THe REALITY BEHIND BRITAIN’S “PRODUCTIVITY PUZZLE”
Adjectives such as ‘shocking’ and ‘astonishing’ have been applied to the recognition, in Britain’s recent budget, that growth is going to be extremely weak well into the 2020s, and that real earnings will remain lower in 2022 than they were back in 2008.
The favoured explanation for this weakness is the so-called “puzzle” of poor productivity. Solving this mystery will, supposedly, restore robust growth and reverse the long years of deteriorating prosperity.
In fact, there’s nothing too ‘astonishing’ about any of this. For a start, productivity is really nothing more than economic output divided by hours worked. The calculation uses GVA (gross value added) rather than GDP (gross domestic product), but the former is a subset of the latter, differing only through some modest technical adjustments. Hours worked don’t oscillate dramatically over time. So saying that ‘productivity is poor’ is another way of saying that ‘economic performance is weak’.
The latest hand-wringing over prosperity really amounts to official recognition that the British economy is feeble. In the years prior to 2008, productivity grew at an average annual rate of 2.1%. Ever since its inception in 2010, the Office for Budget Responsibility (OBR), which advises government, has framed its forecasts on an assumed return to this previous rate.
In reality, trend growth in productivity since 2008 has been just 0.2%. The OBRs acceptance of this new reality was the cause of the sharp downgrades to growth assumptions announced by chancellor (finance minister) Philip Hammond in his budget.
If there’s a “puzzle” here at all, it is why the OBR has expected anything different, and why it has held to this assumption for so long. The shock and astonishment expressed about this by experts and the media is unlikely to be shared by the general public. They know all too well that prosperity has been deteriorating for a long time.
A second “puzzle”, far worthier of attention than the productivity conundrum, is why the-powers-that-be do not seem to understand the real issues involved. Essentially, the most constructive single thing that Britain could do would be to address serious imbalances in the economy.
And none of these is more important than the grave imbalance of incentives. Put another way, risk and return are extremely out-of-kilter, discouraging activities that would inject growth into the economy, and favouring those that do not.
Put yourself in the position of somebody with, say, £1m to invest. How does this person set out to increase this capital?
Essentially, there are two ways of doing this.
First, he or she can invest in an enterprise, bringing new goods or services to the market. This can be described as ‘innovation’, because the aim is to create value where it didn’t already exist.
The alternative is to buy existing assets, aiming to profit from a rise in their price. This can be termed ‘speculation’. This is not intended as a pejorative term. It simply means that anticipated rises in asset prices are speculative, because these increases might not happen, and prices might actually fall rather than rise.
For the investor, either strategy can prove equally efficacious. From a national, macroeconomic perspective, however, they are as different as chalk and cheese.
Investing in new goods and services adds value to the economy.
Investing in existing assets does not.
The trick for government is to favour the innovation route which delivers new streams of value, making it more attractive than the alternative, non-value-adding choice. By ‘more attractive’ is meant ‘offering a more favourable blend of risk and return’.
Britain, to a greater extent than most, has got this balance wrong. Moreover, successive governments, far from addressing this handicap, have gone to great efforts to make it even worse.
The person investing in a new enterprise necessarily faces significant risk. His new product might fail, or the economy might turn against him, making customers less willing or less able to buy his product. He might not have access to sufficient capital, at a low enough cost, to see him through the stages from research and development to marketing and impact. Competitors might undermine his efforts, perhaps through combination or predatory pricing, or perhaps simply by making a better offer to consumers.
Risk, then, is stacked against the innovator. It also requires a lot more effort than simply buying existing assets and hoping for a rise in prices.
Because of this, government needs to be pro-active in encouraging the innovative entrepreneur. This includes not making the alternative, speculative route too attractive.
This hardly describes British policy. The innovator faces hurdles at every stage of the process. He encounters a forest of regulation, some of which is necessary, a lot of which is simply gratuitous, and much of which bears proportionately more heavily on the entrepreneur than on larger, established competitors. Taxation is pretty onerous, including employment levies, the obligation to devote resources to collecting sales taxes, and the truly absurd Business Rates, absurd because it is unrelated even to turnover, let alone to profits.
The speculative route, on the other hand, gets a great deal of help from government. If asset prices, and most obviously those of property, threaten to fall, government will intervene with back-stops, most obviously with harmful gimmicks like “help to buy”, but more seriously with monetary policies calculated to inflate asset markets. No-one is going to back-stop the innovating entrepreneur in the same way. To cap it all, profits made on capital gains are taxed far more generously than income from creating new sources of value.
What successive British governments have said, in effect, is that ‘we favour speculative investment’. They have backstopped speculative activities, and have imposed low rates of tax, and pretty modest regulation, on those who want simply to buy existing assets and gain from increases in their price.
A more sensible route, surely, would be to redress the balance of incentives. This approach would favour innovation by granting some regulatory exemptions to small firms, removing some of the tax burdens imposed on them, perhaps providing advantageous lines of credit, and ensuring that bigger players do not act in ways detrimental to the small business, or otherwise benefit from a playing field that is far from level.
Complementary to this would be higher rates of tax on transactions and capital gains, combined with an avowed withdrawal from backstopping the prices of property and other assets.
These weaknesses are not unique to Britain, of course, but appear more serious there than in many comparable countries. Large allowances are given against taxes on capital gains, taxes which are often levied at rates lower anyway than on comparable amounts of income.
If a country sets out to favour the speculative over the innovative, it can hardly then complain if investors opt for speculation, and don’t put much effort into innovation.
The SEEDS model shows the real severity of the British economic malaise. Per capita prosperity, as measured by the system, has declined by 9.4% since it peaked in 2003, and continues to deteriorate. In the years since then, Britain has borrowed £5.50 for each £1 of recorded growth, and even the latter includes a sizeable component of simply boosting apparent output through the spending of borrowed money.
With energy costs rising, the crunch point of talks over post-“Brexit” trade looming, the currency at significant risk, and investors presumably questioning the wisdom of investing in an economy where customers are getting poorer, now is not the time to fiddle about with cosmetic incentives, and indulge in naval-gazing over a supposed “productivity puzzle” that is, in reality, no puzzle at all.
= = = =
Here’s how productivity looks on a basis adjusted for the “borrowed spending” impact on economic output: