I’m afraid this post is going to seem like an episode of House, except without finding out what the patient had at the end. Indeed it is not even clear which patient, the UK or the US, has the unusual symptoms.
Here are two charts, taken from a new study by the Institute for Fiscal Studies. The first compares UK labour productivity in this recession and two earlier large UK recessions.
The second chart compares labour productivity growth in this recession across selected countries.
These are startling differences, so what can explain them? The IFS study, which builds on earlier analysis by the Bank, MPC member Ben Broadbent, and others , has some ideas about some things that may be going on and some things that are not, but I think its fair to say that we are still in the conjecture phase on this. So this post is mostly conjecture.
Let us start with the first chart. There are two classes of explanation for such a dramatic change. One is that the structure of the UK economy has radically changed. The other type of explanation is that the nature of the recession is different, and so the outcomes are also different. This recession has been generated by a financial crisis rather than by tight monetary policy. However, the fall in productivity growth in the UK is pretty widely spread across industries, so it is not a composition effect caused by a decline in the financial services sector. We need more clues.
One clue may be the unusual behaviour of UK real wages, which have fallen in this recession to a much greater extent than they did in earlier downturns. Unfortunately there is a chicken and egg problem here: does real wage growth reflect productivity growth (as it generally does in the long run), or does it have a causal role? It helps here to look at investment. Investment always falls in a recession, but UK investment has fallen by more in this compared to earlier recessions.
This leads to one possible story: factor substitution. Firms are replacing machines by workers, because real wages are low. Real wages are low because the UK labour market has become more flexible, and workers are cutting wages in response to unemployment by more than they used to. So this is a structural change story. If true, this could be good news. If the economy recovers and unemployment falls soon enough to avoid significant hysteresis effects, real wages will increase again, factor substitution will go into reverse, and labour productivity will make up lost ground.
I’m sure there is some of this going on. But it does not account for why the same thing has not been happening in the US, the archetypal flexible labour market. In addition, Ben Broadbent argues that a much larger fall in investment would be required to explain observed productivity this way. There are also many other reasons why investment in this recession might be relatively low. The size of the downturn is greater, as is probably its expected duration (or at least the uncertainty associated with it’s duration). In addition, firms may just not be able to invest because banks will not lend them the money.
Here is another interesting clue. Large firms appear not to suffer from this problem: they have plenty of cash. There is some evidence that small firms, who are both more reliant in the UK on bank finance and are a more risky proposition, may have been subject to credit constraints. However we should not forget a third category of firms: start-ups.
One final clue. As has been noted by the IFS study and others, company liquidations in this recession have been lower than in previous recessions. (Tim Harford looks at this from a European angle.) In a recession where banks, as well as some firms, were in difficulties, banks may be reluctant to acknowledge failed loans and so may increase forbearance. Equally banks that are particularly concerned about their loan book are unlikely to take on new risk, so it may be much more difficult for new companies to get finance. (There is some support for this idea from the fact that the variance of rates of return and productivity have increased during the recession, but I have not seen evidence on whether this is unusual for a typical recession.) This is a story told about Japan’s lost decade. 
So, to the extent that UK banks have become much more cautious, they have stopped providing finance for new (potentially innovative) firms, but are keeping low productivity firms in business. A similar process may be going on within larger companies, where getting finance is not a problem. Innovation often requires investment, and so a reduction in investment generated by uncertainty (and perhaps greater risk aversion) will slow down productivity growth. (The structural econometric model of the UK economy that I built twenty years ago, COMPACT, has a vintage production structure, so I have a fondness for this idea.)
This story puts the unusual nature of the recession - a financial crisis and an associated reduction in risk taking - at the centre of the explanation of the UK productivity puzzle. There is also a nice corollary, which I have not seen emphasised elsewhere. To the extent that new entry has become less likely because of a lack of finance, the extent of competition has decreased. (Markets have become less ‘contestable’.) This will allow existing firms to increase profit margins, which may also help explain why UK inflation has been surprisingly persistent in this recession. So the story helps explain two UK puzzles rather than just one.
Yet this is a story that explains one of the charts - unusual behaviour in UK productivity - but not why none of this is visible in the US. Indeed, given that many European countries have similar profiles to the UK (except just not so bad), and given the econometric evidence noted below, the puzzle here may actually be the US. There are many people who know much more than me on these issues, but at the moment I cannot see any obvious reason why the US should be different.
The US banking industry appears much less concentrated than in the UK: there are many more US banks than UK banks even after allowing for the different size of each economy. I have seen it suggested that larger banks may find it more difficult to use local knowledge about particular markets or industries, local knowledge which could help offset the impact of higher risk aversion on innovation. Perhaps US start-ups have access to a greater range of sources of finance than those in the UK, but there seems to be the same concern in the US about small business lending as there is in the UK.
So I do not think we even have a potential answer to the puzzle posed by both charts, although I should also note an ever present danger in macro of trying to explain too much with too little data (to overfit). A recent very good study that tries to maximise the data by looking at financial crises the world over has just been published by Nicholas Oulton and María Sebastiá-Barriel. They find that financial crises not only tend to lower productivity by more than other types of recession in the short run, but also that there is a permanent productivity effect from financial crises. However they also find that this long run effect is not robust - it comes from the inclusion of developing countries in the data set, particularly Latin American countries. Which suggests that nothing is inevitable, and being fatalistic about potential output that we can never get back may be a big mistake.
 The productivity puzzles, Richard Disney, Wenchao Jin and Helen Miller, IFS
 Bruegel has some useful links here. This includes some who still believe a lot of labour hoarding is going on, and I would not want to discount that possibility.
 In other words we are seeing very low UK TFP growth as well as low labour productivity growth
 For example Caballero, R. J., Hoshi T and Kashyap A. (2007) “Zombie Lending and Depressed Restructuring in Japan”, American Economic Review 98.
 In fact an increase in monopoly power in the UK following the recession would produce on its own higher inflation, lower real wages and lower labour productivity (via factor substitution). However it would also imply a falling labour share, which as Chris Dillow points out does not appear to have happened. So you need to add some additional productivity story as well.
Man I read through this entire post waiting for the part where the economist gets all hopped up on goofballs, does something unethical, says something rude to someone, and then winds up in a psychiatric hospital after attempting to perform an economic stimulus on himself.ReplyDelete
See my short booklet: Solving the "Productivity Puzzle - and how to 'game' the GDP calculation" at www.matureeconomy.org
The news is good!
What do you make of this idea that the difference between the US and the UK can be explained by the variously flexible respective labour markets?
So if the US labour market is in fact more flexible than its UK counterpart, the costs of firing and rehiring workers must be lower in the US. And the data you have linked to indicates that UK employment has risen over the past 5 years, whereas US employment has fallen. So even if both US and UK firms suspect that demand will recover over a similar time-frame, it may be worthwhile for US firms to fire and rehire labour, whereas it might not be for UK firms.
Might it not be the case, then, that overall productivity has fallen in response to a fall in demand, and that the difference between the productivity of the individual worker in each economy is a function of the different incentive structures for keeping workers on the payroll in each economy?
Thanks for the illuminating post.
The mechanism you describe is the main rationalisation behind the labour hoarding story. Firms keep workers in anticipation of demand recovering. I did not have the space to discuss that idea in this post beyond footnote , but the main problem with it is that we would expect these firms to say they have excess capacity, but in survey evidence they do not. We would also expect this hoarding to decrease as the recovery failed to materialise, yet productivity continues to stagnate.Delete
Perhaps those surveyed in firms have adjusted to the new norm, and have subconsciously adjusted their idea of what their full capacity is?Delete
Maybe productivity is being incorrectly measured here in the US:ReplyDelete
I really like the attempt to link the productivity and inflation narratives together- this seems to be the best way of developing a comparative picture of what is going on.
I have a further question along these lines- during your macro course and previous blog posts you have pointed to exogenous inflation shocks experienced by the UK economy (which in your ZLB argument have disguised the risks of deflation from being to the left of the VPC).
Now, when we talk about workers adjusting real wages, one of the principal mechanisms for this is not downward wage adjustment, but rather freezing wages and allowing price rises to exact real term damage on purchasing power.
Might there be a story here? High inflation in the UK (and Europe?) allows faster real wage adjustment as firms freeze nominal wages. The public sector pay freeze is an obvious example of this. Seeing this opportunity, firms substitute into labour and cut investment. Measures such as QE provide further reassurance that inflation will not fall. Demand has dropped, but employment levels have only partially adjusted, account for productivity.
Does this place too much emphasis on exogenous price shock (oil) or is it credible?
Your argument seems to be that firms are taking advantage of their increased ability to cut real wages to hire new workers in place of investing in capital.
It seems to me that the zero lower bound argument only applies to wages of workers that are already employed. In other words, though it may not be possible to cut the nominal wages of employees, it certainly seems (at least more) possible to hire new employees at a lower nominal wage than a firm is currently paying.
I would also point out that returns on capital investment are usually greatest in the mid (5-10 yrs) term rather than the short term, so that there is a lag in a decrease in worker productivity due to reduced capital investment. Given this, it would seem strange to shortsighted for firms to cut capital investment during a recession in order to hire more workers (even at lower real wages).
I would argue that the traditional causes of inflexibility in the UK labour markets are a better explanation for the relative difference between US and UK employment rates - and therefore productivity - during the recession.
My research shows that this recession is different. I use an equation for total available capacity of factor utilization (labor and capital). The independent variables are unemployment, capacity utilization and capacity utilization as a function of labor share of income.ReplyDelete
UT^2 = u - cu + cu(ls)
u = unemployment
cu = capacity utilization
cu(ls) = 0.78 * labor share (2005 = 100)
UT has a zero lower bound that constrains the economy. The UK and US are reaching their zero lower bounds. You can see more details at this link...
In the US there looks to be a bigger change in the workforce and in the jobs on offer.ReplyDelete
1. US had a huge drop in workforce impossible to explain via aging. My guess is that it will be mainly bottom part of the labormarket that fell off. Guess based on effect described under 2.
2. In the US recovery was more at the high end of the labormarket than at the low end. US is running ahead off Europe on Automation and alike.
3. Recent trend most likely caused by Obamacare into part-time jobs (and likely lower productivity) is simply very recent. My guess not yet included.
4. New hiring is unlike Europe mainly in 50+. A group very likely with a higher productivity (more experience and skills based than education btw).
My own idea furthermore, is that Europe including UK is simply waiting how things will play out with the crisis. Very little happens.
In the service industries it also looks as if everybody thought Europe was very expensive both in relation to say the US but also in relation to GDP (countries with lower per capita GDP were simply more expensive than the US for similar services). In other words that a correction was overdue.
There is another simpler explanation. Suppose that the CPI is not really measuring inflation, and that inflation, in the sense of the changing value of money, is really running at 1%.ReplyDelete
In that case the RGDP measure is wrong, and goes up by about 2%, and so the productivity measure is also wrong, and goes up by 2%, and the mystery goes away.
That is my take on things.
US trend looks to be reversed. See yesterday in Bloomy.ReplyDelete
-Budgetfarce. Most people expect some cuts and with 10% deficit having 2% growth is very poor anyway now. Fate in effectiveness stimulus measures fading anyway, getting the economy restarted via consumption is not working it takes too long and the impulstime of a consumption stimulus looks much too low. You need to convince real business not the financial markets only and real business isnot buying it.
-Stinking stats. Might be human error, but there are simply a lot of them and nearly all are corrected lateron in one direction. In general stats around the elction looked considerably more crap in the US than in the UK.
-Obamacare. Move to more part-time work in the last months. Combined with slihtly adjusting definitions for stats.
if you read the BLS labor statistics rather than depend upon journalists who are innumerate, you will see that since obamacare the trend is to full time jobs. this makes sense as most poor people - who are on medicaid - will now be able to keep it when they start working at low wage jobs.Delete
Jobs at your Home, Internet Online Jobs like data entry, copy pasting, Form Filling, Facebook Sharing Jobs, Clicking Jobs, Web Surfing, Google Jobs and Much More Earning Systems OnlineReplyDelete
In the US it appears that only 30ish% of the group in the workable age and normally working <30K USD annually has a job.ReplyDelete
Most worrying is that that trend might move to Europe (as it usually does).
So problem might be even worse than the stats suggest.