The Bank of England raised interest rates last week, and next week’s figures could show that retail sales volumes fell year on year in October, the first annual drop since 2013. These two events are related, and not because expectations of last week’s rate rise caused sales to fall.
The main reason for the fall in sales is that real wages have fallen. They have done so mainly because productivity has stagnated: if we’re not producing more, we can’t earn more and so can’t (except briefly) spend more. And a big reason for last week’s rate rise is that the Bank believes there has been a “marked slowdown” in the rate at which the economy can grow without generating inflation. This too is because stagnant productivity has reduced trend growth.
What we’re seeing then is vindication of Paul Krugman’s words: "productivity isn't everything, but in the long run it is nearly everything".
And we have a big problem here. Labour productivity is lower now than in 2007; not since the start of the industrial revolution has it been so weak for so long. Forecasters have for years expected productivity to recover. And they’ve been consistently wrong.
Why?
The obvious culprit is the financial crisis. Its immediate effect was to restrict credit and so deny companies the means of investing in new technologies. Cambridge University’s Maartin de Ridder has shown that companies most exposed to especially distressed banks cut productivity-enhancing investments by more than companies who borrowed from stronger banks.
However, it’s plausible that the crisis also had scarring effects. Even though credit is now more readily available the fear that it won’t remain so has encouraged companies to accumulate cash rather than invest and innovate. Also, the awareness that the economy is vulnerable to severe downturns has depressed animal spirits and hence willingness to invest, innovate and start new businesses. The latter is especially significant: as Richard Disney, Jonathan Haskel and Ylva Heden have shown, a lot of productivity growth comes not from existing companies upping their game but from new ones entering the market and less efficient ones leaving. Less entry therefore means less productivity growth.
What’s more, world trade growth has also slowed markedly in recent years. This too depresses productivity by denying us the benefits of a growing international division of labour.
Reduced competition – both from overseas and new domestic entrants – might have exacerbated the slowdown in investment, as Germán Gutiérrez and Thomas Philippon have shown. If incumbent companies face less competition, they needn’t bother investing and innovating to improve efficiency.
On top of all this, it’s possible that fiscal austerity has exacerbated the productivity slowdown. Oxford University’s Simon Wren-Lewis says that in contributing to expectations of weak demand, it has created an “innovations gap”; companies have been dissuaded from investing in better technologies.
All this confirms what economists such as Coen Tuelings, Sweta Saxena and Valerie Cerra have shown – that financial crises do long-lasting damage. In depressing productivity, they lead to sustained low growth.
Yes, it’s likely that these effects will eventually fade and it’s possible (although not certain) that governments can do things to raise productivity. Sadly, though, there’s no strong reason to suppose these will happen any time soon.
