Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 6 October 2017

The OBR, productivity and policy failures

Chris Giles had an article in the FT yesterday about the UK’s continuing dreadful productivity performance, and the implications this might have for forecasts of the public finances. It has the following chart comparing successive OBR forecasts and actual data.


I want to make two points about this. The first is about the OBR’s forecast. [1] It is easy to say looking at this chart that the OBR has for a long time been foolishly optimistic about UK productivity growth. Too often growth was expected to return to its long run trend shortly after the forecast was published but it failed to do so. Expect lots of articles about how hopeless macro forecasts are in general, or perhaps how hopeless OBR forecasts are in particular. It was obvious, these articles might say, that trend productivity growth in the UK has taken a permanent hit following the financial crisis.

Anyone saying this is ignoring the history of the UK economy for the 50 years before the GFC. After each downturn or recession, labour productivity growth has initially fallen, but it has within a few years recovered to return to its underlying trend of around 2.25% per annum. This means not just returning to growth of 2.25%, but initially exceeding it as productivity caught up with the ground lost in the recession. In a boom sometimes growth exceeded this trend line, but it soon fell back towards it.


This made sense. Productivity growth reflects technical progress and innovation, and they tend to continue despite recessions. A firm may not be able to implement innovations during a recession, but once the recession is over experience suggests they make up for lost ground in terms of putting innovations into practice.

Given this experience, OBR forecasts have always been pretty pessimistic. They have assumed a return to trend growth, but no catch up to make up for lost ground. If they had also forecast, in 2014 say, that given recent experience they expected productivity growth to be almost flat for the next five years that would have been regarded as extreme at the time. Why would UK firms continue to ignore productivity enhancing innovations when the macroeconomic outlook looked reasonable?

And of course in 2014 UK productivity growth was positive. This brings me to my second point, which follows from this quote from the FT article:
“In the Budget, both the OBR and Mr Hammond are likely to stress that the downgraded forecasts do not reflect a new assessment of the damage to the UK economy from Brexit, but a reassessment of likely productivity growth after so many recent disappointments.”

Chris may be right that they will say this, but is it remotely plausible? As my recent post tried to suggest, UK productivity growth can be seen as suffering from three large shocks: the recession following the GFC, the absence of a normal recovery as a result of austerity, and then Brexit. The first two of those shocks led to a period of intense uncertainty, causing UK firms to put on hold any plans to innovate. Just as they thought things had returned to a subdued version of normal they were hit by the third, Brexit. During periods of intense uncertainty, productivity stalls or may even decline a little, as firms meet any increase in demand by increasing employment but not investing in new techniques. [2]

This story involving uncertainty seems to fit the data. Once the recovery (of sorts) finally began in 2013, productivity growth picked up. That sustained growth came to a halt when the Conservatives won the 2015 election, and the possibility of Brexit began to be an important factor for firms. [3]

These two points are related in the following way. The experience of the 50 years before the GFC suggested that you could hit the economy with pretty large hammers, but it would eventually bounce back. However that may have been contingent on a belief by firms that if policymakers were wielding the hammer (using high interest rates for example) they would take it away fairly soon, and replace it by stimulus. That belief was shattered in the UK by the GFC and austerity, where policymakers decided to keep using the hammer. What little confidence remained was destroyed by Brexit.

Discoveries are still be being made in universities around the world, and we know innovations are still being implemented by leading UK firms. It seems completely far fetched to imagine the GFC is still having some mysterious impact on the remainder of UK firms such that they refuse to adopt these innovations. A much more plausible story is that we are seeing what happens when most firms lose confidence in the ability of policymakers to manage the economy.

[1] I am on the OBR’s advisory panel, but as our job when we meet once a year is to be critical of OBR assumptions, and as we have no role in producing their forecasts, I think what I say here can be completely objective.

[2] Productivity can initially fall because new employees are not as productive as those who have been working in the firms for some time, for example.
Postscript (7/10/17) For evidence on the impact of Brexit on productivity, see work by Bloom and Mizen here.

[3] An alternative story is that the UK has settled into a new slow growth ‘equilibrium’, where the majority of firms are so pessimistic they hardly innovate at all.      

9 comments:

  1. Your conclusions are pretty thin gruel but this is the type of question of which it is very difficult to arrive at an answer.

    Your answer stresses, in effect, the cyclical whereas Bob Gordon would stress the secular in his analysis. Any time series will contain both as a matter of fact but which is the dominant in a particular series is anyone's guess.

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  2. That's really interesting. It's tempting to look at a 'hairbrush' chart like the top one and read it as a series of wildly optimistic forecasts, on one hand, and disappointingly mundane reality on the other. What gets lost, as you say, is the normality of continuing growth - the horizontal line just looks like 'business as usual'. I wonder if it'd be possible to plot charts like that in such a way that on-trend growth was the flat line. Or perhaps we just need to lean to the left while reading them.

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  3. Does this mean that after Brexit when firms can no longer source the labour they need and the uncertainty associated with Brexit is removed, they will be forced to carry out the innovations they have been thinking of and this will lead to a sudden increase in productivity ? You can already hear the Brexiteers saying, “I told you so.”

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  4. "Discoveries are still be being made in universities around the world, and we know innovations are still being implemented by leading UK firms."

    As you know, it's not that simple - to take a discovery from the lab to market takes a mixture of pure research, applied research and development, carried out in academic, government and private sector facilities. That complex innovation landscape changed a lot in the UK in the twenty years leading up to the financial crisis - in the wrong direction.

    To repeat myself from my last comment, the R&D intensity of the UK economy fell from more than 2% in the early 80's to a low point of 1.55% in 2004, in contrast to what was happening both in other developed nations and in the fast-developing countries of the far east. We'd expect this to be a leading indicator of a reduced rate of innovation, so I don't think you can argue the timing is wrong for a late 2000's decline in productivity growth.

    I don't doubt for a moment that bad macro policies exacerbated and prolonged the productivity slowdown, as you say. But neither do I see that one can entirely rule out, as you seem to do, any contribution from the pronounced structural changes that happened in the UK economy in the years running up to the crisis, including, but not limited to, its declining R&D intensity.

    A final comment about causality - it is very tempting to look at plots of productivity growth vs time and assume that the financial crisis must have caused the productivity stagnation. And indeed, for all the reasons you talk about, a sharp recession would be expected to give a short-term downward jolt to productivity. But taking a longer term view, one might also wonder whether the coincidence might arise at least in part because the same root causes were contributing both to the financial crisis and to a slow-down in innovation - such causes might well include the excessive financialisation of the economy.

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    1. Indeed. It was the 10+ years prior to the crash that we should be looking at to understand the crash itself and its aftermath.
      Also, protecting RBS from bankruptcy was a bad idea: keeping resources non-productive.

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  5. To my simple mind Productivity is the substitution of capital for labour. For some while now the cost of Labour has been falling so a significant incentive for its substitution is also reducing. Until very recently Labour has been in plentiful supply as there has been a surplus labour pool the U.K. has accessed on demand, again a disincentive to Labour substitution.
    The growth sectors in the U.K. Economy have principally been in sectors where substitution of labour is difficult allied with the fact the majority of employment created by those sector expansions has offered Minimum Wage vacancies that have been sufficient to attract the necessary volume of Labour from the surplus available. Globalisation itself will also engender a decline in wage levels in the higher wage economies whilst generating an increase in wage levels in the original low cast wage economies. I'm afraid I don't see the 'missing' productivity gains as much of a mystery at all.

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  6. You don't mention labour market "flexibility" as a factor in the lack productivity growth. Productivity growth is spurred by shortages of labour so that innovation is needed to make the most of all available employees. If there is an ample supply of people unable to turn down zero-hours contracts at minimum wage or less then why not replace say car wash machines with hand car washes? Why would the robot fruit picker machines have a point? And if we have the resulting low wage economy, then those low waged workers won't be able to afford to buy much so can such low productivity will nevertheless provide supply surplus to what they can afford.

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  7. Just a quick question - actually not so quick - why do we assume that productivity growth reflects technical progress and innovation. In particular, why do we assume that the causality involved is increased innovation leads to increased GDP per capita, and not visa versa. Afterall, at least without imposing causality, GDP/capita and productivity would track each other pretty well (notably Total GDP doesn't track productivity since 2007, but then also GDP and GDP per capita are also decoupled.)

    I first thought about this when looking at wages in which it seems to be the same story - wage growth in Economic Theory is dependent on increased efficiency. But why not without making these assumptions simply suggest that wage growth is dependent on increased GDP.

    Afterall, intuitively, if GDP rises for largely exogenous factors (eg. Norweigian GDP will rise if the Oil price rises) then we can well imagine a situation in which Norweigian GDP/Capita rises and also wages rise even though there has been no real labour market efficiency.

    One suggestion I have is that we only really have one model of understanding GDP growth - that it is driven by productivity and efficiency gains. And so we therefore impose the causality on productivity and say that it is low because there have been no real efficiency gains in the economy. When we know that isn't true - what's actually happened is that GDP/capita has stagnated, and because the only way we can explain this is because of 'productivity stagnation' we say that GDP/capita has stagnated because of productivity when actually it has stagnated because of the financial crises and policy mismanagement.

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  8. In my simple opinion, growth in a consumer economy comes from people having enough money to spend to create growth. Low and falling incomes shouldn't surprise anyone if growth falls, meaning in the past people borrowed to increase growth, they have now reached beyond that possibility, and can't even do that now.

    This Graph is a good indicator of how that has come about over the decades, where businesses could pay higher wages, but have refused to do so, bringing the economy to the point we are today.

    http://www.thestand.org/wp-content/uploads/2015/07/ss-productivity-earnings.jpg



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