What’s gone wrong with UK productivity

One of the biggest headaches for Britain's new government is raising productivity. Productivity, or the efficiency of production, is the main driver of human welfare. Raising it is the Holy Grail of economic policy. As Paul Krugman, the economist and Nobel laureate put it, "Productivity isn't everything but in the long run it is almost everything".

UK's productivity performance since the Financial Crisis has been dismal. Unlike previous downturns there has been no bounce in productivity since the recession. Among the major industrialised nations only Italy has done worse than the UK in raising productivity since 2007.

If the UK's pre-2007 trend had continued, productivity today would be more than 16% higher. Wages and the standard of living would be significantly higher than today.

The gap looks even worse measured in terms of absolute levels of productivity. Output per hour in the UK is 25% lower than in Germany, the US and France.

Something seems to have gone badly wrong. As with so many other economic issues, there is no agreement on what. But there are plenty of theories. 

The most comforting is that the UK's productivity crisis is a statistical illusion. Productivity is calculated by divided output by hours worked. If output is underestimated so is productivity. GDP numbers are prone to revision, often years after the event. If GDP gets revised up – and it often does – the UK's productivity performance will improve. Another angle on this theme is that technology is raising welfare in ways that are not being picked up in conventional measures of economic activity – so, for instance, people getting free music and videos via You Tube or using Google Maps. It may be that mismeasurement is part of the story, but I doubt it explains much of the productivity gap.

The gloomiest explanation for weak productivity is that today's technologies are doing less to enhance efficiency than those of the past. Its proponents argue that we have banked the big inventions – everything from antibiotics, the internal combustion engine and electricity – and we are in an era of less revolutionary technological advance.

The most influential advocate of this view is the US economist, Robert Gordon. Gordon invites us to choose between one of today's ubiquitous technologies – the iPhone – and one of the nineteenth century's great inventions, the flushing toilet. His point is that today's innovations are not changing lives in the profound way that the technologies of the nineteenth and twentieth century did.

But this doesn't work as an explanation for the UK's recent performance. Why would UK productivity have stood still when other countries have seen gains? And why, suddenly, in 2007, would technology cease driving productivity after years of good growth?

A more plausible theory is that the shrinkage and disruption in the financial sector has taken a chunk out of UK productivity growth. Tougher regulation and an end to the pre-crisis financial boom which artificially raised financial sector productivity have taken a toll. The Economist magazine estimates that productivity in finance and insurance is 10% lower than in 2009.

There are two other suspects.

The first is a shortfall in investment. The risks attached to investment have risen since the crisis and the opportunities have dwindled. Companies have tended to hang on to cash and squeezed investment. The deterioration in the UK's stock of assets – from machinery and buildings to highly trained workers and research and development – has made employees less productive.

The second suspect is, strangely, too many jobs. On this argument the financial crisis has squeezed pay and made the labour market more flexible (think, for instance, of the growth of part time work and zero hours contracts). Jobs are preserved and unemployment stays low. But, because labour is cheap, flexible and plentiful, it removes an incentive for employers to undertake productivity-enhancing investments. The "productivity crisis" and Britain's success in preserving and growing employment are two sides of the same coin.

The exact reason for the standstill in UK productivity may never be known. That does not mean the UK is stuck with it forever. There are proven ways to raise productivity - improving regulation and state bureaucracy; raising the UK's mediocre record on secondary education and investing in infrastructure. Mrs Thatcher economic reforms of the 1980s are widely credited with having boosted productivity. Between 1991 and 2007 UK productivity rose by 41%, faster than in any other major industrialised nation.

To paraphrase Marx, the challenge is not to interpret productivity growth, but to raise it.