03 August 2022

The causes of the collapse of productivity in the UK Economy after the Financial Crisis

 

 

In an earlier blog I showed that after the financial crisis of 2007-08 real wages fell, while the amount of output produced by each hour worked in the economy rose at a far lower pace than earlier. Figure 1 below reproduces the data from that earlier blog.

 

Figure 1  The collapse of productivity growth in the UK economy post the financial crisis

Source ONS data: GDP per hour is obtained from the volume measure of GDP divided by the measure for total weekly hours worked annualised. Real hourly earnings are from data for average weekly earnings divided by weekly hours worked and deflated by the consumer price index.

 In this figure labour productivity is measured as the amount of GDP (that is the output of the economy) produced per hour worked. In the chart I show the periods of recession where GDP per capita fell. These recessions started in 1974, 1980, 1990 and 2007. In 2008, when real hourly earnings were at their pre-Covid peak of £18 per hour (this is in 2019 prices) real GDP per hour was £39.2. By 2019, the year before the pandemic, real hour earnings had fallen by 7 per cent to £16.8 while GDP per hour had risen 3 per cent to £40.5 – all in 2019 prices. What happened after the financial crisis was quite different from what followed earlier recessions where there appears to be no change in the steady grow of GDP per hour.

 

In this blog I want to answer the question as to why that output per hour worked grew so much slower than before the financial crisis. Why was this crisis so very different from earlier recessions?

 

Teresa May, during the 2017 general election campaign, said there was ‘no magic money tree’ when asked by a nurse why her pay had been frozen.  Well, was that true? A ‘magic money tree’ is an informal way of describing what has been happening to now rich countries for the last 200 years in that the amount of output each produces grows faster than does the labour to produce that output. Her more accurate answer, as the above figure shows, should have been that under previous governments there had been a ‘magic money tree’ but that the conservative dominated governments after 2010 had succeeded in killing it off.  This blog is about the mechanisms by which death was affected.

 

If you work hard and do your job, what if each year you produced more with no additional effort on your part. It sounds a bit unlikely but that is exactly what the UK economy did up to the financial crash. Economists call it total factor productivity (TFP). It is, quite literally, a measure of how much more output you get without more inputs into production (or at least any that are measurable).

 In Figure 2 I show how much this magical effect raised output in the UK from 1970 to 2021. Between 1970 and 2007, the advent of the Financial Crisis, TFP increased by some 60 per cent. Then, as the Figure shows, it fell abruptly and by the start of Covid it had barely recovered to its level at the start of the Financial Crisis.

Figure 2 More output but not more inputs

Source ONS data: Release of Productivity Overview, UK: October to December 2021. The figure for TFP in the chart is for the Total Market Sector.

 Now, of course, there are other ways, not magical at all, as to how you can become more productive. You may have more capital to work with or your travel time to work may be reduced. All these are additional inputs increasing output. One way of summarising how these additional inputs may help increase your productivity, that is how much you can produce, is by the capital labour ratio. That is how much capital is available to each worker. How this has changed since 1970 is shown in Figure 3.

 

Figure 3 How much more capital did workers have?

Figure 4 Changes in capital and labour inputs

Source ONS data: Release of Productivity Overview, UK: October to December 2021. Capital services and  labour hours are for the Total Market Sector.   

While we can see from Figure 3 that the amount of capital each worker has to work with fell soon after the Financial Crisis, we need to know how this changed occurred and that we show in Figure 4.

Two changes occurred after the financial crisis which were quite different from earlier recessions. The first was that capital services grew much more slowly than before. The second was that, in dramatic contrast to earlier recessions, labour supply started to grow. The result was the decline in the capital to labour ratio.

 

We can now answer the question we posed in the title to this blog as to why labour productivity growth collapsed after the Financial Crisis. Labour productivity growth depends on two factors. The first is TFP (Total Factor Productivity) which is the magical factor producing more output with no more inputs. While this fell marked immediately following the crisis it then started to rise again. The second factor is the capital to labour ratio which we showed in Figure 3 fell significantly after the financial crisis. It is this fall which is the most important factor explaining the failure of labour productivity to rise by more than very modest amounts.  

 

Labour productivity is not the focus of political debate. Indeed, outside the columns of relatively specialised newspapers it is not mentioned at all. That is regrettable as it is the collapse of that growth in labour productivity that underlies all the UK’s present economic woes. It explains the low wages many workers face, it explains the inability of the government to fund adequately the NHS and social care, it explains why at the end of a decade of ‘austerity’ there was still no budget surplus and the advent of the pandemic ensured that to address it the result has been a public sector deficit far larger than when ‘austerity’ began. It drives real earnings. It is how all of the painful political choices can be avoided. As real incomes rise taxes will rise even if tax rates do not change, there will be more income for workers and more funds for public services.

 

Put simply more people in the UK have been working so output has been rising but the amount of output each produce has not been increasing – the end of the magic money tree. This shows up in Figure 5 below where, following the financial crisis, after a short term fall, output continued to grow while output per person did not. As Figure 5 also shows this had not happened after any earlier recessions.

 

Figure 5 How output grew and productivity did not after the financial Crisis

Sources: As for Figure 1.

While the above analysis shows how the decline in productivity has been affected, the results clearly poses two more fundamental questions. Why did labour supply start rising and investment start falling after the recession caused by the Financial Crisis, while neither had happened in earlier recessions? To that I will return in a future post.

 

 

 

 

 

 

 

 

 

 

 

 

 

 


 

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