Productivity and living standards: Key issues for the 2015 Parliament

Few economists would disagree with Paul Krugman on this point. Productivity growth – commonly defined as rising output per worker, or output per hour worked – is essential for sustained and sustainable increases in living standards.

Historically, productivity in the UK has grown at around 2% per year, but in the seven years since the recession began, it has stagnated. The Office for National Statistics says this is “unprecedented in the post-war period”.

Most economists expect productivity growth will eventually return to its historic trend; but if it doesn't, the implications for the economy, the public finances and future living standards could be severe.

Why is productivity important?

“Productivity” refers to how much output is produced for a given input (such as an hour of work). The more productive the economy is, the more that can be sustainably produced with a given amount of input.

Over time, higher productivity growth leads to a higher long-term growth rate in the economy. Labour productivity – the value of output per hour worked – also determines wages: the more productive an employee is, the more they are likely to be paid.

Productivity growth is therefore necessary for sustainable improvements in living standards and wages.

What has happened since the 2008 crisis?

The economic recovery following the 2008-2009 recession was the weakest of the post-war era. Since mid-2013, however, the economy has been growing at a faster pace: the estimated rate of growth in 2014 of 2.8% was the fastest of the G7 countries.

However, this extra output has been “bought” predominantly through extra work, rather than an increase in productivity. Although this has resulted in strong employment growth, it means we are working slightly harder to produce each pound's worth of goods and services than we were in 2007, and considerably harder than if productivity growth had continued on its pre-crisis trend.

This weakness in productivity has translated into a stagnation in wages and living standards.

Temporary or permanent?

The recent period of productivity stagnation raises important questions, including: is this just a temporary diversion from historical trends resulting from the financial crisis and recession?

Or is it a sign of things to come: permanently weaker productivity growth, and therefore smaller rises in living standards over the long term?

The Office for Budget Responsibility's (OBR's) central forecast anticipates a return to normality: “Growth is … supported by our assumption that productivity growth picks up towards its historical average rate”.

The Bank of England, while warning of the considerable uncertainty, shares the OBR's expectations of “…a gradual pickup in productivity growth to around its historical average rate.”

However, forecasts predicting an imminent return to <status quo ante> have been made for at least two years, and have consistently proven to be overoptimistic.

The persistent weakness in productivity has puzzled economists and there are many alternative theories to explain it: falling productivity in the oil and gas and financial sectors; weakness in investment that has reduced the quality of equipment employees are working with; the banking crisis leading to a lack of lending to more productive firms; employees within firms being moved to less productive roles; slowing rates of innovation and discovery; an ageing population; even inaccuracies in the data.

None are sufficient on their own to explain entirely what has happened and this makes it difficult to predict when and if the weakness in productivity growth will come to an end.

Running out of road

What can be predicted is that, with the proportion of people in work at historic highs, there is only limited room for growth in the economy to be driven by hiring more people.

For growth to continue for much longer at its current pace of 2.5-3.0% a year, the productivity of existing employees will need to improve. If this does not happen, then we can expect growth to slow and the public finances to deteriorate compared with current expectations.

And if productivity weakness is with us for the long haul, then we had better get used to living standards rising more slowly, even in the good times.

Chart: GDP compared to pre-recession peak

The weak recovery in living standards since the crisis is historically unusual, and due in large part to exceptionally weak productivity growth.

% change in GDP per capita compared to pre-recession peak

How productivity affects the economy and public finances

To illustrate the importance of productivity to the economy, the Office for Budget Responsibility (OBR), the independent fiscal watchdog, in December 2014 produced some forecasts in December 2014 based on three differing assumptions of productivity growth. These were:

(i) a weak productivity scenario – essentially a continuation of recent weakness – with productivity growth of 0.5% per year;
(ii) the OBR's central scenario, where productivity growth gradually rises back to its historic rate of 2%; and
(iii) a strong productivity scenario where productivity growth of 4% is recorded (similar to a few years in the early 1970s and early 1980s).

Faster productivity growth leads to stronger GDP growth. This, in turn, leads to higher tax revenues, which results in a lower government budget deficit and a reduced debt-to-GDP ratio. The differences are stark: the weak productivity scenario results in GDP growth of just 0.7% by 2019/20, compared with growth of 2.3% in the OBR's central scenario and of 3.7% under the strong productivity scenario.

Party Lines

• Labour: boost productivity by implementing commitments in the Workplace and Business manifestos
• SNP: central focus for Government policy should be improvements to productivity to lead to improvements in the UK's fiscal position