On the Productivity Puzzle in the UK

Abstract

We believe that the main problem in European economies post the GFC is lack of demand, which in turn is dampening productivity and putting a lid on supply-side efforts. Macroeconomic policy can indeed contribute to explain and solve the productivity puzzle, especially in the absence of expansionary fiscal policies. We believe that government creation of narrow money is a more appropriate tool for economic stimulus than QE; and that channeling such funds into research-intensive areas (high on human capital, low on capital expenditures) has the highest potential to raise productivity in the long term.

Introduction

This note is focused on the productivity puzzle of the UK. We will focus on the residual of Solow’s model, TFP ≅ GDP/h worked. A recent Q-Bulletin by the BoE (Barnett, Batten, Chiu, Franklin, & Sebastiá-Barriel, 2014 Q2) acknowledges that the:

• Labour productivity growth in the United Kingdom has been particularly weak since the start of the crisis.
• The recent strength in hiring and modest pickup in productivity growth suggests that spare capacity within firms is unlikely to explain much of the current weakness.
• Factors related to the nature of the financial crisis are likely to be having a persistent impact on the level of productivity.

We completely agree with these findings, and indeed believe that the circumstances around and reactions to the Global Financial Crisis (GFC) bear explanatory power.

Backdrop

The financial industry represented, and still does, a bigger proportion of the domestic economy in the UK than it does in most other developed economies (at both sides of the Atlantic). This obviously exacerbated the drop in economic activity during 2008-09. Given the fortunes of the industry since then (increases in capital standards and more stringent regulation), it’s not aided in the recovery either.

On the other hand, the UK benefits from having its own currency. The GBP depreciated significantly against all major currencies. Ceteris paribus this improved competitiveness and foreign demand for British products and services abroad, having a stimulative effect.

Unfortunately this demand was not expected to come from the Euro-zone, the UK’s biggest trading partner. In 2010 Greece lost access to the markets, and it was followed by Portugal and Ireland. The Troika was created to bridge these countries back to the financial markets, implementing deep cuts that would enhance the supply-side and improve competitiveness. The crisis heightened in 2011 and 2012 with the cuts that ensued, pushing the Govs. of Spain and Italy towards insolvency.

The UK elected a new government and also implemented austerity policies. (VAT rose from 17.5 pct to 20 pct; CGT rose; there were welfare cuts, and Whitehall spending restraint. Fortunately the cuts weren’t as deep as announced.) The rationale behind these was maybe best articulated by the Chancellor, in the 2014 January WEF debate at Davos on “The Future of Monetary Policy” were Osborne shared stage with Summers, et al.

The UK Government perceived and responded to the crisis very much as its stranded euro-zone neighbours. ‘Fiscal space’ was perceived from an accounting point of view; and fiscal discipline was the only medicine to fight off budget deficits and minimise the chances of recreating a Greek tragedy.

This was in stark contrast to the US and Japan, whose policymakers seemed to be more focused on the real economy. Fiscal space was seen through the prism of idle econ-resources, especially employment. Stimulating them would pay-off by itself by growing the tax-base.  (And idea that Summers later developed with DeLong (Summers & DeLong, 2012), highlighting that by 2030 the Debt/GDP ratio would have been lower, had a bigger stimulus package (deficit) been implemented. Data were run on the Fed’s model).

Future fiscal burdens were understood to be areas of under-investment / under-maintenance in the economy, such as poorly maintained infrastructure (which will require real assets in the future to be maintained. Hence competing with other real projects).

We believe that the pro-cyclical and pro-austerity behaviour of the UK Government, coupled with the depressed economy of the Eurozone are at the core of the output and TFP loss from the pre-crisis trends.

Fiscal multipliers, Hysteresis, and the MMT

The best data we had on fiscal multipliers came from the natural experiment post the Great Depression and WWII. Even if it was difficult to have accurate measures of the fiscal multiplier (during recessions), most analyses put it above 0.5. (Therefore discarding Ricardian equivalence, and crowding-out counter-arguments.)

Today, it is clear that the level is significantly above 1 (Blanchard & Leigh, 2013), and with the zero-lower bound constraint we believe that the case for state intervention mitigating the business cycle by counteracting economic downturns has been reinforced. We further believe that hysteresis, or inverse Say’s Law, is already detectable in the British economy: Lack of demand is creating lack of supply.

This idea was introduced by DeLong and Summers: Fiscal Policy in a Depressed Economy (2012), and was further contextualized by in Martin Wolf’s The Shifts and the Shocks (2014). To note:

If companies don’t hold prospects of selling new products and services, they will not develop the capabilities required to produce them. They are much more likely to hoard cash and/or reward equity-holders. As companies invest less in R&D and in building future capabilities, potential output decreases. (And indeed, estimates of potential GDP have decreased throughout the world since the GFC.)

We believe that economists solved this puzzle a long time ago. Fallacies of composition, and specifically “The paradox of thrift” are nothing new to Keynesians and Monetarists, and its solutions are also easier than enhancing the supply-side.

In particular, for a country that is leaking currency and demand (jobs) abroad through significant current account deficits, it is very difficult to keep full employment. In fact, using the sectoral balance sheet: (I-S) + (G-T) + (X-M) = 0 (Fetherson, Godley & Cripps); full employment will only be possible if either the private sector or the public sector accommodates. Hence, if the trade deficit is higher than the contribution (deficit) of the Government to the economy, the private sector must be dissaving, leveraging up its portfolio.

“In the real world, there is no deposit multiplier mechanism that imposes quantitative constraints on banks’ ability to create money in this fashion. The main constraint is banks’ expectations concerning their profitability and solvency.”
Quote from (McLeay, Radia, & Thomas, 2014).

Since all new money is created as a by-product of lending by banking institutions, and it is not limited or constrained on deposits (Money Multiplier from Monetary Base to M2 through RRR is not factual (McLeay, Radia, & Thomas, 2014), (Keister, Martin, & McAndrews, 2008)), the system is very exposed to rising asset prices (especially real estate), creating too much money and inducing the private sector to lever up its portfolio. Hence, Quantitative Easing, which mainly stimulates demand by the ‘wealth effect’ of lower rates at the end of the yield curve, just reinforces a trend that decreasing interest rates initiated in the late 1970s.

If Governments insist on running balanced budgets throughout the cycle, private debt has to grow faster than GDP for demand to be in line with potential growth, and that’s a fundamentally destabilizing process (Turner, 2015).

Modern capitalism is biased towards financing real estate financing rather than financing entrepreneurs, SMEs, or PPP; which bodes badly for TFP. Additionally, as per Piketty, the nature of the distribution of income and spending between capital and labour, and among labour (and across the world) is not conducive to sustaining aggregate demand. (Higher savings rate among those most able to support demand (Piketty, 2014))

Henceforth, for countries running current account deficits and output gaps, such as the UK, we believe that permanent money creation by the State (‘high powered’, or ‘narrow’ money) is the best solution to sustain GDP –which could have second order effects on TFP by simplifying the financial services industry and its money creation process. Releasing unquantifiable amounts of human capital now absorbed by the Dodd-Frank act and other regulations).

The Entrepreneurial State

If minimising output gaps is the low-hanging fruit in order to increase TFP, to achieve meaningful and sustainable improvements of the standard of living over time, we believe that further nudging by the state could have beneficial effects.

Besides smoothing the business cycle, we believe that the state should play a role in minimising loss of applied knowledge and know-how. This builds on Kenneth J. Arrow’s 1962 “Learning by Doing”. More recent work by Stiglitz & Greenwald (2014) suggests that market economies alone typically do not produce and transmit knowledge efficiently. Adoption and diffusion of knowledge takes place within institutions; and bigger firms are more stable, and therefore better at preserving it than smaller.

Similarly, Mazzucato’s “The Entrepreneurial State” (2012) defends that the state should regain a more central role in the economy, targeting areas of the economy where the expected return on invested capital is higher. As an example, the US Government through DARPA (at the DoD), ARPA-E (DoE) and NIH created the foundations for the technologies behind the internet, the smartphones’ Artificial Intelligence systems, and a myriad of other technologies in Tech, Green-Tech and Healthcare, respectively.

The tech hubs born in California and Boston owe most of their successes to these programs she argues; but additionally, there are important externalities to these efforts in R&D: an important proportion of the benefits are not purely economic and/or captured by the companies that develop the technologies commercially. They benefit the environment, and/or communities at large, sometimes at almost zero additional costs.

Conclusion

We believe that having a vibrant economy –growing at full capacity– underpinned by state institutions that aren’t scared to respond boldly and counter-cyclically to negative shocks, minimises loss of applied knowledge in the economy, and spurs investments in R&D and technology-enhancement projects.

Bigger corporations generally are more efficient than small: productivity is correlated with organization size. But research activities are often more fruitful and efficient at smaller institutions: more nimble and able to adapt to the new technologies, apply them in new areas, and develop them commercially.

We believe that the government should take a leading role in paving the way an R&D intensive economy comprising both small and big companies; while allowing some degree of market consolidation in mature industries where innovation is difficult to come by.

The retail banking industry is an excellent case in point: the UK Government has encouraged competition and an increase in the number of banks for years. However, an improvement in the customer’s service is much more likely to come from the Fintech startups recently originated in London than from duplicating roles at corporate offices.

Works Cited

Barnett, A., Batten, S., Chiu, A., Franklin, J., & Sebastiá-Barriel, M. (2014 Q2). The UK productivity puzzle. Bank of England.

Blanchard, O., & Leigh, D. (2013). Growth Forecast Errors and Fiscal Multipliers. IMF Working Paper.

Godley, W., & Lavoie, M. (2007). Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth. Palgrave.

Keister, T., Martin, A., & McAndrews, J. (2008). Divorcing Money from Monetary Policy. Federal Reserve Bank of New York.

Mazzucato, M. (2013). The Entrepreneurial State: Debunking Public vs. Private Sector Myths.

McLeay, M., Radia, A., & Thomas, R. (2014). Money creation in the modern economy. Bank of England.

Piketty, T. (2014). Capital in the 21st Century.

Stiglitz, J., & Greenwald, B. (2014). Creating a Learning Society.

Summers, L., & DeLong, J. (2012). Fiscal Policy in a Depressed Economy.

Turner, A. (2015). The Case for Monetary Finance: An Essentially Political Issue.

The Eurozone Dystopia

The economic deterioration in Europe has accelerated substantially since the process of fiscal consolidation started in 2010. The Bundesbank, the most influential member of the ECB system, has enforced an agenda of austerity and strict price control that is at clashes with what peripheral countries need. 

This sequester orchestrated by the creditor nations runs contrary to the lessons learnt during prior crises and to the consensus of the international community –as even the IMF scaled back from expansionary fiscal consolidation theories and supports some of the most progressive views among the FED’s . The situation is such, that not even the most optimists among economists believe that structural reforms and Ricardian equivalences will re-ignite the peripheral economies. The periphery has suffered deflation since starting the crisis, yet, none of these countries have made any meaningful effort to achieve a more balanced position with their creditor counterparts, such as a dual mandate for the ECB (incorporating employment / GDP) or some form of solidarity-compensation stemming from Germany’s ever growing trade surpluses. 

These Governments (Ireland, Italy, Greece, Portugal and Spain) face stratified societies: senior citizens have all their assets denominated in Euro and don’t want to suffer the devaluation associated with leaving the common currency. Younger citizens, whether employed or not, would probably be better-off with the flexibility that a 'devaluable' (able to being devalued) currency would offer, but only the radical political parties echo such views, while the most highly-educated and entrepreneurial of them emigrate to northern latitudes. 

This framework has worked beautifully for the German exporters: not only they benefit from the undervalued domestic currency, they also extract rents from the subsidised labour and the strict anti-inflation mandates embedded in European institutions. 

The problem is to imagine how/when/where this race to the bottom converges with the views of a prosperous Europe that policy-makers had in mind when they designed the grandiose experiment. Sooner or later, the automation of the manufacturing sector will put German’s economic model in jeopardy (Productivity in the manufacturing space will keep raising higher than demand ever does). Equally, South-Europe cannot and should not survive by exporting tourism and olive oil. (There is a better way, even

Now, as the Euro approaches the average life expectancy of monetary unions (not followed by Political and Fiscal unions), the literature to help our ailed Euro-area policy-makers has expanded. Several books point out to the dangers of austerity, advocate for economic stimuli until economic health is restored, and for a new (social) contract between creditor and debtor nations. But perhaps more suggestive for those more strained at home is to dream about Mariana Mazzucato’s “Entrepreneurial State”. She advances that the fiscal multiplier, or the elasticity from the Governments spending in the economy, is greater when the investments are made in value-added sectors, such as research in life sciences, technology, clean-tech energies, etc. With a lion in the cover of her book, she ironizes that it has been Government funding schemes that have paved the way for the private sector to reap the benefits when these technologies have matured. For example: had it not been for the entrepreneurial, dynamic and creative role of the US Government through the DARPA and NIH programs, it would be difficult to imagine such thriving technology and biotech sectors as we know them today in the US. 

In summary, European policy-makers risk falling victims of complacency as sovereign risk premia decrease, but European institutions and R&D intensive SMEs are lagging the progress of international counterparts –sadly, cannot expect that to be reversed through a combination of price controls 

--written in Feb 2014 - Peter Martin fellowship at the FT