What is productivity?

 

 

Productivity is turning out to be the buzzword of the year, with unprecedented focus by economists on the UK’s mysterious-sounding ‘productivity puzzle’.

 

In last week’s Budget 2016 speech Chancellor George Osborne referred to productivity 11 times - he even devoted an entire section of his speech to it.

 

We are told that the UK suffers from chronically low levels of productivity, and last week the Chancellor cited yet another fall in productivity as the reason why the Government’s economic expectations have fallen.

 

 

But what does economic productivity actually mean, and how do economists claim to be able to measure it so precisely?

 

The forecasts that underpin the Government’s budgeting are created by the independent Office for Budget Responsibility (OBR), which published its latest outlook report alongside last week’s Budget speech. It made for grim reading.

 

“A promising pick-up in productivity through most of last year was almost entirely reversed in the fourth quarter, while growth in average earnings has slowed again,” it said.

 

What the OBR is referring to are estimates of ‘real non-oil gross value added divided by total weekly hours worked’. In other words, this means how much money was made per hour worked by employees, outside of the oil sector and adjusted for inflation.

 

In a nutshell, then, it means how much money employees make for their business every hour they work.

 

So does productivity fall because people are being lazy? That could be a factor, but productivity actually measures something greater and more complex. It is a way of telling whether a country’s businesses are geared at delivering high earnings from the resources they have. A company with just 10 employees that makes £1m a year is far more productive than one with 100 employees that makes the same amount.

 

 

It might feel like an abstract notion, but in fact productivity is fundamental to the standard of living experienced in a country.

 

If an economy is productive, it is capable of raising salaries faster than other nations. It is the difference between businesses - big and small - flourishing and floundering. A productive economy is one that offers opportunities for employment, better products for consumers, and better competition on the international stage. A productive economy delivers better tax returns to the Government, allowing it to invest in projects that improve people’s day-to-day lives.

 

Most of all, an economy with high potential productivity growth is one that will be better for our children than it is for us.

 

Paul Krugman, author of The Age of Diminishing Expectations in 1994, wrote: “Productivity isn’t everything, but in the long run it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.”

 

 

In April 2015 the Office for National Statistics reported that UK productivity had been at its weakest levels since the Second World War. This is partly because the UK suffered more than many economies in the financial crisis of 2008.

 

According to estimates to the end of 2014, the UK lags all other nations in the G7 group of major advanced economies except Japan. If the gross domestic product per hour worked in the UK is set at an index level of 100, productivity in Germany would be 136. In France it would be 131 and in the US it would be 130.

 

To put that another way, if the average German decided to only work 4 days a week rather than 5, the German economy would still deliver greater output than the UK’s.

 

 

There are many factors that can affect how much money is being made per employee hour, but there is a crucial element that can govern productivity in the long-term - investment.

 

At a very simple level, imagine a company has decided it has the budget to hire one more person. But it has a decision - should it hire another salesperson to try to sell more products, or should it hire a researcher to think about creating better products it could sell in the future.

 

On the face of it, the salesperson will be far more productive, notching up sale after sale, hour after hour. The researcher, on the other hand, may not look like a productive hire at all - they aren’t generating any gross value added. But what if after a few months of work that researcher has a brainwave - an exciting new product that could take the UK market by storm. Suddenly, sales across the company could triple, and the whole company becomes far more profitable as a result.

 

This simple example belies a conundrum that may concern all businesses at various points in their development. Should we put capital to use delivering short-term sales benefits, but risk finding ourselves on uncertain ground in a few years’ time, or should we ignore the pressure to deliver quick results and invest in projects that could make the company a leader in its field in three, five or even ten years’ time.

 

Economists are divided on the underlying causes for the UK’s low productivity, but short-termism has been mooted as a cause.

Allocating some of your hard-won capital into investments in projects that might not deliver for months – or years – can be a bold decision. But if you are under pressure from management, a Board or shareholders hell-bent on seeing an improvement in performance every quarter, when you publish results, investing in future projects can feel downright impossible.

 

 

The Chancellor’s references to productivity in the Budget are part of a massive agenda towards solving the UK’s productivity ‘puzzle’ outlined as the Conservatives took power last year.

 

Recognising that agenda, the investment industry has been doing some head-scratching of its own on the role it can play. In a project organised by the Investment Association, some of the industry’s brightest minds have come together to consider the issue and the results of that work will be announced at its launch tomorrow. The Government referred to the project in its Budget document.

 

The fact is, we believe that if the industry adopts an organised approach to these issues there’s a huge role our industry, with its £5.5 trillion of investments in companies in the UK and globally, can play in solving the puzzle.

 

The details will be published tomorrow, but we are preparing to outline bold proposals that could fundamentally change the nature of business management in the UK.

 

One of the main purposes of investment in any economy is to allocate capital ‘efficiently’. If money was simply circulated between companies without consideration of their future performance, it would be left languishing in areas that are not likely to perform in future. Investment managers allocate money to companies with good future prospects, and that makes for a more efficient economy.

 

Our project is going to consider numerous ways in which companies can be encouraged to help us to invest based on their future productivity, not short-term results, and in doing that the British economy will become more efficient and more productive.

 

We can’t promise to solve the British productivity puzzle completely, but we can promise to do everything to encourage our own industry and others to play their part.

 

The message from us is clear, British businesses need to adopt a different mind-set to deliver increased productivity. A long-term change in lifestyle, not a sudden shot of espresso, is needed to make the UK economy more productive

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