Category: Essential Economics for Business: Ch 08

In various blogs, we’ve looked at the UK’s low productivity growth, both relative to other countries and relative to the pre-1998 financial crisis (see, for example, The UK productivity puzzle and Productivity should we be optimistic?). Productivity is what drives long-term economic growth as it determines potential GDP. If long-term growth is seen as desirable, then a fall in productivity represents a serious economic problem.

Recent data suggest that the problem, if anything, is worse than previously thought and does not seem to be getting better. Productivity is now some 21% below what it would have been had productivity growth continued at the rate experienced in the years before the financial crisis (see second chart below).

In its latest productivity statistics, the ONS reports that labour productivity (in terms of output per hour worked) fell by 0.1% in the second quarter of 2017. This follows a fall of 0.5% in quarter 1. Over the whole year to 2017 Q2, productivity fell by 0.3%.

Most other major developed countries have much higher productivity than the UK. In 2016, Italy’s productivity was 9.9% higher than the UK’s; the USA’s was 27.9%, France’s was 28.7% and Germany’s was 34.5% higher. What is more, their productivity has grown faster (see chart).

But what of the future? The Office for Budget responsibility publishes forecasts for productivity growth, but has consistently overestimated it. After predicting several times in the past that UK productivity growth would rise towards its pre-financial crisis trend of around 2% per year, in its October 2017 Forecast evaluation Report it recognises that this was too optimisitic and revises downwards its forecasts for productivity growth for 2017 and beyond.

As the period of historically weak productivity growth lengthens, it seems less plausible to assume that potential and actual productivity growth will recover over the medium term to the extent assumed in our most recent forecasts. Over the past five years, growth in output per hour has averaged 0.2 per cent. This looks set to be a better guide to productivity growth in 2017 than our March forecast of 1.6 per cent.

Looking further ahead, it no longer seems central to assume that productivity growth will recover to the 1.8 per cent we assumed in March 2017 within five years.

But why has productivity growth not returned to pre-crisis levels? There are five possible explanations.

The first is that there has been labour hoarding. But with companies hiring more workers, this is unlikely still to be true for most employers.

The second is that very low interest rates have allowed some low-productivity companies to survive, which might otherwise have been driven out of business.

The third is a reluctance of banks to lend for investment. After the financial crisis this was driven by the need for them to repair their balance sheets. Today, it may simply be greater risk aversion than before the financial crisis, especially with the uncertainties surrounding Brexit.

The fourth is a fall in firms’ desire to invest. Although investment has recovered somewhat from the years directly following the financial crisis, it is still lower than might be expected in an economy that is no longer is recession. Indeed, there has been a much slower investment recovery than occurred after previous recessions.

The fifth is greater flexibility in the labour market, which has subdued wages and has allowed firms to respond to higher demand by taking on more relatively low-productivity workers rather than having to invest in human capital or technology.

Whatever the explanation, the solution is for more investment in both technology and in physical and human capital, whether by the private or the public sector. The question is how to stimulate such investment.

Articles

UK productivity lagging well behind G7 peers – ONS Financial Times, Katie Martin (6/10/17)
UK productivity sees further fall BBC News (6/10/17)
UK resigned to endless productivity gloom The Telegraph, Tim Wallace (10/10/17)
UK productivity estimates must be ‘significantly’ lowered, admits OBR The Guardian, Richard Partington and Phillip Inman (10/10/17)
UK productivity growth to remain sluggish, says OBR BBC News (10/10/17)
Official Treasury forecaster slashes UK productivity growth forecast, signalling hole in public finances for November Budget Independent, Ben Chu (10/10/17)
The Guardian view on Britain’s productive forces: they are not working The Guardian, Editorial (10/10/17)
Mind the productivity gap: the story behind sluggish earnings The Telegraph, Anna Isaac (26/10/17)

Data and statistical analysis

Labour productivity: April to June 2017 ONS Statistical Bulletin (6/10/17)
International comparisons of productivity ONS Dataset (6/10/17)
Forecast evaluation report OBR (October 2017)

Questions

  1. Explain the relationship between labour productivity and potential GDP.
  2. What is the relationship between actual growth in GDP and labour productivity?
  3. Why does the UK lag France and Germany more in output per hour than in output per worker, but the USA more in output per worker than in output per hour?
  4. Is there anything about the UK system of financing investment that results in lower investment than in other developed countries?
  5. Why are firms reluctant to invest?
  6. In what ways could public investment increase productivity?
  7. What measures would you recommend to encourage greater investment and why?
  8. How do expectations affect the growth in labour productivity?

According to a new report, Time for Change published by the Institute for Public Policy Research (IPPR), ‘The British economic model needs fundamental reform.’

It is no longer generating rising earnings for a majority of the population, and young people today are set to be poorer than their parents. Beneath its headlines figures, the economy is suffering from deep and longstanding weaknesses, which make it unfit to face the challenges of the 2020s.

The report by the IPPR’s Commission on Economic Justice is an interim one, with the final report due in the latter part of next year. The commission was set up in 2016 and includes business leaders, such as the heads of John Lewis and Siemens, the TUC General Secretary, the Archbishop of Canterbury and other leading figures.

Commenting on the interim report, Justin Welby, the Archbishop of Canterbury said

Our economic model is broken. Britain stands at a watershed moment where we need to make fundamental choices about the sort of economy we need. We are failing those who will grow up into a world where the gap between the richest and poorest parts of the country is significant and destabilising

The report found that wages have stagnated for the majority of the population since the financial crisis of 2007/8. Wage income has fallen as a proportion of national income, while the proportions going to income from profits and property have risen. Young people are poorer than previous generations of young people.

Despite low unemployment, many people are on zero-hour contracts, part-time contracts or employed on a casual basis. For many, their jobs are insecure and they have no bargaining power.

The UK for many years has had a lower rate of investment that other developed economies and productivity, in terms of output per hour, is the lowest of its major competitors. Productivity in Germany is 36% higher than in the UK; in France and the USA it is 29% higher. Although there are some internationally competitive UK firms with high productivity, the country has:

a longer ‘tail’ of low-productivity businesses, in which weak management and poor use of skills leads to ‘bad jobs’ and low wages.

There are many other challenges, including an ageing population, uncertainties from Brexit, a large current account deficit, increased competition from abroad and growth once more in private-sector debt, which means that consumption may cease to be the main driver of economic growth as people seek to curb their borrowing.

The report is also critical of fiscal policy, which with record low interest rates could have been used to finance infrastructure projects as well as supporting public services.

The report recommends three approaches:

The first is institutional reform to support investment.

The second is making the economy more competitive through a coherent industrial strategy, reform of the financial sector to support long-term investment, reform of corporate governance to promote business success and tackling the market dominance of companies such as Amazon and Google.

The third is to bring greater social justice and equality through encouraging more secure and better-paid jobs, strengthening trades unions and reforming the tax system to make it fairer and smarter.

Not surprisingly the government has defended its record of reducing debt, presiding over falling unemployment and reduced inequality as measured by a reduced Gini coefficient. However, there has only been a modest fall in the Gini coefficient, from 0.333 in 2009/10 to 0.315 in 2016/7, and this has largely been the result of the very rich seeing a decline in income from assets.

Articles

Britain’s economy is broken and failing to tackle inequality, says major new report Independent, Ben Chu (6/9/17)
UK’s economic model is broken, says Archbishop of Canterbury The Guardian, Phillip Inman (5/9/17)
Tax wealth or see the UK tear itself apart, Cable will warn Bloomberg, Alex Morales and Thomas Penny (6/9/17)
Archbishop of Canterbury calls for radical economic reform BBC News (5/9/17)
Archbishop warns economy is “broken” as report reveals longest period of wage stagnation for 150 years Huffington Post, Rachel Wearmouth (6/9/17)
Britain’s economy is broken. We desperately need new ideas The Guardian, Tom Kibasi (4/6/17)
Carney: Britain is in the ‘first lost decade since the 1860s’, Business Insider, Oscar Williams-Grut (6/12/16)
Our broken economy, in one simple chart New York Times, David Leonhardt (7/8/16)

Report

Time for Change: A new Vision for the British Economy IPPR Commission on Economic Justice (6/9/17)

Questions

  1. Why have wages for the majority of the UK population stagnated for the past 10 years?
  2. Why is productivity in the UK lower than in most other developed economies?
  3. Is it possible for poor people to become poorer and yet for the Gini coefficient to fall?
  4. What institutional reforms would you suggest to encourage greater investment?
  5. Explain the possible advantages and disadvantages of abandoning ‘austerity policy’ and adopting a more expansionist fiscal stance?
  6. Does it matter that Amazon and Google are dominant players in their respective markets? Explain.

In the last blog post, As UK inflation rises, so real wages begin to fall, we showed how the rise in inflation following the Brexit vote is causing real wages in the UK to fall once more, after a few months of modest rises, which were largely due to very low price inflation. But how does this compare with other OECD countries?

In an article by Rui Costa and Stephen Machin from the LSE, the authors show how, from the start of the financial crisis in 2007 to 2015 (the latest year for which figures are available), real hourly wages fell further in the UK than in all the other 27 OECD countries, except Greece (see the chart below, which is Figure 5 from their article). Indeed, only in Greece, the UK and Portugal were real wages lower in 2015 than in 2007.

The authors examine a number of aspects of real wages in the UK, including the rise in self employment, differences by age and sex, and for different percentiles in the income distribution. They also look at how family incomes have suffered less than real wages, thanks to the tax and benefit system.

The authors also look at what the different political parties have been saying about the issues during their election campaigns and what they plan to do to address the problem of falling, or only slowly rising, real wages.

Articles

Real Wages and Living Standards in the UK LSE – Centre for Economic Performance, Rui Costa and Stephen Machin (May 2017)
The Return of Falling Real Wages LSE – Centre for Economic Performance, David Blanchflower, Rui Costa and Stephen Machin (May 2017)
The chart that shows UK workers have had the worst wage performance in the OECD except Greece Independent, Ben Chu (5/6/17)

Data

Earnings and working hours ONS
OECD.Stat OECD
International comparisons of productivity ONS

Questions

  1. Why have real wages fallen more in the UK than in all OECD countries except Greece?
  2. Which groups have seen the biggest fall in real wages? Explain why.
  3. What policies are proposed by the different parties for raising real wages (a) generally; (b) for the poorest workers?
  4. How has UK productivity growth compared with that in other developed countries? What explanations can you offer?
  5. What is the relationship between productivity growth and the growth in real wages?

According to Christine Lagarde, Managing Director of the IMF, the slow growth in global productivity is acting as a brake on the growth in potential income and is thus holding back the growth in living standards. In a recent speech in Washington she said that:

Over the past decade, there have been sharp slowdowns in measured output per worker and total factor productivity – which can be seen as a measure of innovation. In advanced economies, for example, productivity growth has dropped to 0.3 per cent, down from a pre-crisis average of about 1 per cent. This trend has also affected many emerging and developing countries, including China.

We estimate that, if total factor productivity growth had followed its pre-crisis trend, overall GDP in advanced economies would be about 5 percent higher today. That would be the equivalent of adding another Japan – and more – to the global economy.

So why has productivity growth slowed to well below pre-crisis rates? One reason is an ageing working population, with older workers acquiring new skills less quickly. A second is the slowdown in world trade and, with it, the competitive pressure for firms to invest in the latest technologies.

A third is the continuing effect of the financial crisis, with many highly indebted firms forced to make deep cuts in investment and many others being cautious about innovating. The crisis has dampened risk taking – a key component of innovation.

What is clear, said Lagarde, is that more innovation is needed to restore productivity growth. But markets alone cannot achieve this, as the benefits of invention and innovation are, to some extent, public goods. They have considerable positive externalities.

She thus called on governments to give high priority to stimulating productivity growth and unleashing entrepreneurial energy. There are several things governments can do. These include market-orientated supply-side policies, such as removing unnecessary barriers to competition, driving forward international free trade and cutting red tape. They also include direct intervention through greater investment in education and training, infrastructure and public-sector R&D. They also include giving subsidies and/or tax relief for private-sector R&D.

Banks too have a role in chanelling finance away from low-productivity firms and towards ‘young and vibrant companies’.

It is important to recognise, she concluded, that innovation and structural change can lead to some people losing out, with job losses, low wages and social deprivation. Support should be given to such people through better education, retraining and employment incentives.

Articles

IMF chief warns slowing productivity risks living standards drop Reuters, David Lawder (3/4/17)
Global productivity slowdown risks social turmoil, IMF warns Financial Times, Shawn Donnan (3/4/17)
Global productivity slowdown risks creating instability, warns IMF The Guardian, Katie Allen (3/4/17)
The Guardian view on productivity: Britain must solve the puzzle The Guardian (9/4/17)

Speech
Reinvigorating Productivity Growth IMF Speeches, Christine Lagarde, Managing Director, IMF(3/4/17)

Paper
Gone with the Headwinds: Global Productivity IMF Staff Discussion Note, Gustavo Adler, Romain Duval, Davide Furceri, Sinem Kiliç Çelik, Ksenia Koloskova and Marcos Poplawski-Ribeiro (April 2017)

Questions

  1. What is the relationship between actual and potential economic growth?
  2. Distinguish between labour productivity and total factor productivity.
  3. Why has total factor productivity growth been considerably slower since the financial crisis than before?
  4. Is sustained productivity growth (a) a necessary and/or (b) a sufficient condition for a sustained growth in living standards?
  5. Give some examples of technological developments that could feed through into significant growth in productivity.
  6. What is the relationship between immigration and productivity growth?
  7. What policies would you advocate for increasing productivity? Explain why.

The UK Chancellor of the Exchequer, Philip Hammond, announced in the Budget this week that national insurance contributions (NICs) for self-employed people will rise from 9% to 11% by 2019. These are known as ‘Class 4’ NICs. The average self-employed person will pay around £240 more per year, but those on incomes over £45,000 will pay £777 more per year. Many of the people affected will be those working in the so-called ‘gig economy’. This sector has been growing rapidly in recent years and now has over 4 million people working in it.

Workers in the gig economy are self employed, but are often contracted to an employer. They are paid by the job (or ‘gig’: like musicians), rather than being paid a wage. Much of the work is temporary, although many in the gig economy, such as taxi drivers and delivery people stick with the same job. The gig economy is just one manifestation of the growing flexibility of labour markets, which have also seen a rise in temporary employment, part-time employment and zero-hour contracts.

Working in the gig economy provides a number of benefits for workers. Workers have greater flexibility in their choice of hours and many work wholly or partly from home. Many do several ‘gigs’ simultaneously, which gives variety and interest.

In terms of economic theory, this flexibility gives workers a greater opportunity to work the optimal amount of time. This optimum involves working up to the point where the marginal benefit from work, in terms of pay and enjoyment, equals the marginal cost, in terms of effort and sacrificed leisure.

For firms using people from the gig economy, it has a number of advantages. They are generally cheaper to employ, as they do not need to be paid sick pay, holiday pay or redundancy; they are not entitled to parental leave; there are no employers’ national insurance contributions to pay (which are at a rate of 13.8% for employers); the minimum wage does not apply to such workers as they are not paid a ‘wage’. Also the firm using such workers has greater flexibility in determining how much work individuals should do: it chooses the amount of service it buys in a similar way that consumers decide how much to buy.

Many of these advantages to firms are disadvantages to the workers in the gig economy. Many have little bargaining power, whereas many firms using their services do. It is not surprising then that the Chancellor’s announcement of a 2 percentage point rise in NICs for such people has met with such dismay by the people affected. They will still pay less than employed people, but they claim that this is now not enough to compensate for the lack of benefits they receive from the state or from the firms paying for their services.

Some of the workers in the gig economy can be seen as budding entrepreneurs. If you have a specialist skill, you may use working in the gig economy as the route to setting up your own business and employing other people. A self-employed plumber may set up a plumbing company; a management consultant may set up a management consultancy agency. Another criticism of the rise in Class 4 NICs is that this will discourage such budding entrepreneurs and have longer-term adverse supply-side effects on the economy.

As far as the government is concerned, there is a worry about people moving from employment to self-employment as it tends to reduce tax revenues. Not only will considerably less NIC be paid by previous employers, but the scope for tax evasion is greater in self-employment. There is thus a trade-off between the extra output and small-scale investment that self-employment might bring and the lower NIC/tax revenue for the government.

Articles

Thriving in the gig economy Philippine Daily Inquirer, Michael Baylosis (10/3/17)
6 charts that show how the ‘gig economy’ has changed Britain – and why it’s not a good thing Business Insider, Ben Moshinsky (21/2/17)
What is the ‘gig’ economy? BBC News, Bill Wilson (10/2/17)
Great Freelance, Contract and Part-Time Jobs for 2017 CareerCast (10/3/17)
We have the laws for a fairer gig economy, we just need to enforce them The Guardian, Stefan Stern (7/2/17)
The gig economy will finally have to give workers the rights they deserve Independent, Ben Chu (12/2/17)
Gig economy chiefs defend business model BBC News (22/2/17)
Spring Budget 2017 tax rise: What’s the fuss about? BBC News, Kevin Peachey (9/3/17)
Self-employed hit by national insurance hike in budget The Guardian, Simon Goodley and Heather Stewart (8/3/17)
What national insurance is – and where it goes The Conversation, Jonquil Lowe (10/3/17)
Britain’s tax raid on gig economy misses the mark Reuters, Carol Ryan (9/3/17)
Economics collides with politics in Philip Hammond’s budget The Economist (9/3/17)

UK government publications
Contract types and employer responsibilities – 5. Freelancers, consultants and contractors GOV.UK
Spring Budget 2017 GOV.UK (8/3/17)
Spring Budget 2017: documents HM Treasury (8/3/17)
National Insurance contributions (NICs) HMRC and HM Treasury (8/3/17)

Questions

  1. Give some examples of work which is generally or frequently done in the gig economy.
  2. What are the advantages and disadvantages to individuals from working in the gig economy?
  3. What are the advantages and disadvantages to firms from using the services of people in the gig economy rather than employing people?
  4. In the case of employed people, both the employees and the employers have to pay NICs. Would it be fair for both such elements to be paid by self-employed people on their own income?
  5. Discuss ways in which the government might tax the firms which buy the services of people in the gig economy.
  6. How does the rise of the gig economy affect the interpretation of unemployment statistics?
  7. What factors could cause a substantial growth in the gig economy over the coming years?