of the puzzle will automatically correct.

Frances Coppola: I’ve heard that argument a lot but I’m not 100% convinced. You’ve got to look through the recession to see what the long-term secular trend is.

Over the last few years we’ve seen a huge increase in self-employment and at the same time self-employed incomes have crashed. That can’t be to do simply with unproductive companies.

Jonathan Portes: It’s an aggregate demand problem.

Frances Coppola: Exactly!

Jonathan Portes: Actually it was part of David Blanchflower’s recent paper that discussed a growing number of people in the UK who want to work more hours and can’t get them. If you’re self-employed and you want to work more hours the only thing that is stopping you is a lack of demand.

Frances Coppola: Speaking from personal experience, as I am self-employed and have been for a long time in a business that requires specialist skills, things were fine until two years ago. Since then demand has collapsed. And it’s not just singing. I’ve never seen the situation out there this bad.

 

Further Reading

Part 1: Pieria debate on electronic money and negative interest rates

How Can We Explain Britain’s Productivity Puzzle? – Pieria

Perverse incentives and productivity – Coppola Comment

Can Intangible Investment Explain The UK Productivity Puzzle – Professor Jonathan Haskel


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There is no puzzle. Falling productivity, rising inequality, slow growth, falling labour share of national income and real wage stagnation are all inevitable consequences of globalization. Indeed, it would only be remarkable if this did not occur. Academic economists have adopted free trade and globalization with almost religious zeal to the point that it has blinded them to what there own basic theory tells them. I have noted that the theory is almost never correctly explained, so here is a shortened version.

When a capital rich country (home) opens trade with a capital poor country (foreign) in a scenario where there is a large difference in their respective capital/labour ratios, and foreign can match home in terms of technological efficiency, then trade alone will not be enough to equalize factor prices. This will leave rents (the return on capital) lower at home than in foreign and wages (the return to labour) higher at home than in foreign. If, also, productive capital is internationally mobile, then there is an economic incentive for capital to transfer from home to foreign in search of higher rents. In technical terms, in a static model, the production possibility frontier (ppf) at home shrinks and that of foreign expands. International capital transfer is a much slower process than restructuring from trade in goods where the transfer of capital is local. It must await the development of infrastructure in foreign before productive capital can be absorbed (this includes roads, rail, ports, power generation, training and educational facilities as well as the legal frameworks appropriate to modern business. This long term restructuring will take many decades to play out and will only end when rents and wages have roughly equalized.

The consequences of capital transfer for home are easily seen. The big winners are rentiers (the owners of capital). They not only benefit from earning higher rents abroad but also they earn higher rents at home as capital becomes more scarce there. The big losers are wage earners. Real wages at home fall as labour productivity declines having less capital to work with. The twin results of a declining wages and a rising rentier income lead to a fall in the labour share and a rise in the rentier share of national income, with a consequent increase in inequality. In terms of the economy, productive capacity declines in line with the loss of productive capital.

In a dynamic model, these effects show up as slow growth, stagnant wages and productivity, and rising inequality. Interestingly, dynamic simulations also predict a falling labour participation rate long term. Mainly because unemployment now has a strong structural component. This shows up clearly in computer simulations of trade. What is happening is that structural unemployment - usually thought to be a short to medium term response to trade - becomes long term with capital transfer. The reason is that trade can no longer find an equilibrium while the difference between capital/labour ratios at home and foreign are narrowing. Sectors may contract, expand and then contract again in a complex response to this changing environment.

All this makes dealing with a downturn very difficult. With weak demand it is likely that capital transfer abroad will dominate capital formation at home, gradually evaporating the output gap. Applying fiscal stimulus will then simply drag in imports and worsen the debt position. Probably the only realistic response is the current one. Print money, create mild inflation and hope to bring the down the value of the currency and lower the real wage sufficiently to prevent a spike in unemployment.

At any rate, that is what the theory says. It is strongly backed by mathematical modelling and computer simulations of trade. It also explains the observed experiences of most developed economies, including the "puzzles" of productivity, inequality, wage stagnation and much else besides. I find it bewildering so many economists refuse to accept that globalization is the underlying cause. Like King Canute, perhaps they believe that a collective act of will can prevent global tides.

Hi Tomas,

The post you linked to seemed to bear out my thoughts on household costs, but I'm intrigued that your preferred method of stimulating the economy would be via large infrastructure projects.

If I understand the theory correctly, it's that such projects generate jobs in the construction industry (while new infrastructure is being built) then when construction is finished, further jobs are generated by whatever activities are carried out in the newly constructed building(s). The new jobs lower unemployment, the demand for skilled employees becomes greater and therefore the downward pressure on wages is eased.

I believe such a move would be helpful (for example, I'm aware that we are not building enough new homes to lessen the pressure on demand) but I don't think the benefits would be as great as hoped for. Suppose we embark on a national building programme that includes the building of factories, homes, reservoirs, power stations, roads and shopping centres.

Now suppose that this creates 100,000 new jobs. Of those jobs, only a very small percentage will be paying wages over the national average. Many will be at minimum wage or at best the living wage.

Unless the cost of essentials is reduced (rent/mortgage, food, utilities, petrol/rail fares) then these jobs will reduce unemployment, but most of these new employees will still not have any significant discretionary income.

As such, the potential customer base of those offering non-essential goods and services will still be extremely small.

Price controls are almost universally acknowledged to be a dreadful idea, and I can't see that they could work. However, if we can't control the cost of essentials, then I'm not sure I see how infrastructure projects will, in themselves, be sufficient to re-ignite consumer spending.

To my mind (and I must re-iterate I'm far from an expert) only a more balanced distribution of wealth could provide the majority of workers with the means by which to resume spending on non-essential items.

Tomas Hirst

Hi Mark,

No need to apologise, I think it's an excellent point. Indeed I have written about this problem before:

http://pieriaview.blogspot.co.uk/2013/02/why-this-time-is-different.html

It is certainly a concern that during periods of economic uncertainty, such as we're in now, the overwhelming preference may be to save rather than spend. Under such circumstances pushing up asset prices (through QE for example) may not have much impact on activity and may simply serve to increase the wealth disparity, while those who are unable to save see their wages stagnate or fall in real terms.

So the question is how do we address this? As you suggest, one possibility would be some form of redistribution (either through increasing wages or bolstering welfare programmes) or through finding a way to increase economic activity sufficient to increase the demand for workers - boosting their negotiating power.

That we have seen very little evidence of the latter should, in my opinion, suggest we should at least revisit the UK's current strategy, which is pulling money away from welfare programmes while simultaneously weakening the position of labour. Many of our experts on Pieria have advocated a new economic strategy that would involve a significant increase in government investment to help boost aggregate demand and increase the long term productivity capacity of the economy. I can't find many reasons to disagree with that.

I am in no way an economist, and so I apologise if my comment comes across as uneducated, trite, or uses incorrect terminology, but is this whole issue not centred around the fact that in the UK, and most developed market economies, money flows upward and becomes concentrated in a very few hands? As such, when times of economic uncertainty hit and organisations (private or public) take up defensive positions on spending, it is those at the bottom of the pile who are the worst affected.

If somebody earns the national average wage or below, and their real income falls by 2% a year, while at the same time their groceries, utilities and rent increase by significantly more than 2%, the upshot is that they have no discretionary income. I don't have figures on how many people live on the national average wage (or below) but I suspect it's a significant proportion of the nation. I also suspect that London skews the overall UK results considerably.

If somebody is earning a more reasonable salary of say £50,000pa or above, then such a fall in real income is still not welcome, but it won't prevent them from (for example) having a meal out, or giving their child singing lessons.

It's my understanding that shareholders are seeing smaller returns from their investments, as boardrooms and top executives swallow up larger percentages of overall profits in the form of salaries and bonuses, while regular employees are squeezed in an attempt to reduce costs or at least prevent them from growing.

Meanwhile providers of essentials such as electricity and food are under pressure from shareholders to keep delivering growth when their market is fully mature and isn't really growing to any appreciable extent. There are only three options open to them:

1. raise prices (unhappy customers)
2. cut costs (unhappy staff)
3. accept reduced profits (unhappy shareholders)

Most seem to choose a mixture of 1 and 2, exacerbating the problems of those with low incomes, ignoring the salient point that people without discretionary income cannot spend on goods or services. As costs continue to rise while income continues to fall, the greater the percentage of the population that fall into this trap, and the smaller the prospective customer base of those who provide non-essential goods and services.

Is there any workable solution to the current stagnation that doesn't involve those at the top voluntarily giving up some of the wealth that they may or may not have generated and allowing it to cascade down to those they employ? It seems short-sighted for organisations to be allowing such disparity in the remuneration between the boardroom and those whose skills are seen as more easily replaceable.

Sorry for such a long post, especially when the gist is 'We're all skint.' but I'd appreciate any feedback you can offer on where my understanding is incorrect, and pointers on what I'd need to read/understand before I could take part in a fuller discussion on the subject.

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