The UK's poor productivity performance must be addressed

The UK must be more effective in turning labour and capital into output through encouraging research & development, up-skilling, entrepreneurship and infrastructure investment, writes Lloyds Bank’s Adam Chester 

RECENTLY released figures show that UK productivity contracted by 1.2% in Q4, the largest quarterly drop in seven years.  The decline is the latest in a series of weak outputs-per-hour that date back to the onset of the financial crisis.  Over the past eight years, productivity levels have risen by just 0.6%, compared with a rise of 15% between 2000 and 2008 and 20% over the preceding eight years.

So what has caused the UK’s poor productivity performance and what can be done about it? One line of thought is that the economic environment has encouraged companies to replace capital with labour. Uncertainty over demand forecasting and the tightening of credit conditions following the financial crisis may have deterred companies from taking on big investment projects to boost productivity.

Instead, businesses may have chosen to ‘hoard labour’ – hold on to workers even if they are under-worked – to ensure they have a skilled workforce when good times return. Indeed, the fall in real wages appears to have given them an incentive to do so. It is difficult to know, however, whether it has been the fall in real wages that has contributed to the fall in productivity, or the other way around.

Poor productivity may also be due to a misallocation of capital. Since 2009, ultra-low interest rates may have enabled weaker companies, with low productivity, to survive, resulting in a lack of ‘creative destruction’. The low level of company liquidations seems evidence of this.  Furthermore, some have argued that the pace of innovation and its implementation – key drivers of productivity – have slowed.

Lastly, it may be that there isn’t a puzzle at all.  Recent studies argue that productivity weakness has been overstated due to mis-measurement and failure to fully capture the value of the digital economy. For example, improvements in the quality and proliferation of internet services, smart phones, and smart TVs may mean that actual inflation is well below recorded inflation, in which case real output would be higher. Growth in the use of the digital economy may be massively under-recorded in official GDP statistics.

However, it would take some fairly heroic assumptions about the value of digital industries to fully explain the productivity puzzle. Rather, all of the factors above are likely to have some bearing.

Looking ahead, what matters is how the UK can generate efficiency gains, while at the same time maintaining full employment.  It is unlikely to achieve this unless it becomes more effective in turning labour and capital into output – through encouraging key productivity drivers, such as research & development, up-skilling, entrepreneurship and infrastructure investment.

With the country approaching full employment, the ability to rely on employment and hours worked to drive output gains many soon diminish.  To sustain growth in output and real incomes, to keep inflation low and to continue to reduce the budget deficit, productivity needs to improve.

Adam Chester, head of economics, commercial banking, Lloyds Bank