Productivity statistics expose deep weaknesses in theoretical economics

I hadn’t intended to post for another couple of weeks, but this article in the Financial Times is too good to miss. It tackles one of the central issues in modern economic debate: why productivity growth is so slow. Productivity lies at the heart of the conventional view of public policy – and yet it is very poorly understood. This article sheds light on what is happening in the UK – and it should give politicians and economists pause.

Productivity is in principle a very simple idea. It is the amount produced by a unit of labour in a unit of time – the number of widgets per person per hour, for example. This immediately conjures up a clear mental picture of a factory producing cars, say. Count the number of cars produced, and the number of hours of labour required and it is easy-peasy, surely? Alas in a modern economy  it is a much more difficult idea. What if your car factory is producing both Ford Fiestas and Mondeos, and switches to the smaller car? Has productivity gone up if more are produced? And how do you distinguish product enhancement from inflation?  And then there are problems treating capital outputs and inputs, research and development, and so on. In the end the productivity measured across an economy is a bit of a balancing figure, as we accountants would call it – or a bit of a dustbin – what’s left when you’ve taken everything else out. It is just a number relationship without a coherent meaning in its own right. It is not like the concepts that physical scientists are used to dealing with – such as the temperature and pressure of a gas. Macroeconomics is heterogeneous, to say nothing of being subject to capricious social forces that tend to corrupt all attempts at measurement.

Now, what is the productivity puzzle? It is that productivity growth, as measured by macroeconomic statisticians, has slowed markedly since 2008, when the financial crash caused a dislocation in measured income. This applies to all developed economies, but to the British economy most of all – UK productivity growth, according to the article, fell from 1.6% per annum before 2008 to just 0.3% after. This has profound implications, since in the long term productivity growth is what drives income per head, alongside the average hours people work (influenced strongly by workforce participation – such as how many women are in paid employment). And this drives tax revenues, from which public services are funded. Since we assume that quality of life is mainly driven by income, and that public services can constantly be enhanced by extra spending (apart from occasional periods of “austerity”), this has profound implications. Prior to 2008 most economists assumed that productivity growth of 1-2% pa was a law of nature and  main driver of “trend growth”, which could be baked into economic models. The corollary was that weak growth since 2008, and the failure of GDP to catch up with the pre 2008 trend-line, was a failure in macroeconomic policy.

But given the dustbin nature of the productivity statistics, it is very hard to drill down into them to find out just where the problem is – though that there is a problem of some sort is clear. This is licence for all manner of people to project their speculations into a fact-free zone. Mostly these are based on the intuitively obvious idea that the changes to the productivity figures represent trends in the efficiency of workers. Recently Bank of England bigwig Andrew Haldane moaned that the problem was that efficiency was stuck in a rut, especially in a swathe of mediocre firms. He based this on sectoral analysis which showed that the productivity had stagnated across all sectors – with economic growth mainly attributed to rises in employment, not efficiency.

The FT article, authored by Chris Giles and Gemma Tetlow, challenge that. A close examination of the numbers shows that the crash in productivity growth arises from changes in a small number of economic sectors, accounting for just 11% of income. These are banking, telecoms, electricity and gas, management consultancy, and legal and accounting services. Actually Mr Haldane’s and Mr Giles/Ms Tetlow’s analysis can be reconciled. Mr Haldane was taking a general view across the economy since 2008, where productivity growth is now very limited. The FT writers are looking at the transition from before and after 2008. The curious point is why productivity growth was so high in that small number of industries before 2008 – and the realisation that this is what was driving so much of the figures for productivity growth before that date.

And that leaves this blogger asking whether that pre-crash productivity growth – and by implication the pre-crash trend rate of overall economic growth – was in any sense real, other than statistically. In banking we know that in 2008 massive state resources were required to keep the industry alive, and that since then the industry has been much better controlled. This suggests that “productivity” would more correctly be described as “recklessness”. And in each of the other industries you can point to factors that demonstrate that growth was not simply incremental improvements in efficiency. For example in electricity and gas productivity was based on high inputs of fossil fuels and nuclear energy – and the switch away from these destructive sources of power has caused a decline in measured productivity. And how on earth do you assess the output of management consultancy, and accountancy and legal services? The transition may simply be from high margins in boom economy conditions to higher scrutiny when times were harder – or to put it another way, what was supposedly economic growth prior to 2008 was in fact concealed inflation.

All this supports the narrative that I have been promoting for quite a few years about the transition from growth to austerity. This is that the supposed growth of the economy of the early to mid noughties in the UK was down to excess demand, of which reckless fiscal policy was a part  – though you might alternatively argue that it was reckless borrowing by the private sector that the government turned a blind eye to. It also suggests that the lacklustre economic performance of the UK economy since 2008 reflects a lot more than just weak demand management: it is chickens coming home to roost.

This takes me to two very important conclusions. The first is that we have to be very careful about the recommendations of macroeconomists – and the eco-system of commentators and policy types that use macroeconomics as their starting point. The bandying about of aggregate statistics is all very well – but the aggregates hide as well as reveal – and we need to base economic prescriptions on the complexities of the real economy. That is hard, but necessary.

The second point is that overall productivity is indeed stuck in a rut, and has been since well before 2008. It must reflect structural issues in real economy – and not simply laziness amongst mediocre firms or poor macroeconomic management. There is no shortage of potential culprits: demographics; the nature of modern technology; the temporary nature of gains from trade with Asian economies. The world may still be becoming a better place – but because of things that are not captured in GDP, and hence productivity statistics. The problem for public policy is that tax revenues are largely driven by GDP (which is why it is an important statistic) – so we can’t expect an ever increasing flow of tax revenue to fund public services. In the long run we must either reduce the demand for public services (healthier people, fewer crimes, less skewed income distribution, etc.), raise taxes, or compromise what level of services and benefits we think that a civilised state should provide.

And that is a completely new way of thinking about public policy. The political right have grasped this (for the wrong reasons, perhaps) – but the left has not.


The Lib Dems hope that Britain goes Dutch

After a couple of days sightseeing in York, one of England’s most spectacular cities, I want to report back on the Liberal Democrats’ conference held there over the weekend. It ended with the traditional rallying cry from the party leader Tim Farron. He spelled out a bold strategy for the party: to replace Labour as the principal opposition, and then to take on the Conservatives for government. Well that’s not the first time I’ve heard such ideas from a Lib Dem leader’s speech – and the only result has been that the party’s wings melted like those of Icarus when it got too close to the heat of power. Could this time be different?

The Lib Dems are particularly taken by the result of the recent General Election in the Netherlands, and their hopes rest on similar trends being repeated in Britain. Now if your knowledge of the Dutch election was based reporting by the BBC News, and other mainstream news outlets, you might be a little surprised. The BBC pitched the contest as between the party of the Prime Minister, Mark Rutte, the VVD, and the populist-right PVV, a one-man vehicle for its leader Geert Wilders, and his extreme views against immigration, the EU and Islam. The BBC hunted out Dutch working class voters for its vox pops,  giving us the impression of a surge of support, in the manner of that that swept Donald Trump to power in the USA. The VVD meanwhile, though nominally a liberal party, seemed beholden to the PVV agenda, and anxious to sound tough on immigration, engineering a spat with the Turkish government to prove their point. When the VVD ended up with 33 seats, in the highly proportional Dutch electoral system, to the PVV’s 20, the BBC proclaimed the VVD as the winner, and quickly moved on.

But there a 150 seats in the Netherlands parliament, so the VVD and the PVV covered barely a third between them. Elsewhere something much more interesting was happening, which puts the whole picture in a different perspective. There were in fact two main losers in the election: the VVD, which lost 8 seats, though remained the largest party, and, most spectacularly, the Labour Party (the PvdA), which was reduced from 38 seats to just 9. The PVV advanced by 5 seats, but there were bigger winners. D66, the liberal left party most similar in outlook to the British Lib Dems, advanced 7 seats to 19; the Christian Democrats (the CDA), a party not unlike Britain’s Conservatives as they are being refashioned by Theresa May, also took 19 seats, gaining 6; and the biggest winner was the GreenLeft, which advanced 10 seats to 14.

What to make of this? Well it is fair to suggest that Mr Wilders and his PVV has set the political agenda. The CDA did well by coopting some of its ideas, and the VVD managed to hang on with similar tactics. But the two parties that where most vocal in promoting the opposite agenda, of voicing a sense of Dutch identity based on tolerance and being part of Europe, picked up 17 seats and have real momentum. The traditional Labour party was unable to hold together its coalition and collapsed.

And so the implications for British politics are clear. Mrs May’s strategy for the Conservatives, with a lurch to right on identity and social issues, and to the left on economic ones, looks sound enough. The polls show it has a commanding lead, crushing the populist Ukip, and even doing respectably in Scotland. Labour, meanwhile, are floundering – unable to find a formula that holds together its coalition of traditional working class, new working class (including ethnic minority workers) and liberal public sector workers. Its problems are compounded by spectacularly weak leadership, and a sense of political entitlement amongst its membership that makes them focus inwardly, rather than develop an effective political presence in the country at large. And the success of D66 and the GreenLeft shows the possibilities for the Lib Dems, by wearing its liberal and pro-European heart on its sleeve. There should be an opportunity for Britain’s Greens too, but they seem to have lost critical mass. Their move to being a party of the socialist left before the 2015 general election, including the adoption of Universal Income, was probably a major strategic error – and anyway the party seems allergic to clear leadership.

And so the Lib Dems at York went big for being pro-European, promoting a second referendum with a way back into the EU – and promoting the rights of EU citizens living in Britain. Political realists may dismiss this as being silly, but it lights fires. The populist surge, promoted by a hateful press, and supporting a hard Brexit, is generating a backlash, and the Lib Dems mean to exploit it.

But Mr Farron, and the party at large, are starting to look beyond that. That was evidenced by one fudge and one new idea. The fudge was on nuclear weapons. The party’s liberal principles point to unilateral nuclear disarmament, eloquently argued for by many activists. But members at large sensed danger and adopted a fudged policy that will go nowhere. As David Grace, one of those advocating the unilateralist position, rightly pointed out – the party was not afraid of the Russians so much as of the Daily Mail. While intellectually persuaded of the unilateralist line, I personally lacked the courage to support it. It would put off too many floating voters.

The new idea was put forward by Tim Farron in his speech: an economic commission of independent experts to develop new ideas on economic policy. This follows a similar idea on health and social care. This is a step that the Labour leader Jeremy Corbyn started to take and then dropped – no doubt because he feared it would be a hostage to fortune. The time is ripe for new thinking on economic policy, and the Conservative government is heading for some deep trouble, with its over-commitment to austerity and low taxes, not to mention hard Brexit. Tim’s commission cuts across the brief of an internal policy group (on the “21st Century Economy”), which I am planning to contribute to, but this looks like a sound move by him. The party can’t carry a new economic policy by itself.

Tim’s strategy is clear. Develop a core vote based on European identity and a liberal understanding of British values. And then pitch for floating voters, including those that voted for Brexit, based on economics and public services. Could it work? Labour could yet scupper it by dropping Mr Corbyn and going for the right replacement leader. Their German counterparts seem to be having some success with such a strategy. The most convincing alternative leaders are probably David Miliband or Ed Balls – but both are out parliament. Meanwhile the threat of complete collapse remains – the Dutch Labour Party is only the latest in a line of spectacular political failures by traditional socialist parties in Europe. The Lib Dems will still need a lot of luck – but this looks like their best chance.

I do not warm to Tim Farron personally. I am too cynical for his grand rhetoric, and bored of his jokes. But he is proving to be a very capable political strategist – much better than his predecessor. This will be interesting to watch.