At the time of writing, the Bank of England had recently released its quarterly Inflation Report along with the decision and minutes of the month’s MPC meeting. The report clearly forecasts a tendency for CPI inflation to increase in the next four years, assuming nominal base interest rates and asset purchases remain constant, however this increase is likely to be very well controlled to avoid exceeding the 2% target. Aggregate demand in the economy is growing steadily at rates similar to those from before the recession of 2008-9, rising by 0.7% in Q2 2015, up from 0.5% in Q1 2015. Consumption remains the largest component of aggregate demand, and supported by increases in nominal income through both increased employment and wages, very high consumer confidence, and real incomes being boosted by falling prices in many costs of living such as fuel, food and selected imports, this is expected to continue, although is likely to depend on the variation of retail interest rates offered by commercial banks.
The newly-installed Conservative government has been reacting to this news in the best way it can- promoting its own (now-clichéd) phrase- the long-term economic plan, and how it is working to improve the economy for the people of the UK. Their definition of economic improvement is certainly up for question, but is surely a topic for another essay. The first Budget of the new government laid out the first year’s fiscal intentions- the most headline-grabbing being the introduction of a living wage, but with other significant policies such as a reduction in the rate of corporation tax to 17% in 2017 and 18% in 2020, £3,000 removed from the National Insurance contributions made by employers, and increasing the personal income tax-free allowance to £11,000 and the higher rate tax threshold to £43,000 all make this budget key for attempting to improve the economic outlook (in terms of GDP at least) of the UK as a whole.
Outside of the UK, one of the fastest growing economies, China, looks set for a slowdown across labour (possibly as a result of the children of the One-Child Policy now reaching working age, leading to a decline in those of working age in the economy), capital (China has seen its debt climbing to 250% of GDP[i] through the most recent financial crisis- allowing it to keep growing but leaving it with huge future burdens) and productivity (largely fuelled by labour falls and rapid wage rises in line with the cost of living[ii]); initial signs of these fears were confirmed in the stock markets on `Black Monday’- Monday 24th August 2015, when the Hang Seng fell by 5.17%, and the Shanghai Composite Index fell by 8.52%- its worst single-day fall in eight years. The most reasonable cause is appropriated to the government’s recent decision to devalue the Yuan in an attempt to boost economic confidence in the markets (through making exports cheaper), although the government’s abilities in pretence were weakened by poor results from industrial growth, which sent other markets relying on Chinese industry spiralling in addition to the country’s own. The foreign markets recovered, but China’s are still suffering. Economic confidence in the country is weakened, but for productivity to improve there need to be significant structural changes such as automation and greater research and development, reducing the dependency on a decreasing labour force and repetitive investment on credit.
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London (September 24th, 2013) (used with license)
There is also the possibility that increased pay will increase the chance a worker will work longer hours to maximise income, although the motivation is also to maximise future leisure time (e.g. for a pension or large saving target). Increased hours may lead to inefficiency and a fall in productivity, while a worker wanting to maintain a steady income will work at the same level or possibly harder in the shorter period of time, maintaining or increasing productivity. Research and development is also key to German productivity, with 17% [v]more workers in this sector than the UK, often spurred on by a more friendly relationship with the EU and tax relief encouraging investment.
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(December 24th, 2013) (used with license)
The UK’s productivity problem is generally assumed to have arisen as a result of the recessions between 2007 and 2010. Figure 2a clearly shows that productivity has, on average, remained one or two index points below 2008 levels since 2008, whereas the trend line assumed that productivity would continue rising. This change fits the trends for GDP and employment in Figure 2b until mid-2011, when there was a significant decline in productivity by 2 index points on average. While the economy recovered from the worst financial crisis in recent times, productivity did not.
The cause of Britain’s troubles has been up for debate by economists and politicians alike for over 5 years, and still no-one seems able to draw a solid conclusion. Some argue businesses found it hard to make workers redundant following declines in demand, effectively becoming overstaffed for the output they were producing. When demand increased, the workers continued to produce as if they were overstaffed- at a lower output than possible- reducing productive efficiency. Alternatively, theories have centred on the idea of family-run firms hiring on relationship and not productivity or efficiency, the use of cheap and inefficient labour, or the financial crisis reducing access to loans for businesses, reducing investment and reducing the long-run ability of the economy to expand.
I therefore propose three categories of problems and possible solutions to the productivity puzzle. The first of these categories relates to government policy decisions, such as those outlined in the most recent budget, the most groundbreaking of these being the introduction of the National Living Wage, which could be both a help and hindrance to UK productivity. As already suggested, increased pay may lead workers to work longer hours, which should increase the output, and thus GDP of the UK economy. However, there are a number of points to consider, not least the fact that productivity may fall as a result of this change. John Hicks put this argument most succinctly, reasoning that if longer hours were worked, employees lose energy and produce less output.[vi] The health of workers is likely to suffer, increasing the strain on the NHS and government spending, as well as leading to the deterioration of the workers’ skills over time, exacerbating the decline in productivity.
It is good then, that this is not how this was presented by the Chancellor. The almost-jovial tone with which he announced this policy- `Britain deserves a pay rise[vii]`-gave the impression to Britain’s media and citizens that they were working hard and deserved a reward. This gives credit to the latter of the earlier theories- that an increase in pay would allow workers to work for fewer hours while maintaining the same income. This is one of the simplest and easiest ways to try to raise productivity- reducing the hours worked, which in the reverse of the argument above should have a smaller effect on output, so output per hour increases. However, does Britain really deserve this pay rise? If we treat the entire economy as a single firm, is giving all of the lowest-paid employees a pay rise more effective than performance-based pay? The problem is that the UK economy is so diverse that it is not possible to treat the entire economy as a single firm- performance means so many different things to different firms, that attempting to force a method of pay on firms would be a political disaster. The minimum and living wages aren’t necessarily meant to provide motivation or encourage rest- they are there to sustain a reasonable quality of life and avoid employee exploitation, but political spin can have unintended consequences.
The government could therefore need some policies that are intended to influence productivity. A possible new fiscal policy could be an adaptation of another of the Chancellor’s clichéd phrases- the `Northern Powerhouse`. The intention of this government is to create a belt of cities in the north of England that when combined can rival the economic juggernaut of London. It plans on achieving this in several ways- the promotion of Manchester as the `capital of the north` by developing industrial parks such as MediaCityUK, as well as beginning to devolve powers northward- starting with Greater Manchester’s control of its own NHS services. This is likely to be helped by electrification of Trans-Pennine rail routes in an attempt to cut journey times and make the belt more attractive to firms, as well as attempting to reduce road congestion and air pollution, making the region more pleasant, dispelling the image of the old industrial, coal-mined north.
The MediaCityUK site. Courtesy of the University of Salford
(image used under Creative Commons license)
Some regions (particularly in Tyne and Wear[viii]) argue that the benefits will be so skewed that Manchester will simply mirror London and the inequality surrounding it on a smaller scale. I tend to agree with this sentiment, in that it cannot be possible to link several far-flung cities with an improved rail line (currently Liverpool to Newcastle can be achieved in 2 and ¾ hours, falling to just under 2 hours in aspiration), build some new, equally spread infrastructure for each city and expect economic performance on par with the second most competitive global city in the world[ix]. If the goal really is to compete with London, then the expectation must be that funding will be skewed towards the new `capital`- however misguided the intention. Productivity should improve for those in the north as the improvements in infrastructure should improve logistics and increase the provision of services for firms, increasing output, as well as the increase in labour mobility allowing more suitable and more productive workers to be selected from across the region. However, this still leaves a large proportion of the UK (and all home nations apart from England) without an economic hub. In order to boost productivity, the UK needs more individual economic hubs- self-functioning centres of commerce, research and development that do not depend significantly on outside infrastructure.
Cambridge Science Park. Courtesy of cmglee
(image used under Creative Commons license)
It is also possible that the productivity gap could be solved by fixing the structural problems in the economy. The most commonly referenced problem in Britain is the lack of labour mobility- most often geographical, as many parts of the labour force are unwilling to leave their home regions to find work, resulting in either under-qualified workers being unable to produce the optimum level of output for the role they hold, or underemployed workers producing the optimum level of output for the role, but who would be able to produce more output in a different role. This is a very simplified form of the problem Britain and the world faces, in that the whole world really is going to university, and in developed countries this has led to a sense of entitlement, where an excess supply of graduates and lack of supply of graduate-level jobs results in disequilibrium. The resource of graduate labour is not allocated efficiently- so labour productivity is, in theory, lower than its potential.
In the UK labour market as a whole, the excess graduates attempt to find work at lower-qualified levels, although the search theory of unemployment tends to suggest that it may take some time for a graduate’s expectations to fall in line with a job vacancy. An increasing proportion of graduates are now choosing to take part-time work or enrol in further study. While both the graduate[xi] and general [xii]employment rates have increased from March 2014 to March 2015, the impact of migration on the UK labour market should be taken into account. From 1993 to 2013, the share of foreign-born workers in the UK increased from 7.2% to 15.3%.[xiii] While this includes those who were born overseas then migrated to the UK as children, the average age of UK immigrants was just above 26 in 2014[xiv]. Some may be asylum seekers or refugees- the Home Office received 25,020 applications in the year ending March 2015[xv]- a mere 3% [xvi]of UK immigrants. This suggests that the vast majority of UK immigrants are economic- and therefore increase the size of the labour force.
The proportion of foreign-born workers is increasing most significantly in low-skilled jobs- the largest being in process operatives (e.g. logistics and food production), increasing from 8.5% in 2002 to 29.3% in 2013[xvii]. These low-skilled roles (such as those in manufacturing of clothing or domestic service) are typically low-paid roles in the secondary or tertiary sectors, requiring few qualifications and more experience-based recruitment, however basic. These roles are attractive to migrants, offering a stable rate of pay greater than the average wage in several origin countries, and enabling the migrant to gain transferable skills and send remittances if necessary. These roles are less attractive to graduates as the graduates believe that their qualifications warrant a higher-skilled or higher-paid job, so the graduates remain unemployed- and less productive. As the migrants become more skilled, they become able to take higher-skilled jobs- potentially preventing graduates from taking graduate-level roles. This isn’t necessarily a bad thing, apart from the fact that a graduate’s qualification may now lead to lower output for the economy- but reducing job prospects for graduates could just be a potential solution. The key is making sure potential productivity is always achieved at every level of skill or pay- as well as allowing workers to appreciate or depreciate as they become more or less productive.
This solution is very radical, in that I suggest the education and employment systems are combined. The situation detailed above suggests that high-skilled workers might not become employed in a job which harnesses their potential level of output- affecting productivity. The converse can also be true- similar to the situation in family businesses depicted earlier where staff may be chosen for their relationship to the firm rather than how suitable and qualified they are for the role and the firm is less productive as a result. A lower-skilled worker could rise through a firm to a job that requires more skills then they have- so output and potential productivity in that role is lost.
The education and employment systems are entirely separate: you learn for qualifications, and apply for jobs which may or may not use them. If the education system offered a view to employment, either through strengthening the currently weak careers advice in state-funded schools, or by ensuring young people stayed in education, employment or training for as long as possible (an ideology already put in place by this government). This is a good solution for building skills with a view to employment, but what would be better is if more firms took an active role in education- not so much as operating schools, although the actions of MEI in offering their own A level maths qualification[xviii] are a strong step in the right direction. The government could offer incentives to local firms in exchange for offering career-based courses in schools alongside typical qualifications, with the intention that pupils who do well could move directly from education into employment as the most suitable and productive candidates, reducing recruitment costs for firms and government spending on social security, as well as maximising productivity for local business and ensuring that labour mobility has less of an influence. However, more-able pupils should always be encouraged to continue to university or into apprenticeships for more technical roles.
Perhaps the most cost-effective for a deficit-reducing government, changes could be made to working life and the workplace itself in order to improve productivity. This is the realm of nudge behaviour- adjusting small conditions in order to have a more significant effect. Strategies such as loss-aversion could motivate employees to work harder, as was proved in a Chicago research paper in July 2012[xix]. The researchers used teachers to measure the effect, since the output could be clearly measured through the test scores of the students. Two sets of teachers had the same standard pay, and one set was given the traditional end-of-year bonus based on student performance, but the other was given the bonus at the start of the year and asked to pay back as much as required at the end of the year. If two teachers had classes performing equally, the bonus would be equal. The teachers who had been given the bonus early saw increases in the test scores by `an equivalent of increasing teacher quality by one standard deviation`. The other set had statistically insignificant results. The output of the loss-aversion set had increased, and the hours they spent working outside of teaching were lower than the other group. This suggests loss-aversion is a very credible method of motivation.
Loss aversion may work well for medium-to-high-skilled jobs such as teaching, where the wage level is able to facilitate a bonus and performance-related pay scheme, but in lower-skilled roles where the National Minimum Wage is paid, an employer would have to allow an effective pay rise in order to introduce a bonus system. On top of the new National Living Wage being phased in over the next couple of years, this would cause significant upward inflationary pressure, and although many employers may set the wages of employees in the current NMW-to- future-NLW bracket to only increase to the NLW, thus giving a smaller pay increase (and more demotivation) than those who were on the NMW, the number of workers who could use this system will fall significantly.
Alternative nudge ideas could also be considered. The Behavioural Insights Team, a part-public-owned social purpose company, experiments with behavioural economics in public policy. A recent experiment was commissioned by the Department for Work and Pensions to attempt to get more people back into work through Jobcentre Plus in trials in Essex[xx][xxi]. Making claimants make commitments to future goals as part of a daily, not weekly, routine in an encouragement-based system worked better than the previous control-and-restrict methods- the off-flow rate from benefits to employment was 4% higher if claimants were encouraged, and on an even more positive note the wellbeing of staff also improved. Other experiments include the use of repeated SMS prompts to remind claimants of an appointment or job fair they were booked on to or might be interested in- attendance increased by over 4%, while including personal information or a good luck message increased attendance even more. All these measures should have the effect of increasing employment, if roles are available.
Courtesy of J J Ellison
(image used under Creative Commons license)
With each of these possible solutions, both those existing and proposed, there will be impacts beyond productivity, and beyond the UK’s economy. I shall evaluate these policies on three key criteria- the international impact, equity, and the effects on inflation. Introducing the NLW should increase the average wage in the UK, which may well increase immigration as working in the UK becomes more attractive compared to other developed countries. However, the costs of production for firms are likely to increase significantly- increasing the cost of exports and likely decreasing the balance of trade. Developing more regional hubs should have an influence on foreign direct investment- but innovation must be already present to encourage research and development to improve productivity, and not simply production or manufacturing. Combining education and employment will have less of an international impact, although over time it should make UK labour more attractive to the global labour market, which could cause the wages for some roles to rise in other countries to attract British workers (this is, however, a very long-term view). Introducing loss-aversion pay or nudging JSA claimants back into work should have no external impact.
Introducing the NLW is equitable only if the pay of workers above the NMW increases in line with it, which employers have a choice to do- but with this cost of production rising significantly, some smaller firms are unlikely to want to do this, under a pay increase which may already have threatened their viability. Developing more regional hubs will only ever deliver benefits to that region and the surrounding area; although as these spread the improvements in infrastructure should spread across the country as the hubs become the economic focus points of their regions. Combining education and employment by using local firms will restrict the career-based courses on offer; however this could be justified by initiating the scheme in areas of low labour mobility such as the north-east of England or Northern Ireland. If loss-aversion pay is introduced in some jobs, even though the rewards should be the same for the same levels of output, there may be a psychological impact on workers who feel under pressure to perform or pay the money back- some workers may even keep the bonus for themselves and leave the job- increasing the risk of extra costs for these firms. Apart from the unemployed applying from Jobcentre Plus now being more likely to be employed by attending more, this nudge incentive should be fairly equitable.
Inflation remains the key topic of this essay, since in the coming months both the Bank of England and Federal Reserve are expected to make decisions to raise base rates after long periods of low rates with no change. Introducing the NLW, while mainly a boost to living standards, is likely to have a significant impact on inflation in an attempt to restore steady 2% inflation to the UK economy, after cutting rates to 0.5% for several years has only resulted in low (and at one point, negative) inflation. Firms are likely to increase their prices as a result of the increasing cost of labour, although will be aided by falling rates of corporation tax and reduced NI contributions for small businesses. The development of regional hubs will be a boost to aggregate demand- creating demand-pull inflation, but the hubs are likely to offer reduced costs for businesses in order to make the hubs attractive, so cost-push inflation could fall. Combining education and employment will provide a small boost to demand-pull inflation with the increase in government spending, although the counterargument is that the scheme will reduce government social security costs, offsetting the cost of implementing this scheme. Increased employment as a result of nudge behaviours should increase consumption and demand-pull inflation, while adjusting pay schedules is unlikely to create any inflationary pressure.
The most important policy indicator for the Chancellor currently appears to be the government budget deficit- several years of austerity are promised to result in the UK holding a budget surplus by 2020; however this is only given a 55% chance of happening by the Office for Budget Responsibility[xxii]. Introducing the NLW may have an impact on productivity, but it is unintentional and could even decrease productivity if workers become inefficient. Creating regional hubs is an effective supply-side solution to a long-term problem, encouraging productivity-enriching research and development that could give Britain’s economy a more innovative image and make it even more attractive to international firms- however the time periods for these to spread across the country are likely to be long, so some regions may see little benefit for years or even decades. Combining education and employment will have several positive local impacts, but for the economy as a whole this is a very small solution to a macroeconomic problem. The nudge incentives, while a very cost-effective solution to motivational problems in individual firms, are simply not applicable enough to the whole economy, and on their own are unlikely to have significant enough an effect.
In my opinion, the policy which will have the most positive effect on productivity and output in the UK economy is the development of regional hubs as opposed to two competing economic centres of London and the `Northern Powerhouse`. Creating a network of self-sufficient settlements capable of facilitating innovation will attract firms to the UK and increase the concentration of innovative firms in these areas, potentially allowing firms to work together more easily and increasing their output even more. The potential for the multiplier effect in these areas should develop settlements with high living standards which can improve the health of their inhabitants (and decrease NHS pressure). Attaching the first experiment to a government project already agreed to reduces the risk should the project fail- however given the high quality international infrastructure links at Ebbsfleet this is unlikely to happen.
|Courtesy of Katie Chan |
(image used under Creative Commons licence)
[i] The Economist explains: Why China’s economy is slowing (March 11th, 2015) (http://www.economist.com/blogs/economist-explains/2015/03/economist-explains-8)
[ii] WSJ Blogs: China’s Productivity Problem drags on growth (September 1st, 2014) (http://blogs.wsj.com/economics/2014/09/01/chinas-productivity-problem-drags-on-growth/)
[iii] The Guardian: Productivity growth is weakest since WWII, says ONS (April 1st, 2015) (http://www.theguardian.com/business/2015/apr/01/uk-productivity-growth-is-weakest-since-wwii-says-ons)
[iv] The Economist: Get a life (September 4th, 2013) (http://www.economist.com/blogs/freeexchange/2013/09/working-hours)
[v] Business Weekly: Germany calling the shots in productivity terms (June 23rd, 2015) (http://www.businessweekly.co.uk/blog/cambridge-today-blog/germany-calling-shots-productivity-terms)
[vi] The Economist: Proof you should get a life (December 9th, 2014) (http://www.economist.com/blogs/freeexchange/2014/12/working-hours)
[vii] The Telegraph: Budget 2015- Osborne gives Britain a pay rise (July 8th, 2015) (http://www.telegraph.co.uk/finance/budget/11726159/Budget-2015-George-Osborne-gives-Britain-a-pay-rise.html)
[viii] Financial Times: Manchester `heart of` Northern powerhouse claim irks north-east (last accessed September 2nd, 2015) (http://www.ft.com/cms/s/0/52d121f2-2fc5-11e5-8873-775ba7c2ea3d.html)
[ix] The Economist Intelligence Unit: Hot spots (last accessed September 2nd, 2015) (http://www.economistinsights.com/sites/default/files/downloads/Hot%20Spots.pdf)
[x] The Economist: Getting to Cambridge (22nd August 2015) (http://www.economist.com/news/britain/21661670-political-philosophy-britains-most-successful-city-getting-cambridge)
[xi] GOV.UK Graduate Labour Market Statistics (last accessed September 2nd 2015) (https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/432873/BIS-15-304_graduate_labour_market_statistics-January_to_March_2015.pdf)
[xii] ONS Labour Market Statistical Bulletin (last accessed September 2nd, 2015) (http://www.ons.gov.uk/ons/dcp171778_412021.pdf)
[xiii] BRIEFING: Migrants in the UK Labour Market: An Overview (last accessed September 2nd, 2015) (http://www.migrationobservatory.ox.ac.uk/sites/files/migobs/Briefing%20-%20Migrants%20in%20the%20UK%20Labour%20Market_0.pdf)
[xiv] Royal Economic Society: The Fiscal Effects of Immigration (last accessed September 2nd, 2015) (http://www.cream-migration.org/files/FiscalEJ.pdf)
[xv] The Independent: The difference between asylum seekers, refugees and economic migrants (August 18th, 2015) (http://www.independent.co.uk/news/world/europe/the-difference-between-asylum-seekers-refugees-and-economic-migrants-10460431.html)
[xvi] Calculated from ONS Migration Statistics Quarterly Report (last accessed September 2nd, 2015) (http://www.ons.gov.uk/ons/rel/migration1/migration-statistics-quarterly-report/august-2015/stb-msqr-august-2015.html)
[xvii] BRIEFING: Migrants in the UK Labour Market: An Overview (last accessed September 2nd, 2015) (http://www.migrationobservatory.ox.ac.uk/sites/files/migobs/Briefing%20-%20Migrants%20in%20the%20UK%20Labour%20Market_0.pdf)
[xviii] MEI Syllabus (last accessed September 2nd, 2015) (http://www.mei.org.uk/syllabus)
[xx] University of Stirling Behavioural Science Centre Nudge Database (last accessed September 2nd, 2015) (https://www.stir.ac.uk/media/schools/management/documents/economics/Nudge%20Database%201.2.pdf)
[xxi] Behavioural Insights Team Update Report (last accessed September 2nd, 2015) (http://38r8om2xjhhl25mw24492dir.wpengine.netdna-cdn.com/wp-content/uploads/2015/08/BIT_Update-Report-Final-2013-2015.pdf)
[xxii] Office for Budget Responsibility: Economic and fiscal outlook, July 2015 (last accessed September 2nd, 2015) (http://cdn.budgetresponsibility.independent.gov.uk/July-2015-EFO-234224.pdf)
EU: European Union
GDP: Gross Domestic Product
HS1: High Speed One, rail line from London St Pancras to the Channel Tunnel
HS2: High Speed Two, proposed rail line from London to destinations in the north
JSA: Jobseeker’s Allowance
MEI: Mathematics in Education and Industry
NHS: National Health Service
NI: National Insurance
NLW: National Living Wage
NMW: National Minimum Wage
OECD: Organisation for Economic Co-operation and Development
SMS: Short messaging service
1. While productivity in its simplest definition is the output generated measured in terms of the input used, several references in this essay refer to labour productivity (output per hour worked per unit of labour) or productivity of another factor such as capital or land.
2. This essay was written with the aim of being economics-oriented; however I think over time some areas strayed more into general interest politics and/or economic journalism, with more focus on case studies and evaluation than quantitative analysis.
3. Final word count: 4727 words
· I wanted to include more in terms of quantitative data like in the opening paragraphs from the ONS, but any data I found was not relevant enough to my arguments
· There may be some ambiguity/ `waffling` in several places, which I tried to avoid but in several places couldn’t
· If I wrote this essay again, I would make a greater emphasis on the international aspect of productivity throughout the essay, not just an opening comparison.