The productivity puzzle: would better allocation of capital make a difference?

• Author: Davies, Howard

In all major economies, the so-called productivity puzzle continues to perplex economists and policymakers: output per hour is significantly lower than it would have been had the pre-2008 growth trend continued. The figures are stark, particularly so in the United Kingdom, but also across the OECD. And while it goes without saying that economists have many ingenious explanations to offer, none has yet proved persuasive enough to create a consensus.

According to the United Kingdom's Office for National Statistics, output per hour in France was 14 percent lower in 2015 than it would have been had the previously normal trend growth rate been matched. Output was 9 percent lower in the United States and 8 percent lower in Germany, which has remained the top performer among developed economies, albeit only in relative terms. If this new, lower growth rate persists, by 2021 average incomes in the United States will be 16 percent lower than they would have been had the United States maintained the roughly 2 percent annual productivity gain experienced since 1945.

The United Kingdom exhibits a particularly chronic case of the syndrome. British productivity was 9 percent below the OECD average in 2007; by 2015, the gap had widened to 18 percent. Strikingly, UK productivity per hour is fully 35 percent below the German level, and 30 percent below that of the United States. Even the French could produce the average British worker's output in a week, and still take Friday off. It would seem that, in addition to the factors affecting all developed economies, the United Kingdom has particularly weak management.

Some contributing factors are generally acknowledged. During the crisis and its immediate aftermath, when banks' efforts to rebuild capital constrained new lending, ultra-low interest rates kept some firms' heads above water, and their managers retained employees, despite making a relatively low return.

On the other hand, new, more productive, and innovative firms found it hard to raise the capital they needed to grow, so they either did not expand, or did so by substituting labor for capital. In other words, low interest rates held productivity down by allowing heavily indebted zombie companies to survive for longer than they otherwise would have done.

The Bank of England has acknowledged that trade-off, estimating that productivity would have been 1 percent to 3 percent higher in the United Kingdom had it raised interest rates to pre-crisis...