Understanding Output - An economist's perspective

by Professor Jagjit Chadha

Posted: 26 Nov 2018

"[T]echnology remains the dominant engine of growth...

if we suppose that all...countries had access to roughly the same pool of technological innovations, then it appears that the ones that invested fastest were best able to take advantage of the available knowledge...

it could be the case that some countries are better able to exploit the common pool of technological progress than others, for reasons that have nothing to do with the rate of capital formation; but in exactly those technologically progressive countries investment is most profitable, so naturally the rate of investment is higher. Or else rapid technical progress and high investment could both be the result of some third factor, like the presence of conditions that encourage entrepreneurial activity. High investment and fast technical progress will then go together."

R. M. Solow, "Growth Theory and After", Nobel Prize Lecture, 1987.

Introduction[1]

Economic growth matters. The material improvement in living standards as measured by the increase in the production of goods and services has been an artefact of the modern world. Britain has been characterised as the first industrial nation and accordingly with a sustained period of economic growth, it reached a peak in 1900 of 9.4% of world output. This fraction has declined with the increasing growth of emerging parts of the world but also because Britain's relative performance has tended to deteriorate. At present the UK is at some 2.8% of world GDP and seems likely to fall to 1% or less over the next 20 to 30 years. That observation does not necessarily imply that living standards, as measured broadly by per capita income, will fall but more that many other nations may see their living standards rise materially faster. This process has been emphasised by the phenomenon that has come to be known as the productivity puzzle: that growth in measured productivity has fallen far behind previous trends and this has opened up a large gap between anticipated and actual income per head.

We might characterise 'normal times' as involving the steady expansion of the economy's supply capacity with small jolts or shocks to demand, from changes in confidence, sentiment or from overseas markets, that lead to small fluctuations around that expansion path: these small fluctuation are called business cycles. The growth in capacity can most easily be thought about as the sum of the growth in inputs, typically capital and labour, and how they combine to produce a given level of output, total factor productivity: a set of words that act to describe technological progress. The growth in total factor productivity is thus simply the growth rate in the index of outputs to the index of inputs in production. Providing short run fluctuations in demand, which take the economy temporarily away from this level of supply capacity, do ebb away then we can concentrate on accounting for economic growth in terms of these factors alone.

The problem following the financial crisis of 2007-8 is not so much that we cannot account for growth in output in this manner, as we are well past the tenth anniversary, but more that the growth in output seems concentrated in the increase of inputs rather than productivity. It is as though the economy rather than working smarter has simply been working harder. If we normalise output, jobs and hours worked to 100 for 2008Q1. And we can see that after the recession, which reached a trough in 2009, each of output, jobs and hours were some 7-8% above their previous 2008 peak by the end of 2016. The productivity question arises because each of output per job and output per hour were by the end of the 2016 broadly speaking exactly where they were in 2008. The productivity of labour employed as measured by quantity (what economists call the extensive margin) or by hours (the intensive margin).

Long run trends in output

If we examine the long run patterns of growth that puts recent patterns into context. Over the very long run since around 1760 growth has averaged at slightly under 2%. We can account for growth by two inputs, labour and capital, and a single measure of overall (total factor) productivity. The idea is that firms in the economy combine inputs in a mix between labour and capital and create a given level of output using available level of technological progress. Over the long run, increasing labour inputs have contributed just under 20% of the overall increase in output, capital 37% and productivity 44%. If we examine the mid-twentieth century onwards, the average growth rate creeps up to around 2.5% but the overall contribution of labour inputs falls to well under 5% with capital explaining around 40% and overall productivity just under 60%.

Indeed, this picture becomes clearer if we account for the overall growth in income per worker, which is a measure of labour productivity. And we can see to what extent it is explained by the increased deployment of capital, which is called capital deepening, or the growth in overall productivity. Over the long run, we note labour productivity, in terms of a simple production funding, seems to be explained by around 40:60 in favour of the growth in overall productivity.[2] In attempting to understand the recent productivity puzzle we shall need to understand both the lack of capital formation and the cessation in overall productivity growth.

If we examine both the year to variance in measures of total factor productivity, labour productivity and real wages that suggests short run demand conditions may play an important role in understanding year to year fluctuations. But the long run trends indicate deterioration in measures of productivity in the UK. Total factor productivity has crept down in three steps from the immediate postwar period to be hovering just above zero at present. Labour productivity follows a similar path and together these suggest a narrowing of the ratio between outputs and inputs. Real wages growth ought to follow labour productivity relatively closely but labour market institutions and the tightness or otherwise in the labour market may lead to some temporary deviations. And so we observe growth rates in real wages of around 4% from approximately 1960 to the late 1980s. But as with the fall in labour productivity growth, average real wage growth has started to fall this century. Indeed we can observe that real average weekly earnings at the end of 2017 were some 5-7% below their pre-crisis peak in February 2008.

We can now turn to the capital stock and capital formation. We can note a similar secular decline in the growth of investment, which appears to be below the rate of depreciation in the capital stock, which has been estimated to be around 8%. Aggregate investment equations have not performed well recently and have over-predicted investment growth, this is particularly the case given lower real rates that arguably ought to have stimulated investment. Accordingly the real capital stock has not increased since the start of the recovery. And according to European Commission estimates the capital stock to output ratio has also suffered a secular decline. If we used the ONS estimates of the capital stock to output ratio there is not such a decline decade by decade but a similar pattern since the 1970s of a decline in the capital-output ratio.

High Employment and Low Productivity

In many larger advanced economies, labour productivity growth slowed sharply and remained subdued for years after the financial crisis of 2007/08. Arguably nowhere was this more obvious than in the UK. Understanding the sources of weak productivity growth is crucial for formulating appropriate policy responses. As already explored, over the long run the UK has suffered from low levels of investment and relatively low increases in total factor productivity. The large recession following the financial crisis has highlighted this problem. And although much of UK employment experience after financial crisis can be understood in terms of labour market flexibility, it has at the same time exacerbated the problems of low investment and productivity. The labour market reforms in the last three decades of the twentieth century created the conditions for a flexible response to the recession. These reforms shifted incentives to employers with reductions in tax and made unemployment (and non-participation) support less generous. There was also an increase in the institutional flexibility of the labour market with some reform of trade union powers and employment protection legislation. Trade union power also diminished because of the decline in both traditional manufacturing industry and of large public sector monopolies.

In effect, we have stumbled on a low wage-low productivity-high employment outcome (equilibrium). This outcome limited the impact on unemployment from the Great Recession and may have played a role in reducing the extent to which households increase their savings ratios. The maintenance of relatively high levels of employment may have helped limit the impact on house prices from the recession and thus limited spill-overs to a vulnerable financial sector. The problem is that this outcome is one that implies low productivity growth.



[1] This notes draws heavily on the work of Nick Oulton (2016) and I am grateful to him for advice. It is a short form of a lecture given at Gresham Lecture on 21st September 2017 and the whole lecture can be seen at https://www.gresham.ac.uk/lectures-and-events/the-productivity-puzzle#hbceZuQRUPuhLDtj.99

[2] In a standard neo-classical model, sustained growth in output cannot be explained by one-off increases in the capital stock because these lead only to temporary increases in growth but clearly persistent increases in capital may achieve something similar to growth in overall productivity.

 

 

About this author

Jagjit Chadha is the Director of the National Institute of Economic and Social Research (NIESR).

Disclaimer

The opinions expressed in this article are those of the author, and do not necessarily represent the views of St Paul's Institute or St Paul's Cathedral.