By Paul Warner, 3 March, 2017

One of the current buzzwords in economics is productivity. Philip Hammond will probably mention it in his spring Budget on 8th March. The reason why it has become so commonplace in the thoughts of policymakers is that it has fallen substantially after the financial crisis, and is considered to be directly linked to living standards. Many believe that a country can only improve its living standards by growing its productivity.

Productivity is how much is produced for any given input. It is normally measured as output per hour worked. There are three variables to this equation: output, number of people in work and number of hours worked. Output is GDP (gross domestic product), and 'per hour worked’ is a function of both the number working and how long they work for. So if GDP increases but hours worked don't change, then productivity will increase. Alternatively if GDP remains unchanged, but the total of hours worked increases, productivity will fall as it takes more hours to produce the same amount. Rising employment and no change in GDP would therefore reduce productivity.

Productivity growth is defined as rising output per worker. Higher productivity growth means more can be produced in a sustainable manner, and therefore leads to a higher long-term growth rate of the economy. It also has an impact on wages, as the more productive a worker is, the more they are likely to be paid. Historically in the UK, labour productivity was running at around 2% a year. Since 2007 it has been flat, after initially falling in the 2008/2009 recession. In fact, that drop was the largest annual fall since 1974, when the UK was impacted by the first oil shock and was experiencing a three-day working week.

Productivity is extremely important to public finances. This was demonstrated last year when the OBR (Office for Budget Responsibility) reduced their short-term productivity forecast and put a £55bn hole in Osborne's figures. Back in December 2014 the OBR produced forecasts for three different scenarios. The first was that productivity growth remained weak at 0.5% a year. The second scenario, which was the OBR's central forecast, that productivity growth would have a mean reversion and gradually rise back to its 2% historic level. The final scenario was of a strong recovery of productivity growth to 4%, which was similar to a few years in the early 1970s and again in the early1980s. In this 2014 forecast for 2019/20, the weaker scenario saw GDP growth of 0.7%, public sector net borrowing increasing to 2% of GDP and overall public sector net debt rising to 86.6% of GDP. Its central scenario was of GDP growth of 2.3%, public sector net borrowing decreasing by 1% of GDP, and public sector net debt of 72.8% of GDP. Finally, at 4% productivity growth, the OBR had GDP growth at 3.7%, public sector net borrowing decreasing by 4.4% of GDP, and overall net debt reducing to 56.7% of GDP. Looking at those figures you can see how important it is in the minds of economists that productivity growth is lifted as high as is achievable.

Recent better than expected GDP growth has been achieved by the large increase in the number of people employed. It means we are working harder to produce the same amount of goods and services than we were in 2007. This could explain the political backlash that assisted in the UK voting for Brexit.

The continued weakness in productivity is a puzzle to most economists. It was supposed to be a short-term phenomenon. What's more it is not just a problem for the UK, although our productivity is 18% below the average of the other G7 countries. However, that under-performance goes way back and is not relevant to the current debate. In the UK productivity is 19% less than it would have been if the economy had maintained its pre-crisis growth rate. Economists have been scratching their heads as to why productivity has not got back to pre-crisis growth levels.

There have been many alternative theories to explain this. Some have suggested that investment has been poor, which has reduced the quality of equipment employees are using. Others suggest the banking crisis has led to a lack of lending to more productive firms. Falling production in the oil and gas, and financial sectors is another potential cause, or could it be because in an ageing population higher numbers of people are working beyond normal retirement age due to population and pensions changes? Maybe companies have moved employees into less productive roles. It could be that the data collection is at fault, as our economy moves on-line. There are other theories but none can really be singled out as the reason why so many countries have suffered this drop in productivity since the financial crisis.

In our view, as is often the case, the very people asking the question are indeed the cause of the problem. Firstly, there is little doubt that the banking sector has been hampered by new regulations brought in to ensure that a future banking crisis will not require government support. This has hampered bank lending. So too have the record fines levied on banks for their previous misdemeanours like PPI mis-selling. Often the companies that are most likely to be productive are new and riskier ventures. These are the very companies least likely to secure lending from a banking system concerned about new regulations.

Probably the single biggest cause for the productivity puzzle is the quantitative easing and zero interest rate policies of central banks. The unintended consequences of these actions are immeasurable. Very simply they have destroyed the avenues through which capitalism works. They have created a miss-allocation of capital in many ways. Their whole design has been to manipulate markets, and as history has shown this is something you can only do over a relatively short time period.

Zero interest rates have enabled companies to maintain less productive parts of their organisations and even allowed some companies that would normally have gone bust to stay in business. This has created zombies, which has the effect of stopping more innovative companies, that is more productive companies, thriving and gaining a foothold in the respective sectors. The main avenue for borrowing has been the bond markets, but this only allows big companies access and they have been borrowing to buy back shares due to poor executive incentives. Capital expenditure has been low. One of the prime ways of increasing productivity is giving workers better machines and tools with which to work.

Ironically, the only way you are likely to engender a pickup in productivity growth is to allow nature to take its course. That would require some form of normalisation of interest rates and unfortunately a recession. It was the recession of 1980/81 that enabled a reallocation of resources, which led to productivity growth recovering after the flat period in the 1970s. We suspect that central banks and governments will try and stop such a recession occurring for at least another year or two.