There have been many
ideas put forward to explain the low growth in UK productivity, but
among mainstream accounts the impact of austerity is not usually high
up on the list of possibilities. I have talked before about what I
call an ‘innovations gap’, and how the UK is currently suffering
a particularly large innovations gap. The idea of an innovations gap
can link inadequate demand, like austerity, to low productivity
growth.
Let me use a very
simple example to explain how an innovations gap can arise after a
deep recession followed by austerity. Assume that improvements in
technology and production techniques are constantly taking place, or
being learnt from other firms/countries, but they need new investment
to put them in place. This is what economists call embodied
technical progress.
Imagine a firm where
demand is not increasing. Will that firm invest to become more
productive? Only if the additional profits it can make as a result of
investing (suitably discounted) is greater than the cost of the
investment. For this firm we therefore need quite a big innovation
gap before it is worth its while to undertake investment and before
its productivity increases.
Now imagine that
demand increases. The firm now has to undertake some additional
investment to increase its output. It makes sense to invest in
techniques that embody the latest technology. The increase in demand
leads to both higher investment (what economists call the
‘accelerator’) and higher productivity.
In a normal recovery
from a recession, demand recovers rapidly (growth easily exceeds past
trends), leading firms to invest in the latest technology. Any
innovations gap that might have opened up in the recession is quickly
closed. In contrast, a very slow recovery caused by austerity will
reduce the need for investment, allowing a large innovations gap to
open up.
This idea fits in
with some recent work
which suggests that productivity growth in ‘frontier’ firms
(firms that already have relatively high productivity) has not
slowed, and a gap has opened up between these frontier firms and
laggards. (See also here.)
This would make sense if the frontier firms are growing (because they
are the most productive) but the laggard firms are not. Growing firms
need to invest to expand, but stagnant firms are not expanding.
The same model could
also suggest how wage led productivity growth could occur (see Ben
Chu here
for example). As most innovations are likely to be labour saving,
then higher wages can increase the profits that come from any
particular investment, without necessarily increasing the cost of
that investment. So an increase in wages caused by an increase in the
minimum wage, for example, could increase investment and therefore
increase productivity. The other side of that coin is that the period of stagnant wage growth we have had since the recession
provided no incentive for firms to invest in higher productivity
techniques.
I doubt that this
story explains more than a part of the UK’s productivity gap. In
the UK investment in plant and machinery fell
sharply in the recession, and has not yet recovered to pre-recession
levels, but its decline is unlikely to be enough to explain a
productivity standstill. (For an account of some other key factors that could explain the UK productivity puzzle,
see here.)
But if it explains even a little, it makes austerity a lot more
costly.
One way of
describing what I’m saying is that austerity influences supply as
well as demand. You could say austerity ignores the accelerator as
well as the multiplier, which is cute but does not capture the idea
of embodied technical progress which is crucial to this argument. It
is why it is always best to run a high pressure economy (see Martin
Sandbu here
who links to an interview
between Jared Bernstein and Josh Bivens).
As I explain here,
I do not use austerity as just another name for any fiscal
consolidation, or fiscal consolidation involving cuts to spending.
Fiscal consolidation need not reduce output for the aggregate economy
if monetary policy is able to offset its impact. But if interest
rates are at their lower bound, as they are once again in the UK [1],
fiscal consolidation will reduce output and lead to another needless waste of resources. Since Brexit we have a second period of
UK austerity. In assessing how costly this will be, we need to look not just at whether it creates a negative output gap, but also how it creates an innovations gap that reduces productivity.
[1] We know this,
because the Bank is increasing the amount of QE.
