Productivity and the allocation of capital following the great recession

Labour productivity fell sharply at the start of the 2008 financial crisis. Output produced per worker remains around 14 percentage points below the pre-crisis trend. The scale of the productivity fall and the continued stagnation has been the defining feature of the UK's Great Recession and is commonly termed the 'productivity puzzle'.

Headway has been made in solving the puzzle, much of it by work at the Bank of England and the Institute for Fiscal Studies. We know that the solution does not lie in the changing composition of the work force or in an industrial shift in the economy. At the start of the recession productivity was depressed as employers with sufficient resources retained skilled and experienced workers even though they were less productive at that time (this is known as 'labour hoarding'). Since then, multiple factors have likely contributed to the continued weakness, including: a fall in real wages (that may have facilitated labour hoarding and led firms to substitute labour for capital, but that may also be a result of lower productivity); a fall in investment (such that workers have less, and less good capital to work with); higher firm survival than in previous recessions. However, it has been difficult to account for the entire puzzle by appealing to these factors alone.

In this project we will explore the role of capital allocation. Previous evidence shows that the overall productivity of the economy - Total Factor Productivity (TFP) - is improved substantially when resources flow to the uses that have the highest return. We have found preliminary evidence that the link between investment and rates of return in the UK has broken down since 2008. The recession was characterised by relative demand shocks and an increasing dispersion in rates of return to capital across firms. Despite this, there has been very little adjustment in the allocation of capital; capital is not flowing to the projects with the highest returns. This is perhaps not surprising given that the key channels through which capital flows across the economy (new investment and the entry and exit of firms) have been notably weak since 2008. The UK experience stands in contrast to previous UK recessions, and to the current experience of the US.

An increase in uncertainty and financial market impairment are important candidates for why capital has not been adjusted in response to shocks. In this project we view such factors as distorting firms' choices over how much capital to invest in. Our objective is to quantify the scale of such distortions and to estimate how important they are in impeding the allocation of capital and thereby lowering aggregate TFP (and therefore labour productivity).
This project will be novel in applying previously developed methods from the academic literature to the context of an advanced economy recession; most of existing literature on resource misallocation focuses on developing countries and seeks to explain their relatively poor productivity performance. In addition, we plan to extend the existing modelling framework to explicitly account for a process of dynamic capital adjustment. That is, to account for the presence of costs that inhibit the adjustment of capital even in normal times.

Productivity growth is the source of rising living standards and economic growth. Understanding the causes of weak productivity is therefore central to identifying the policy challenges and designing the solutions. For example, the extent to which low productivity is a temporary or permanent problem is central to judging the UK's supply capacity, and whether expansionary policies are called for. This is of particular importance to monetary policy, which must consider the inflationary consequences of economic expansion. This project will bring together expertise from the Bank of England and the IFS with a view to advancing the solution to the productivity puzzle and directly informing policy makers.

Productivity growth is the key driver of living standards and economic growth. As such, understanding the drivers of productivity is of interest to a wide group. More specifically, understanding the causes of weak productivity following the recent recession (including how persistent the problem is and where distortions are arising) is central to identifying the policy challenges and designing the solutions. The results of this research will inform an area of ongoing concern, and therefore be of direct benefit to a wide range of policy makers. It will do this in a timely fashion, such that it is relevant to the current policy environment, as well as to any future crises.

Benefits to monetary policy makers

Understanding productivity has been one of the key research challenges at the Bank of England since 2008. In the broadest terms, the outlook for productivity maps directly onto the question of how much supply capacity the UK has. This in turn is crucial for deciding whether expansionary policies are called for and what the inflationary consequences would be. To the extent that there are specific financial market frictions impeding productivity growth, understanding these factors is directly relevant when considering other forms of central bank policy (such as the 'funding for lending' scheme).

The direct collaboration embedded in this project will ensure that the views of monetary policy makers feed directly into the design and development of the research. It will also provide a direct link between the output of the research and a key group of beneficiaries.

Benefits to other policy makers and experts

The research is also relevant in providing important context for fiscal policy. For example, there is currently a large debate about stagnating living standards and the appropriate policy response. Understanding weak wage growth, which is likely to be directly related to weak productivity, is central to this debate.

Despite the UK specific context of this research, it will speak more broadly to the literature on recoveries from economic crises. This will be relevant for a wide group of policy experts, including those working in other central banks and governments. We would expect the research to be of particular interest to those European countries that have also experienced weak productivity since 2008.

We expect international organisations (e.g. the IMF and OECD) to be interested in our research to the extent that it helps to understand the differing international experiences in the post crisis period. The research will also benefit the business, professional and media communities by providing them with better information, and thereby help them to engage in an evidence-based debate with policymakers on an important policy issue.

Finally, this project will have a clear impact on the PI, for whom this project will be a pathway to further developing skills in the design, conduct and management of research. Both parties in this collaboration bring different strengths to the project. This will be beneficial to the overall research outcome, but also to the researchers involved.