Over the last 12 months we’ve seen quite impressive falls in unemployment. At the same time though, growth in labour productivity has been disappointing to say the least. This apparent mismatch between rising unemployment and falling or static productivity has been labelled “The Productivity Puzzle”. Many possible explanations to the puzzle have been posited. In a recent entitled “The UK Productivity Puzzle”, researchers from the Bank of England reviewed some of these explanations to see if any provided satisfactory answers.
First though, what do we mean by productivity? The BoE paper says:
Labour productivity is defined as the quantity of goods and services produced per unit of labour input. Since the onset of the 2007–08 financial crisis, labour productivity in the United Kingdom has been exceptionally weak. While labour productivity — measured by whole-economy output per hour worked — started to improve in 2013 alongside the recovery in output that was taking place at this time, it is still some 16% below the level implied by a simple continuation of its pre-crisis trend.
It then puts current productivity in context against the period following previous recessions. This chart shows that the current period has seen by far the largest fall in productivity than during any other post-war recession, and the recovery has been the longest and slowest:
The BoE say the possible explanations for the weakness in productivity can be grouped into two broad hypotheses. The first is what they call ‘cyclical factors’. Chiefly that following the downturn, firms were unwilling or unable to lay off workers either because they needed a minimum number of staff to keep the business going, or because they were ‘hoarding’ labour, believing the downturn to be only temporary. While they operate in this manner, firms are less productive than they could be. The BoE dismisses this as a full explanation however, because employment has recovered strongly and GDP is growing, and prior to this latest recession, productivity recovered strongly alongside employment and GDP.
The second hypothesis the BoE sets out says that weak productivity is likely to persist due to a disruption in the ability of the economy to produce goods and services. They suggest a number of actions that could have caused this disruption, including impaired access to finance and greater uncertainty about the future which both act to dissuade firms from investing in new projects, which in turn impacted upon productivity.
The BoE find the second hypothesis more persuasive, citing a fall in innovation by firms since 2008, which they say has important implications for productivity. At the same time, the BoE cite problems with securing finance impacting upon form’s working capital positions which means their production process became less efficient.
The paper also raises the issue of high business survival rates, pointing out that while the level of company liquidations has been low since the onset of the crisis. the number of loss-making businesses has actually risen significantly (see chart below). The have been referred to elsewhere as ‘zombie firms’. What this means is that while the lower liquidation rate would mean lower unemployment than would otherwise be the case, the higher proportion of unhealthy (but surviving) firms would have a negative impact on productivity.
In drawing conclusions, the BoE paper attempts to quantify how each explanation for the productivity puzzle accounts for the 16% fall. This can be seen in the table below. With the caveat that a large amount of uncertainty remains, they say that 4% of the 16% can be explained by changes in the way productivity and and GDP are measured. They say the impact of hypothesis 1 is uncertain, but attribute 0% to this explanation. Hypothesis 2 though they think explains 6-9% of the 16% fall split almost equally between reduced investment and high business survival rates.
This then leaves 3-6% unexplained. So more research needed!