How can Britain’s productivity puzzle be solved?
With recent statistics revealing Britain’s “steady” economic growth, Melanie Powell and Eugene Michaels, both Lecturers in Economics at the University of Derby, analyse what the figures mean.
What’s wrong with UK productivity?
This month, the Office for National Statistics (ONS) released figures for UK productivity. UK productivity, measured by output per hour, fell by 0.5% between the last quarter of 2016 and the first quarter of 2017. The question is, is this a short run fluctuation or part of a bigger, long run problem?
The UK productivity flatlines
We can see the long run UK problem in Chart 1. UK productivity, although not as bad as in Italy, has flatlined since 2007, whereas productivity in other developed economies like the US, Germany and France has increased since the financial crisis. One explanation might be the UK’s relatively flexible labour market which has kept unemployment lower than in other countries over the period.
Is the latest drop in UK productivity just a short run fluctuation?
The UK’s more flexible labour market might also explain the latest dip in the ONS figures. We are experiencing a period of rising employment so productivity will fall if output does not increase proportionately. So will future output rise? Current increases in output should result from previous increases in investment, so one explanation for the current fall in UK productivity is weak previous investment.
Does the UK have an investment problem?
We can see how UK investment, measured as gross fixed capital formation, has grown quarter on quarter over the past seven years in Chart 2. While there has been a modest percentage increase in UK investment in the first quarter of 2017, it was virtually stagnant between the last quarter of 2015 and the last quarter of 2016, so the two longer run problem of rising employment and stagnant prior investment in 2016 may be causing the current falling productivity.
Of course, investment may take more than 18 months to affect output but the stronger investment growth between the last quarter of 2012 and the first quarter of 2014 has had little impact on current productivity.
Can higher productivity in manufacturing solve the problem?
Part of the UK’s long run productivity problem may lie in the manufacturing-service sector mix in the UK economy which cannot be easily changed. The problem lies in the weaker productivity of the service sector which comprises 80% of UK output.
Chart 3 shows the level of productivity in the UK’s manufacturing sector compared to the service sector since 2008. What is clear is the smaller variation and weaker growth in productivity in UK’s dominant service sector compared to manufacturing. We can also see that the recent 0.5% fall in UK productivity in 2017 results from a 0.6% fall in services productivity overwhelming the 0.2% rise in manufacturing productivity.
Could expanding global markets solve the problem?
Chart 4 shows the market outlook from overseas Purchasing Managers for the six months from January to June 2017. A value of more than 50 in the Purchasing Manager Index means the expectation is for markets to grow. All overseas markets look positive, which suggests UK manufacturers will continue to invest for future growth. However, the UK service sector is not only dominant but more dependent on home demand than UK manufacturing. Recent political events including the Brexit vote and the General Election results have increased uncertainty and adversely affected UK home demand. This is likely to lower service sector investment and employee training, dragging down future service sector productivity.
Does this mean UK productivity will continue to fall?
In the light of the importance of the service sector in the UK, the UK’s increasingly flexible labour market, and continued uncertainty over the next 2 years, UK productivity is unlikely to reverse the trend in the short run.
However, if inflation persists and real wages continue to fall, home demand could slow enough for a shakeout of labour in the UK service sector. Perversely, if that happened, the productivity measure could rise.
Sources: Markit, ONS and authors’ calculations.