Spencer Dale: Productivity and monetary policy
Speech by Mr Spencer Dale, Executive Director, Monetary Policy, and Chief Economist of the
Bank of England, at the South Tyneside Manufacturing Forum, London, 21 September 2011.
* * *
Thank you for the invitation to speak to you this morning.
It is a pleasure to be in the North East and to have the opportunity to speak to a forum of
business leaders from the manufacturing sector. As our economy recovers and rebalances
towards a more sustainable pattern of growth and demand, manufacturing and the export
sector more generally will need to play an increasing role. So I'm really pleased to have the
opportunity to speak to a group of companies at the forefront of this process.
The topic of my talk today is one that is close to many of your hearts. Indeed, it concerns the
life blood of the long-term success of each and every one of your companies.
It is also central to the setting of monetary policy.
Productivity
As you know far better than I, strong, sustained productivity growth is vital for ensuring that
your companies remain competitive in the global market place.
Productivity is equally important for the long-term health and prosperity of our economy as a
whole. To paraphrase one economist "productivity isn't everything, but in the long-run it is
almost everything". (Krugman 1994).
Productivity matters for monetary policy since it plays a crucial role in determining the supply
capacity of our economy. The balance between an economy's capacity to supply goods and
services and what is actually demanded is a fundamental driver of inflationary pressure in the
medium term, and so central to the MPC's task.
The recent behaviour of productivity has been puzzling and worrying in equal measure.
The level of measured productivity in the UK private sector today is lower than it was at the
time of the financial crisis.1 We have had over three years of stagnant productivity. If private
sector productivity had continued to grow at the average rate seen prior to the crisis of
around two and half percent or so, the level of productivity today would be around 9% higher
(Chart 1).2,3
What might account for the UK's productivity shortfall? And what implications might it have
for monetary policy?
1
The private sector has been approximated by excluding employment and output data for the public
administration and defence, education and health sectors, reflecting that a significant proportion of these
sectors are within the public sector. Workforce Jobs data on sectoral employment have been scaled to match
aggregate employment levels indicated by the Labour Force Survey. Resulting calculations for the private
sector are estimates only. Official ONS productivity estimates are for the whole economy and so differ slightly.
2
The productivity shortfall is measured in terms of output per head. The scale of the shortfall would be slightly
less if measured in terms of output per hour worked, but the same qualitative patterns (and puzzles) are
apparent in productivity per hour measures.
3
The UK is not alone: OECD data reveal that several of the world's largest economies (including Germany,
France and Italy) have also been experiencing sluggish productivity growth by historical standards. One
exception to this is the US, where productivity has actually grown at rates in excess of the pre-crisis average
over much of the past three years.
As I fear may often seem to be the case with economists - I'm not going to offer you a simple
answer. There is no single smoking gun. Rather I think there are a number of candidate
explanations, each of which is likely to have played some role. In the next section of my talk,
I'll highlight three broad classes of explanation - which range from the relatively benign to
more worrying diagnoses - and try to provide some guide as to their relative importance.
I'll then discuss how the uncertainty surrounding recent developments in productivity
complicates the setting of monetary policy. The MPC needs to form an assessment of the
strength of supply as well as demand when setting policy. I'll conclude with some thoughts
on recent developments in the economy more generally and how they have affected my
policy decisions.
Productivity weakness: a reality or an illusion?
So what could account for the recent poor productivity performance?
One possibility is that the weakness of measured productivity growth may exaggerate the
true extent of underlying weakness. Let me explain.
An encouraging aspect of the recent recession is that although unemployment increased, it
rose by far less than we might have feared given the depth of the recession. The recent data
on employment and unemployment are worrying in that context, with unemployment edging
up over the summer, after having previously fallen by over 50,000 from its peak in early 2010.
If this weakening in the labour market continues that could materially change the relationship
between output and employment.
But to date, companies appeared to have held onto a greater proportion of their labour force
than in past recessions. My own experience of speaking to businesses at the depth of the
recession is that this was driven by a desire to retain valuable skills and experience. Many
companies had learned from past experience how difficult it is to re-employ skilled workers
once let go. But a consequence of this labour hoarding is that the amount of output produced
per worker fell very sharply, in many cases partly because working hours were cut back. And
although there has been some rebound since then, the level of labour productivity has still
not recovered to its previous level.
This greater retention of labour suggests that firms may be sitting on a substantial degree of
spare capacity. Underlying productivity - the level of productivity that would be possible if
workers and capital were utilised at normal levels of intensity - may have continued to
improve even though measured productivity has not. But this will only become apparent if
and when demand recovers and the workforce is fully utilised.
Although I place some weight on this explanation, I worry that it is contradicted by what
business leaders - just like you - typically say and, more importantly, by what they have
been doing. Despite all this apparent hoarding of labour, when responding to business
surveys and questions from our network of Agents, companies often say that they have
relatively little spare capacity. Now there are good reasons why a company's notion of spare
capacity may differ from that of an economist, and so there's a danger that we over-interpret
these responses.4 But it is not just what the managers of those businesses say, it is also
what they have been doing. Over the past year, despite only sluggish output growth, private
sector employment increased by almost half a million people - the strongest increase in
employment since 1997. It is difficult to understand why firms should increase employment
so significantly if their existing workforce is not fully utilised.
Some of this behaviour may be explicable if employment growth were concentrated in
sectors of the economy which are expanding most quickly, especially those orientated
towards the export sector. But it is striking that this pattern of rising employment and weak
productivity is common across most sectors of the economy (Chart 2).5 It is also possible that
firms in some parts of our economy are having to work flat out just to generate the same
amount of business. Estate agents, for example, trying to match buyers and sellers in a thin
housing market. Or M&A teams pitching for new business. The extra effort that is required
may explain why these types of companies do not report much spare capacity. But it does
not help to explain why companies facing these types of pressures should want to expand
greatly their workforces.
It is hard to reconcile the number of new jobs created over the past year with the belief that
firms are sitting on a substantial margin of spare capacity.
The recent weakness in productivity may also have been exaggerated by the sheer difficulty
of measuring economic activity in real time. We know that early estimates of output are often
revised as more comprehensive data become available. Recent productivity may look less
disappointing if subsequent estimates of output are marked up. And indeed, based in part on
the pattern of past revisions, the MPC does think that the current and recent level of
measured output is more likely to be revised up than down (Chart 3).6 But such revisions are
likely to provide only a partial explanation of the productivity puzzle. For example, if GDP
were to be revised in line with the path the MPC judge most likely, that would account for
only around one fifth of the 9% productivity shortfall.7
If labour hoarding and data revisions provide only a partial explanation of the recent
sluggishness of productivity growth, what else might account for it?
Difficulty of extrapolating from the past
The second explanation is that it might be misleading to extrapolate from previous trends
when gauging the extent of the productivity puzzle. The past is not necessarily a good guide
to the future. In particular, there are reasons to think that past productivity growth in both the
energy extraction sector and the financial services sector may provide a poor guide to more
recent trends in underlying growth in those sectors.
In the twenty years prior to the financial crisis, productivity in the energy sector grew at an
average annual rate of over 3%. But the pace of productivity growth slowed markedly in the
past decade or so as North Sea oil fields aged and energy extraction became more difficult.
Indeed, since the mid-2000s, productivity has actually been falling (Chart 4).
In contrast, productivity growth in the financial services sector increased very sharply in the
10 years prior to the financial crisis, underpinned by the process of financial liberalisation and
strong growth in financial sector balance sheets. It does not seem sensible - certainly with
the benefit of hindsight - to think that this strong growth would continue indefinitely.
Re-estimating the scale of the productivity puzzle using more plausible estimates for trend
productivity growth in these two sectors reduces the size of the productivity shortfall by up to
2 percentage points - that is from around 9% to 7% - with the majority of that difference
reflecting slower underlying productivity growth within the energy extraction sector.
Extrapolating from the past may also be misleading if some businesses were operating at
above normal levels of capacity utilisation prior to the recession. If that were the case, some
of the subsequent slowdown in productivity growth would simply reflect the need for
companies to adjust to more sustainable operating levels. And that indeed appears to be the
case, with business surveys pointing to above average capacity pressures in both the
manufacturing and services sector prior to the recession. The implied required adjustment
may account for around a further 1% point of the productivity shortfall.8
Taking account of changes in productivity trends within key sectors of the economy and of
the position of the economy prior to the start of the recession may account for around one
third of the productivity shortfall. But even if we combine both of these factors with the impact
of the likely upward revision to GDP, this still leaves a sizeable productivity puzzle - of
around one half of the productivity shortfall - to explain.
The third explanation is that underlying productivity growth has been weakened by the
impact of the financial crisis. It is notable that this explanation is consistent with evidence
from business surveys of spare capacity which suggest that underlying productivity growth in
the manufacturing and services sector has essentially stagnated since the start of the
recession (Charts 5 and 6).9 What might account for this flat lining in potential productivity?
Impact of financial crisis
In an accounting sense, this stalling in productivity growth must be attributable to one of two
factors. A slowing in the rate at which companies have added to the physical capital used by
each member of their workforce. Or a slowing in the pace of efficiency gains associated with
the way in which companies combine capital and labour to produce output, known in the
jargon as total factor productivity.
In reality, it is unlikely that a slowing in the pace of capital accumulation contributed
significantly to the weakness of productivity. This is largely a matter of arithmetic. Annual
business investment flows are small relative to the size of the capital stock. So even though
business investment fell by around a quarter in the year following the collapse of Lehman
Brothers, and remains 20% below its pre-crisis level, it is unlikely to have had a significant
impact on the stock of capital available per worker.10
8
Evidence from business surveys (eg BCC, CBI) and the Bank's Agents suggest that capacity utilisation was
above normal in both manufacturing and services sectors. Qualitative survey balances can be adjusted to
match the mean and variance of an estimated productivity gap from which inference about productivity may be
drawn. See Charts 3.7 and 3.8 in the August 2011 Inflation Report.
9
Potential productivity is constructed using the BCC surveys of capacity utilisation and productivity data from
the ONS for the manufacturing sector and private services excluding finance sector. The BCC survey asks
firms whether they are operating at or below full capacity. Since the survey measures are qualitative, they
have been mean and variance adjusted over the period 1989 to 2006 to infer a measure of the gap between
actual and potential productivity. The trends shown in charts 5 and 6 are chosen such that the shortfall
between actual and potential productivity maps closely to the mean-and-variance-adjusted survey measures
of spare capacity.
10
The annual flow of business investment prior to the recession averaged around 7% of the UK capital stock. A
20% reduction in business investment for 5 years would result in the capital stock being only around 2% lower
(assuming plausible assumptions for the rate of depreciation).
It is possible that this simple arithmetic underestimates the impact of the falls in investment
spending, particularly if the falls were concentrated in highly-productive forms of investment.
Perhaps because in the face of the deep recession companies were less willing to undertake
riskier, high-return investment projects, and the constraints on UK banks made them less
willing to finance them. But even so, this skewing would have to be very marked to have had
a material impact on the quality of the capital stock.11
The capital stock is also likely to have been eroded by increased levels of capital scrapping,
as some companies were forced out of business and others scaled back their operations in
order to survive. Although increased levels of capital scrapping are likely to have played
some role, they seem unlikely to provide the key to the productivity puzzle. In particular,
although corporate liquidations have increased in the recession, that increase has been
relatively contained and significantly less than we might have feared given the depth of the
recession.
Rather if the evidence from the business surveys is to be believed, and the growth of
productive potential in the manufacturing and services sector has indeed largely stalled in
recent years, this is more likely to reflect a slowing in total factor productivity (or TFP for
short).
I know what some of you might be thinking: this sounds like another one of those
unobservable, abstract concepts so beloved by economists, but with little connection to the
real world. And you would have a point! But think of it as efficiency gains. The fact that
companies, as they hone their working practices and improve their internal processes, are
able to increase the amount of output they produce for a given level of labour and capital
input.
Did the financial crisis and recession dampen the pace of efficiency gains in our economy, at
least temporarily?
Recessions are actually often credited with improving average levels of efficiency, as less
productive firms are forced out of business and others drive through productivity gains in
order to stay afloat. Only the fittest - and the most efficient - survive. But this recession
differed to those in our recent experience since it was triggered by a financial crisis. Banks'
ability to lend was reduced. Credit conditions tightened. The implications of this for the
efficiency with which companies operate are potentially far reaching.
Many smaller companies and new businesses, which are a critical source of innovation in our
economy, have struggled to secure the finance they need to grow and expand. Company
start-ups fell sharply during the recession, and evidence from the Bank's Agents suggests
that many smaller businesses are still struggling to access funds at affordable rates. In that
context, it is worth recalling that small companies, employing less than 100 employees, hold
over 40% of UK patents, even though they account for less than 20% of total investment.12
Even for those companies that are able to borrow funds, the tightening in credit conditions is
likely to have impeded the efficiency of supply. Some companies have become more
cautious, preferring to hang onto liquidity or pay down debt rather than invest in increased
levels of training and R&D. The increased cost of working capital has led many firms to cut
back substantially on their inventory levels, disrupting the efficiency of supply chains. More
generally, the amount of management time devoted to raising finance and managing banking
relationships has increased very substantially, diverting attention from the search for new
products and new markets.
It is impossible to quantify with any precision the effect that strains within the banking system
have had on the growth of productivity over the past few years. But evidence from previous
periods of financial turmoil suggests that the effect might be material. In particular, research by
the IMF suggests that persistent falls in TFP growth following banking crises can account on
average for around one third of the loss of output seen following such episodes (IMF 2009).
So where does all this leave us?
As I warned you upfront, I don't think there is a single, simple explanation for the recent
surprising weakness of productivity. Some of it may well get revised away. And some of it
may be because our sights were set too high based on past trends. But I also think there are
good reasons to think that the recession, and particularly the impact of the financial crisis,
may have dampened underlying productivity growth in recent years. At the risk of stating the
bleeding obvious, we need the banks to be working for our economy to grow and prosper.
Productivity and monetary policy
Why does all this matter for monetary policy?
The medium-term outlook for inflation depends critically on the balance of demand and
supply in the economy. If demand is greater than the goods and services that can be
supplied, prices will tend to rise. And vice versa. As such, when setting monetary policy, the
MPC needs to make an assessment about current and future trends in supply, as well as
demand.
The discussions about economic growth we typically read about in newspapers and see on
TV are normally posed in terms of demand. Is gloom on the high street spreading? Claims
and counter-claims about the likely impact of the fiscal consolidation. But the MPC also
needs to consider the prospects for supply. How quickly is the capital stock likely to grow?
And, importantly, will the recent weakness in productivity persist or reverse?
Typically, the growth rates of factors determining the supply potential of our economy
- population, the capital stock, structural productivity - are far less volatile than those of
demand. As such, it is often natural for the main focus of policy to be concentrated on the
prospects for demand. But judgements about supply also matter, particularly so in the
aftermath of a deep recession.
In recessions, demand typically falls by more than supply. An output gap opens up - the
economy can supply more than is currently demanded. And unless that gap is closed, it will
push down on costs and prices. The job of monetary policymakers is to loosen policy, so that
demand is brought back into balance with supply and inflation remains close to target.
Exactly how expansionary policy should be depends critically on the size of the output gap.
But assessing the size of the output gap is very difficult, for exactly the reasons we have
been discussing today. Early estimates of economic activity can be revised substantially, so
it is hard to know just how weak demand and output really are. And it is equally difficult to
know the extent to which the supply potential of the economy has been affected by the
recession.13 This difficultly greatly complicates the setting of monetary policy. Indeed, in a
series of influential papers, Athanasios Orphanides (eg Orphanides 2003) has argued that
over-estimates of the size of the output gap played an important role in the policy mistakes
that led to the period of persistently high inflation in the US in the 1970s and 80s.
I hope that we are learning some of the lessons from the past. Taken at face value, the depth
of the recession might suggest there is considerable spare capacity within our economy. And
indeed there is considerable slack within the labour market - unemployment has risen by
almost 900,000 since the start of the recession - and this has acted to contain wage
pressures. But the degree of slack within firms is probably significantly less than implied by
the shortfall in productivity for all the reasons I've just explained.
An assessment of the output gap requires an evaluation of the current level of supply. But
the MPC also needs to form a view about the pace at which the supply capacity of the
economy is growing. When faced with a period of weak output growth, it is tempting to
conclude the policy should be eased in order to boost the pace of growth and so stop the
output gap widening further. And that may well be the right policy prescription. But just how
much demand should be boosted depends on the extent to which the weak demand growth
is matched by sluggish growth in potential supply.
If indeed underlying productivity growth in our economy has been weak in the recent past
- perhaps due to the lingering effects of the financial crisis - this may well continue for a
while yet. To be clear, this is not the same as saying that the growth rate of the supply
potential of our economy has been permanently scarred by the financial crisis. But rather
over the next two or three years - which is the horizon which matters for monetary policy -
we shouldn't automatically assume that underlying productivity will necessary grow at the
sorts of rates to which we have become accustomed to in the past.
Policymakers need to think about supply as well as demand when responding to weak output
growth.
Recent policy developments
Let me conclude with some brief comments about the current policy outlook.
You may know that between February and August of this year, I was one of the members of
the MPC that had been voting to raise Bank Rate. As I mentioned at the time, my vote was
not based on the nice reasons that the economic recovery looked firmly entrenched and the
exceptional monetary easing implemented at the height of the crisis was no longer required.
Rather, it was driven by nasty reasons. I wasn't confident about the strength of the recovery
and I was worried about the downside risks to growth. But I was even more worried about the
outlook for inflation. In particular, the risks from continuing global price pressures, and the
risk that the prolonged period of high inflation would affect the credibility of monetary policy.
And as I've just discussed, the growing belief that the degree of spare capacity in our
economy was probably less than might appear at first sight.
But I also suggested that policymakers should approach their task with considerable
pragmatism, and that if some of the downside risks to growth materialised, I'd reverse my
vote. And that indeed is what has happened. The outlook for demand over the past few
months has weakened quite materially. Consequently, at the August MPC meeting, I
reversed my position and voted to maintain Bank Rate at 0.5% and the stock of asset
purchases at £200 billion. And as shown in the minutes published this morning, I voted the
same way at this month's MPC meeting.
So what has happened to our economy over the past few months?
The deterioration in the outlook largely reflects developments outside of our shores. Growth
in the world economy, including in our core trading partners in Europe and the US, has
slowed. Concerns about the fiscal positions of some countries, particularly within the euro
area, have intensified. This in turn has fuelled worries and uncertainties about the resilience
of the international banking system. And perhaps most fundamentally of all, confidence that
the authorities have the ability to respond to these challenges in a decisive and timely
manner has diminished. These four factors have fed on each other, leading to a pronounced
downward spiral.
The UK has been caught in the fallout from these external developments. The strong growth
in our exports seen through much of the past year has faltered, with knock on implications for
the growth of manufacturing output. Renewed turmoil within financial markets has led to a
sharp reduction in asset prices and to increased funding pressures on our banks. And
confidence, both within companies and households, has taken another downward step.
The role of monetary policy in such circumstances is to support demand, so as to help bring
inflation back to target in the medium term. And that is exactly what the MPC is doing.
Interest rates remain at exceptionally low levels. The programme of quantitative easing
undertaken last year continues to provide significant stimulus to demand. It is also
noteworthy that market interest rates two and three years ahead have declined markedly
over the past couple of months, leading a material easing in monetary conditions. If the
economic situation continues to deteriorate, some additional loosening in monetary policy
might be needed. But that decision will need to be weighed against the backdrop of
continuing high inflation, with inflation set to climb higher over the next few months. And, as
I've emphasised today, it will also need to take account of the extent to which the slowing in
output reflects weak growth in supply as well as demand.
Chart Pack
Chart 1: Chart 2:
Private sector output per head(a) Private sector output per head(a)
Change in productivity relative to level implied by trend(b)
Index:2008 Q1=100
10
Recession (from 2008Q1 to 2009Q3)
110
Recovery (from 2009Q3 to 2011Q2)
Continuation of 5
(b)
prerecession trend
0
100
-5
90
-10
80
-15
-20
70
sector
Finance
60 services
services services
Construction
Private
Other
Manufacturing
50
Business
1987 1991 1995 1999 2003 2007 2011 Consumer
Source: ONS (including the Labour Force Survey) and Source: ONS (including the Labour Force Survey) and
Bank calculations
Bank calculations.
(a) Calculated using Workforce Jobs sectoral
(a) Private sector approximated by excluding
employment and output data for public administration employment splits scaled to match total LFS
employment levels.
and defence, education and health sectors. Workforce
Jobs sectoral employment splits scaled to match total
(b) Percentage deviation from trend. Trend calculated by
LFS employment levels.
projecting forward output per job from 2008 Q2 using the
average quarterly growth rate between 1987 Q1 and
(b) Trend calculated by projecting forward output per
2008 Q1.
head from 2008 Q2 using the average quarterly growth
rate between 1987 Q1 and 2008 Q1.
Chart 3: Chart 4:
Bank estimates of the level of GDP(c) Output per head in the
UK energy extraction industry
Index: 2008 Q1=100
104
Labour productivity, index
Data Fitted trend
2008=100
180
102
160
100 140
120
98
100
96
80
60
94
Latest ONS data 40
92
20
90
0
2006 2007 2008 2009 2010 2011 1987 1991 1995 1999 2003 2007 2011
Source: ONS (including the Labour Force Survey)
Source: ONS and Bank calculations.
and Bank calculations.
(c) Chained-volume measures. The fan chart depicts an
(a) Calculated using Workforce Jobs sectoral
estimated probability distribution for GDP over the past.
employment splits scaled to match total LFS
It can be interpreted in the same way as the fan charts in
employment levels.
Section 5 of the August 2011 Inflation Report.
(b) Trends are calculated over the periods 1987 Q1
to 2005 Q4 and 2006 Q1 to 2011 Q2
Chart 5: Chart 6:
Measured productivity and an estimate Measured productivity and an estimate
of trend underlying productivity, of trend underlying productivity, based
based on the BCC survey of space on the BCC survey of space capacity
capacity within firms in within firms in manufacturing.
private services (ex. finance).
Labour productivity, output
Labour productivity, output
per head 10
per head
16
14
8
12
10
8
6
6
4
4
1989 1993 1997 2001 2005 2009
1989 1993 1997 2001 2005 2009
Productivity Trend implied by BCC survey
Productivity Trend
Source: ONS (including the Labour Force Survey),
Source: ONS (including the Labour Force Survey),
British Chambers of Commerce and Bank calculations.
British Chambers of Commerce and Bank calculations.
References
IMF World Economic Outlook, "Sustaining the Recovery", October 2009.
Krugman, P (1994), "The Age of Diminished Expectations: US Economic Policy in the
1980s", MIT Press, Cambridge.
Mason, G., and Bishop, K (2011). "The impact of recession on adult training: Evidence from
the UK in
2008-09", paper prepared for the EUROFRAME Conference on "Labour Markets
after the crisis: policy challenges for the EU economies".
The Global Competitiveness Report 2011-2012, World Economic Forum
Thomas, A (2011), "Investigating the characteristics of patents and the businesses which
hold them", Economic and Labour Market Review, Vol. 5: No. 4, 68-86.
Weale, M (2010), "After the recession: Thoughts on the growth potential of the UK". Speech
delivered at the Department for Business, Innovation and Skills Analysts' Conference,
London, available at:
http://www.bankofengland.co.uk/publications/speeches/2010/speech461.pdf