It's productivity, stupid

Without a plan to boost productivity, whoever leads our country after the election will be doomed to fail.

by Erik Britton
Last Updated: 28 Jul 2015

The General Election is in the offing and the outcome is, you could say, uncertain. David Cameron wants to reduce government debt. Ed Miliband wants to improve the living standards of hard-working families. Nick Clegg wants to safeguard the NHS.

None of them will get his way unless he can solve the biggest economic problem facing this country - productivity. It determines our standard of living, and yet nobody has a plan for tackling it.

Without higher productivity, those other political ambitions have no prospect of being realised. But the UK's productivity performance is dire. There is no peacetime precedent for the falls we have seen since the recession.

It is easy to boost growth in the short term. The government can spend more or cut taxes; the central bank can loosen monetary policy. When demand is weak, such measures can be helpful. It is much harder for governments to influence long-term growth. That is determined by productivity.

Governments can boost productivity by getting out of the way of private industry, by supporting activities that generate big positive benefits to the whole economy - ideally without creating too many distortionary incentives - and by encouraging 'creative destruction', the reallocation of unproductive capital and labour. The US does better than the UK on all three, but it is the last that really matters.

Creative destruction is like decluttering your home. The book that has sat on a shelf untroubled for 20 years, the unread newspapers, the old clothes. Once in a while, you need to throw those things away to make room - room to think, and for new things that you might actually use.

But there's a bit of the hoarder in all of us. We watch them on those TV shows and see how it ends: you can't move in your own house. You've nowhere to sleep, nowhere to cook - no room to live, let alone to grow.

So we know rationally that this must be done, but these are the hard yards of economic policy and can conflict with goals such as fairness, insulation from global markets and job security.

In the decade before the recession, banks across the developed world - enthusiastically encouraged by policy makers - amplified the flows of cheap credit from China and Germany and channelled them into the ultimate unproductive asset: real estate. This was a colossal error.

A real-estate bubble ensued, with household debt and house prices rocketing compared with income, and credit-fuelled consumer spending flattering our growth figures. Then of course the bubble burst.

What happened next is crucial - a case study in the efficacy of creative destruction.

Policy responses in the US and the UK were similar in many ways. Interest rates plummeted. Government deficits soared. Currencies depreciated. Money was printed under QE. And taxpayer capital was injected into the banks. But that is where the similarities end.

The US went on to improve the supply-side of its economy - the hard yards of creative destruction. The UK did not.

Five hundred US banks failed but not one in the UK. US banks foreclosed on non- performing loans. In the UK, forbearance was the order of the day. US unemployment rose sharply as it normally would in such a recession. Unemployment rose in the UK, too, but by far less than expected. US house prices and household debt fell back to sustainable levels. In the UK they remain at least 30% too high.

Finally, the US removed bad assets from its banks via the Troubled Asset Relief Program (Tarp). The UK did not. Consequently, UK banks are solvent only for as long as house prices remain overvalued. UK banks, homeowners, the government and growing swathes of the corporate sector are 'zombies', hooked on zero interest rates.

US banks are functioning properly again, lending to corporates and households. UK bank lending to the corporate sector has fallen consistently since the recession. The US can start to tighten monetary policy without inflicting too much damage; the UK cannot.

The US is poised for growth; the UK is already running out of steam.

The US used the recession to force important markets to clear. The instincts of our policy makers were the opposite - to protect jobs, to protect homeowners, to protect firms with weak cash flow. We can all understand why. The trouble is, the long-run cost of that protection is enormous, as Japanese policy makers have been discovering these past 20 years and more. They needed radical restructuring then, as we do now. They never found the political will to do it and have paid the price with two lost decades. So far, we appear to be retracing their steps.

Our policy makers are like the TV hoarders. US policy makers threw open the windows and ordered a skip. They were right and we were wrong. The next government needs to learn this lesson, or forget about its other ambitions.

Erik Britton is a director of Fathom Consulting,

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