Understanding the Productivity Puzzle

January 21, 2017

Understanding the Productivity Puzzle

by Howard Davies


Howard Davies, the first chairman of the United Kingdom’s Financial Services Authority (1997-2003), is Chairman of the Royal Bank of Scotland. He was Director of the London School of Economics (2003-11) and served as Deputy Governor of the Bank of England and Director-General of the Confederation of British Industry.


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In all major economies, the so-called productivity puzzle continues to perplex economists and policymakers: output per hour is significantly lower than it would have been had the pre-2008 growth trend continued. The figures are stark, particularly so in the United Kingdom, but also across the OECD. And while it goes without saying that economists have many ingenious explanations to offer, none has yet proved persuasive enough to create a consensus.

According to the UK’s Office for National Statistics, output per hour in France was 14% lower in 2015 than it would have been had the previously normal trend growth rate been matched. Output was 9% lower in the United States and 8% lower in Germany, which has remained the top performer among developed economies, albeit only in relative terms. If this new, lower growth rate persists, by 2021 average incomes in the US will be 16% lower than they would have been had the US maintained the roughly 2% annual productivity gain experienced since 1945.

The UK exhibits a particularly chronic case of the syndrome. British productivity was 9% below the OECD average in 2007; by 2015, the gap had widened to 18%. Strikingly, UK productivity per hour is fully 35% below the German level, and 30% below that of the US. Even the French could produce the average British worker’s output in a week, and still take Friday off. It would seem that, in addition to the factors affecting all developed economies, the UK has particularly weak management.

Some contributing factors are generally acknowledged. During the crisis and its immediate aftermath, when banks’ efforts to rebuild capital constrained new lending, ultra-low interest rates kept some firms’ heads above water, and their managers retained employees, despite making a relatively low return.

On the other hand, new, more productive, and innovative firms found it hard to raise the capital they needed to grow, so they either did not expand, or did so by substituting labor for capital. In other words, low interest rates held productivity down by allowing heavily indebted zombie companies to survive for longer than they otherwise would have done.

The Bank of England has acknowledged that trade-off, estimating that productivity would have been 1-3% higher in the UK had it raised interest rates to pre-crisis levels in the recovery phase. But they believe the consequences – slower income growth and higher unemployment – would have been unacceptable.

This argument has now been extended beyond the banking system, to the capital markets themselves. Critics of central banks have claimed that a sustained policy of exceptionally low interest rates, reinforced by huge doses of quantitative easing, have caused asset prices to rise indiscriminately. That has not only had adverse consequences for the distribution of wealth; it has also muted the ability of capital markets to distinguish between productive, high-potential firms and others that deserve to fail. According to this view, a rising tide lifts even fundamentally unseaworthy boats.

This argument has some explanatory power, though it says little about the value added by highly paid asset managers and whether they really are prepared to put their money to work simply on the basis of a monetary-policy effect on relative prices, paying no attention to individual companies’ strategies and performance. But the key question the argument raises is what to do about it.

Would it really have been preferable to tighten policy far earlier, to kill off weaker companies in the interests of improving productivity? The BoE has given an explicit answer, and the other major central banks implicit answers, to that question. They do not think so.

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A preferable approach to resolving the problem might be more vigorous use of the tools available to market regulators. These authorities tend to focus more on investor protection than on the allocational efficiency of the markets they oversee. Investor protection is important, of course, but as the Nobel laureate Eugene Fama put it, “the primary role of the capital market is allocation of ownership of the economy’s capital stock.”

A regulator focused on that objective would be especially rigorous in overseeing the transparent disclosure of information, and would seek to promote vigorous competition among companies and also, crucially for this objective, among investors. It should not be acceptable for asset managers to earn extravagant returns for following a market benchmark.

There are, no doubt, other dimensions to the productivity puzzle. Maybe we are not measuring output well. As developed economies become more service-based, our measures of output become less objective. In many service industries, outputs are effectively measured by inputs. Maybe we are not measuring enhancements in quality, which may mean that output increases are understated. Maybe we have reached a point at which the productivity boost from Internet-based technology has been cashed, and we need another technological leap to move forward again.

But one key challenge for central banks, as we edge toward the normalization of interest rates, will be to develop a framework for thinking about the impact of monetary policy on the allocation of capital. The task is urgent, as the social and political implications of a prolonged period of no productivity or real wage growth may be very serious. Indeed, arguably they have been factors behind the political upheavals in the US and the UK already.

13 thoughts on “Understanding the Productivity Puzzle

  1. Interesting as always. What about our- malaysian productivity- where do we stand among all other countries? Our civil service said to be over staffed must show a very low productivity ?

  2. When we take a walk through a store and look closely at where the products are made, we might find ourselves wondering if anything is manufactured in the US anymore. As it turns out, manufacturing output in the US is near its highest levels ever. In fact, the US produces twice as much as it did in 1982, with one-third fewer workers (source: US Bureau of Labor Statistics and Board of Governors of the Federal Reserve System).

    Here’s our riddle: How does an economy manufacture more goods with fewer workers? The answer lies in the economic concept of productivity – the ratio of output per worker per unit of time. Increasing productivity enables an economy to produce the same amount of output, or more, with fewer workers. In fact, productivity is key to raising the standard of living. Basically, a country can buy more goods and services per person if they produce more goods and services per person. But how does this happen? Economists say that changes in productivity are usually due to some combination of these factors: (1) Increases in physical capital, both quantity and quality, per worker; (2) Increases in human capital per worker; and (3) Technological change.

    Economists concerned about the decrease in productivity suggest that government policy can play a role. Government spending on infrastructure (e.g., airports, highways, and bridges) could increase productivity because it reduces the cost in time and money of transporting goods and people from one place to another. Government could also increase productivity by increasing education spending, which increases the human capital of the workforce. In addition, tax reform that creates incentives for capital investment by private firms and more effective regulations could also increase productivity. Spending on research and development could promote technological change, but more R&D does not always result in new technologies. And, because government intervention has costs, paying for these policies will result in higher taxes, larger budget deficits, or the loss of services currently enjoyed. The key piece of the productivity puzzle – technological change – is the most difficult to achieve because it is unpredictable.

    US productivity experienced rapid growth from 1995 to 2010, but it has slowed recently. Because productivity growth directly affects living standards and workers’ wages, economists have discussed many potential reasons for the slowdown. They have identified weak capital investment and a slowdown in educational attainment as causes but also a slowdown in technological change. Historically, the largest contributor to productivity growth has been technological change. Capital investment and educational attainment are easier to improve through investment and spending on education; however, technological change is more difficult to fix because it is inherently unpredictable.

  3. All you young people out there do not worry about productivity. As an individual take matters in your own hands and do not rest just because someone tells you that we are all equal. Even the five fingers in your right hand are not equal. But they have survived through the ages because each one of them has a function and they continue to do their job well. You are the future of the world means nothing until you take your future in your hands.
    1. Respect your parents.
    2. Respect the law.
    3. Get as good an education as you can and do at least two years of post Form Fiive studies.
    4. Get a job. Any job even it only pays you what a foreign worker would earn.
    5. Do not have children until you are married
    6. Have only one spouse in one house.
    7. As you work develop a skill any skill and learn it well
    8. Try to live beneath your means and save some money.
    9. Please, no debts and no buying on 12 monthly installment plans. Save the money and buy what you want at the end of 12 months.
    10. You may not be well off but at least you will stay out of poverty.

    • When you say, “Respect the law,” does that include respecting the unjust law? I believe in Martin Luther King, Jr. on our moral responsibility to break unjust laws, as he convincingly illustrated in his letter from Birmingham jail: “There comes a time when the cup of endurance runs over, and men are no longer willing to be plunged into the abyss of despair. I hope, sirs, you can understand our legitimate and unavoidable impatience. You express a great deal of anxiety over our willingness to break laws. This is certainly a legitimate concern. Since we so diligently urge people to obey the Supreme Court’s decision of 1954 outlawing segregation in the public schools, at first glance it may seem rather paradoxical for us consciously to break laws. One may well ask: ‘How can you advocate breaking some laws and obeying others?’ The answer lies in the fact that there are two types of laws: just and unjust. I would be the first to advocate obeying just laws. One has not only a legal but a moral responsibility to obey just laws. Conversely, one has a moral responsibility to disobey unjust laws. I would agree with St. Augustine that ‘an unjust law is no law at all.'”

  4. It is not the productivity puzzle that needs to be understood…the real puzzle is…how is it that there exists a system that oversees growth in productivity while it allows a larger growth in income disparity…
    Solve that puzzle and you have the solution to what needs to be put right…
    Bernie Sanders kept hammering away at the solution…and had tens of millions of his countrymen behind him…and would have walked away to the White House…but he was sidetracked? Why?…that is the second puzzle…

  5. I agree with you. But that is for our elders to lead the way. Perhaps I should have added rules, regulations and laws in making reference to “respect the law”. A young man who comes from a family in the bottom 75% of society does not have that luxury, so eloquently stated in this blog. Life is a struggle and like that person who comes to Kuala Lumpur for a holiday from Jerantut without knowing the rules, regulations and laws related to our city highways will go round and round every time he misses ‘a turn’. In the countries of Northeast Asia “respect for the law” has made a major contribution towards building a stable society. And some of those rules, regulations and laws relate to the most basics of our conduct.

    At all levels, our goal should be to do the right thing and to make things better. General Elections Jingle in 1959:
    I put my name onto the register
    I want to make it
    I want to make it
    Make Malaya (now Malaysia) better.

  6. Productivity is a humanist jargon for a measure of economics, which in itself, is a pseudoscience. Britain has never been very productive, ever since her Empire collapsed at sunset. USofA’s productivity is limited her coastal regions, where coal brains are not Trumped about. East Europeans, unlike the Franco-Germans and perhaps Scandinavians, are as leery of production as the Greeks – except when it comes to local alcoholic beverages.

    Malusia? Our MPC (Malay-sian Productivity Center) is pokkai – not only in operational expenditure but also in ideas. Right now, everybody i know there, are behaving like chickens pecking at chicken feed.

  7. Economic theory is just a theory depending on, ‘ceteris paribus’, other things being equal. Productivity itself depends on other things remaining equal. When economic theory hits politics nothing remains the same with a sharp shift to give and take. Here again who gives and who takes is dependent on the power matrix.

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