From the TUC

The Productivity Puzzle: Why We Need Demand & Supply Side Policies

01 Feb 2013, by in Economics

Today the IFS have published a new paper on the productivity puzzle facing the UK, attempting to explain the apparent paradox of rising employment coupled with stagnant output.  This is one the most important issues facing the British economy and cuts to the heart of the macroeconomic debate. I highly recommend taking the time to read it (or at least their summary).

The TUC’s next Economic Report will be out next week and is on the very same issue. It agrees with much of what the IFS have argued. I’ll be blogging about this issue again next week but I thought it might be useful to draw out some important policy lessons today.

Low productivity growth since the crisis has led to a wide ranging as to whether the UK currently faces demand problem or a supply problem. These rival camps are often described as ‘supply pessimists’ and ‘supply optimists’.

Supply pessimists believe the economy is supply-constrained and hence a stimulus to demand would be more likely to generate inflation than growth. By contrast, supply optimists believe the UK’s primary problem is a lack of demand and that an expansion of demand (such as fiscal stimulus) would be a boost to growth.

In recent months this debate has become increasingly polarised but possible to argue that both positions contain an element of truth.

So – how do the IFS explain poor productivity? They have come up with three explanations:

Real wages have fallen. Lower real wages have played a part in reducing aggregate labour productivity by allowing firms to employ more workers than they would otherwise have done…

 A sharp fall in business investment. Business investment remains 16% below the pre-recession high. The fall has been sharper and more persistent than in previous recessions, likely aided by high levels of uncertainty. If workers have less, and less good, capital to work with they will produce less…

 Misallocation of capital is also likely to be reducing productivity. An impaired financial sector that is extending forbearance to low productivity firms while being more risk averse in funding new projects seems to be reducing firm entry and exit. And firm turnover is a key driver of aggregate productivity increases.

The TUC analysis strongly agrees with the first two reasons and partially agrees on the third (more details next week).

The point on real wages is especially important as I argued last Spring:

But what if low productivity growth isn’t the problem? What if it is merely the symptom?

This is the powerful case by Bill Martin last year, in a report which I’d highly recommend published by the Centre for Business Research at Cambridge University.

Martin notes that both the UK and the USA experienced similar crisis in 2008/09- a banking collapse, a contraction in bank lending, a rapid falling away of demand and a deep recession. But the impact on the labour market was very different.

In the USA unemployed soared, whilst in the UK the adjustment came not from a huge increase in unemployment (although unemployment did rise considerably, it was less than could be expected given the scale of the recession) but rather from a collapse in real wages.

This collapse in real wages maintained employment at a higher level than it otherwise would have done and also supported corporate profits. But – given weak demand, higher employment means (all things being equal) lower output per worker. As Martin explains:

“America’s demand deficiency is registered in a high unemployment rate coupled with high productivity. In the UK, greater real wage moderation averted the large increase in unemployment. Demand deficiency was instead registered in the post‐2007 productivity shortfall.”

In other words, via the connection of real wages, the UK’s weak productivity growth may be a function of low demand rather a problem affecting the supply side of the economy.

Weak business investment can also be at least partially explained by weak demand and partially by the impaired nature of the banking system. The role of the banking system in the ‘misallocation of capital’ is a factor that bears closer examination.

The debate around productivity growth, and the reasons for its weakness, is currently doubling important to the UK. The government’s decision to target the structural deficit means that fiscal policy is being guided by estimates of medium term productivity growth.

The TUC’s own analysis suggests that much of the weak productivity growth we have experienced since 2009 is due to a lack of demand (as evidenced by falling real wages and weak business investment) but that is not to say we do not face supply side problems.

It is just that the supply side problems we do face – a banking system that isn’t working , excessive short-termism from firms, under-investment, skills shortages – are not the ones the government seems to think we have. The 2011 ‘Plan for Growth’ (remember that?) was almost entirely premised on labour market deregulation and corporation tax cuts but there is no evidence that either will address any of the real issues facing the UK economy.

The problem is that when faced with a potential supply-side problem, many members of the government have an almost Pavolvian reaction. They assume that type of issue on the supply –side of the economy is best met by 1980s style deregulation and tax cuts.  But you can’t tackle a banking system that isn’t working or long-term underinvestment through tax cuts and deregulating.

The TUC’s own analysis draws on recent work from Bill Martin and Robert Rowthorn to argue that the UK is becoming a ‘demand-constrained, cheaper labour economy’. High productivity firms were more likely to keep a hold of variable labour during the downturn and this showed up in the official data as lower productivity. But after labour costs fell it was low productivity firms (that tend to be more labour intense) that had the greater propensity to hire labour.

The end result is that falling real wages related to weak demand may explain not only much of the fall in productivity during the recession but also the growth of lower productivity, lower wage firms in the ‘recovery’.

Today’s IFS report and the TUC’s forthcoming work point to five lessons for policy makers.

  1. There is a strong case for a stimulus to demand.  Many of the suppose supply constraints the UK economy currently faces are actually related to problems on the demand side of the economy. Boosting demand now would boost productivity.
  2. The output gap is almost certainly larger than the government currently estimate. Fiscal policy is tighter than is far too tight. This raises questions about the choice of the structural deficit as the target for policy.
  3. The Government’s current supply-side polices will not address the real supply-side issues we face.
  4. The UK does however require supply-side reforms – but the reforms we need are reform of the banking system, corporate governance reform to encourage long-termism, a better skills policy and a modern industrial policy to support the sectors of the future.
  5. Most worrying of the Government continues with its current policies of extreme fiscal consolidation and the wrong supply-side reforms the UK risks going further down the path of a being a ‘demand-constrained, cheaper labour’ economy.

As the TUCs Economic Report argues:

If these two steps are not followed (demand stimulus in the short term and reform in the medium term) then the UK risks continuing down the path of being a demand constrained, cheap labour economy – one marked by lower real wages, lower productivity and ultimately lower living standards in the future. The UK economy requires not just a short term stimulus to demand to boost growth but also wider reforms in banking, skills and industrial policy that ensure we get the ‘right’ kind of growth.  And the stakes are high, as the longer we stay on this course the more economic damage will be done, and the smaller the output gap will become – potentially significantly limiting growth prospects in the future.

2 Responses to The Productivity Puzzle: Why We Need Demand & Supply Side Policies

  1. TUC Economic Report – Productivity | ToUChstone blog: A public policy blog from the TUC
    Feb 7th 2013, 12:01 am

    [...] leads to five lessons for policy makers which I blogged about last week, following the release of the IFS’s own analysis of [...]

  2. The Coming Welfare Apocalypse | A Thousand Flowers
    Mar 9th 2013, 7:28 pm

    [...] In recent months, employment has actually been going up slightly, but people are accepting worse paid, crappier jobs, and so how efficient and productive our economy is actually going down. [...]