THE BLOG

Dear Business Secretary: There Is No Productivity Growth Left

14/05/2015 17:39 BST | Updated 14/05/2016 10:59 BST

While the Chancellor is going to be tied up for at least the next six months conducting a spending review and beginning a renegotiation with the EU Commission, the task of ensuring the economy continues to expand will largely fall to the new business secretary. That, rather than changing the law on strike ballots, will be the biggest issue in Sajid Javid's inbox.

There is no note left by his predecessor, nor is there a manual at BIS to guide him. The current economic recovery has been unusual in at least two respects. First, it has been weak by historical standards. Real GDP at the end of 2014 was only 4% higher than in the final quarter of 2007. Second, it has relied wholly on increases in employment. Productivity fell in the recession, recovered a little in the first years of recovery but has fallen back again over the last three years.

This pattern of recovery cannot be sustained for much longer. The employment rate is at a record level and, while there are benefits to be gained from pushing it even higher (both for the economy in aggregate and specifically for those people brought into work), further substantial increases will be hard to achieve. Unemployment is already down to 5.7% and it has rarely been below 5% since the early 1970s. Moving the employment rate higher will increasingly require getting people who are not active in the labour market into work. This will be tough.

If growth is to be sustained, there needs to be a revival of productivity growth. Unfortunately, economists do not know why productivity has stopped increasing. Indeed, they are so confused that they have dubbed recent developments the 'productivity puzzle'. Most, though, accept that the weakness of productivity is probably due to a combination of cyclical, demand-driven factors and structural, supply-side problems.

The best way the government can alleviate cyclical pressures on productivity is to ensure that it does not take demand out of the economy too quickly. The path for the deficit set out in the March 2015 budget envisages a big increase in the pace of public spending cuts in 2016/17 and 2017/18. With interest rates already at rock-bottom levels, there would be nothing the Monetary Policy Committee could do to offset the effect of these cuts on the economy, so this would be likely to lead to a sharp slowing in real GDP growth (as occurred in 2011 and 2012).

Action is also needed on the supply-side of the economy. The financial crisis has exacerbated existing structural weaknesses in the UK economy and created some new ones.

The best thing you can do to help deliver a pick-up in productivity growth is to put in place an active industrial strategy to tackle these structural problems. At the centre of this strategy should be measures to improve the UK's historically poor record of spending on innovation and investment. Among other things, this will require better access to finance for firms. More also needs to be done to improve vocational education and training - including the retraining of older workers - so that firms can find workers with skills they need. The government also has an important role to play in upgrading the nation's infrastructure.

An additional reason for taking these steps is that a revival in productivity growth is necessary for any improvement in living standards. Developments in real wages are closely linked to what happens to productivity. Productivity growth is therefore likely to be crucial for perceptions of the success (or failure) of the government's economic policies.