Productivity and Employment: A Cautionary Tale

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Frances Coppola
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To be sure, it doesn't sound nebulous. It is output per worker per hour. What is so difficult about that?

The problem is how you define "output". Usually, we take this to mean GDP (gross domestic product), though we might use GNP (gross national product) or GVA (gross value added). In this post, I shall use GDP.

As Diane Coyle has engagingly written, GDP is a deeply flawed measure. Yet we are obsessed with it. The Eurozone uses government debt-to-GDP and deficit-to-GDP ratios to justify harsh spending cuts and tax rises. In the UK, "WE MUST PAY DOWN THE DEBT!" roar the headlines, entirely missing the point that debt-to-GDP is a ratio, so even if we never borrowed another penny, it would rise if GDP fell. Even if GDP growth remained positive, but slowed down - say to 1.5% per annum instead of the predicted 2% -  debt-to-GDP would take longer to reduce for the same nominal amount of debt.

The same applies to the deficit. The deficit is the gap between taxation and spending, expressed as a percentage of GDP. If GDP falls, the deficit automatically widens. If GDP increases more slowly than forecast, the deficit takes longer to close than forecast. So the next time someone says that the fact that the deficit is taking longer to close than the Government predicted means that the Government has "eased off on austerity", tell them to go and learn some basic maths.

And the same also applies to productivity. Productivity is GDP per worker per hour. If the number of workers doesn't change, and the hours that they work don't change, then if GDP is growing, workers are producing more per hour. Their productivity is increasing.

There is thus a firm positive link between GDP growth and productivity. Ceteris paribus, rising productivity means rising GDP.

This is why the OBR's downward revision of UK productivity figures is so devastating. As a direct consequence, the forecasts for GDP over the next five years are significantly lower than before. And this means that the deficit will take longer to close than predicted, and debt-to-GDP will take longer to fall than predicted.

But why should we expect workers constantly to increase their output per hour? Surely there is an absolute limit to the amount that workers can produce per hour. What if we are simply approaching that limit? What if productivity is flat-lining because workers are at full capacity? Are we reaching the limit of GDP growth?

Well, there might be such a limit. But I don't think we are anywhere near it. You see, what enables workers to produce more is investment. And in the UK, investment - both by business and government - is very low.

Let me use an historical example to show how productivity relates to investment. Recently, I have been reading about the Irish potato famine of the mid-19th century. Ireland at the time was part of the United Kingdom and ruled directly from Westminster, so the policy responses to what was by any standards a dreadful humanitarian crisis came from the UK Government. One of the things it did was provide work for unemployed labourers. The work was utterly pointless, building "roads to nowhere" so as not to benefit any particular landowner, or digging holes in existing roads and filling them in again. But it was work, and it paid a wage which was supposed to be sufficient to provide bare subsistence for the labourer and his family.

To start with, they paid the labourers a day rate. But the labourers, worried that when the pointless road was built they would lose their jobs, stretched the work out by doing as little as possible. So the UK government, prompted by public anger in England about the "lazy Irish" (does this sound familiar, Graecophiles?), responded by changing the way it paid the labourers. Instead of paying them by the day, it paid them according to the amount of road they built - we might call this "road inches". This was a productivity incentive: the more road they built per hour, the more they would be paid. The Government's benchmark productivity level would pay workers a subsistence wage.

But there was a problem. In fact there were several problems. Firstly, the Government did not provide equipment - picks, shovels and the like. But the labourers had sold their own equipment for food, so they were forced to dig the roads with their bare hands. Secondly, the labourers lacked road-building skills, since their usual occupation was growing potatoes. And thirdly, the labourers were severely malnourished and often ill. So productivity fell far below the benchmark. The roads were built, but painfully slowly. And the labourers were paid less than half the amount they needed to live. They starved despite being in work.

Now, at this point most of you will say "That's ridiculous. Why didn't the Government provide equipment and training for its workforce? And why did it pay them so little they starved?" Of course, these were roads to nowhere, so nobody really cared whether or not they were built. The Government was simply creating work to justify paying benefits. If the workers didn't work, and therefore didn't get paid, it was their own fault. The Government's conscience was clear.

But just suppose that these were real roads that would have brought real benefit to the economy of the West of Ireland. How could they have been built faster and better?

Well, the Government could have employed more labourers. There was at the time something of a glut of half-starved Irish labourers, so employing lots more would not have been difficult. The roads would have been built more quickly - although as any manager will tell you, there comes a point at which adding additional bodies becomes counterproductive. However, employing extra workers does not raise productivity. It increases the quantity of labour, but the output of each worker per hour remains the same.

The Government could also have increased working hours. Suppose that our labourers were doing a standard 12-hour working day (this was not unusual at the time). The Government could have increased the working day to 16 hours. There's a snag, of course: in the winter, there is a shortage of light. Productivity falls catastrophically when people are working in the dark. But the roads would still have been built more quickly.

However, increasing working hours isn't increasing productivity. It's the same as adding more workers. There is more output, but the output per worker per hour remains the same (or probably worsens, especially in the winter). I've noticed that this is widely misunderstood. Working more hours is not working more productively. As we shall see, working more productively might actually mean working fewer hours.

But what if the Government decided, rather than employing more workers or increasing the length of the working day, to equip its existing workforce with state-of-the-art picks and shovels, plus light and heat so they can work better in the dark, cold winter mornings and evenings? With better equipment, workers could produce considerably more road inches per hour. This is increased productivity. It arises directly from capital investment.

So, let's suppose the Government invests in equipment. The labourers produce more road inches per hour, and their pay therefore rises. In this case, there is a firm positive link between capital investment, productivity and wage growth. However, note that when labourers are paid a day rate regardless of output, there is no such connection.

If labourers are paid more, they can buy more and better food (there was never an absolute shortage of food in Ireland during the famine, only a disastrous shortage of money among the agricultural poor, especially in the West). So their general health improves, and their output therefore increases again.

But even without the equipment, paying the labourers better would improve productivity. In fact as the workforce was half-starved to begin with, providing workers with food and basic healthcare free of charge would probably be a good strategy. Fit and strong labourers produce more road inches than weak half-starved ones, even with poor equipment. Paying people starvation wages is a false economy, unless you think working people to death because there are plenty more where they came from is a reasonable way to run a business.

Now suppose our enlightened Government decides not only to equip its Irish navvy gangs properly, and provide free food and basic healthcare, but to train them in modern (for the 19th century) road-building techniques. Remarkably, their road inches output increases considerably, because they now have both good tools and the skills to use them efficiently. Their pay rises more. They begin to look well and feel happy.

By this time the UK Government has invested rather a lot in its Irish workforce. The combined investment in fixed capital (picks and shovels, light and heat), and human capital (food, healthcare, training) has caused a massive productivity increase. Roads have never been built so fast or so well, and the now-skilled workers are earning more than ever before. Private sector employers, impressed with the new roads, start to move in to poach workers by offering even better pay and conditions. Some are British firms, since they have heard that Irish road builders are the best in the United Kingdom.

Of course, the success of the Government's road-building scheme could cause a problem in an agrarian economy. Indeed it did cause a problem, even though it was nowhere near as productive as the scheme I have described. In 1848, there was famine not because the crops failed, but because they didn't get planted in the first place. Too many people were working on the roads.

However, the fact remains that if the UK Government had abandoned its belief in the morality of work and its laissez-faire economic ideology, and invested in its Irish workforce, many thousands of deaths could have been avoided.

But employing so many people is expensive. They are highly productive, but - could there be a way of reducing the number needed for each road? After all, skilled road builders are in demand. And we still need people to till the fields, anyway.

And so the quest for productivity goes high-tech. Innovation raises productivity far beyond the capability of manual labour, even with high quality picks and shovels. Nowadays, roads are no longer dug by Irish navvy gangs. One man with a JCB can produce more road inches per hour than any number of labourers, and although his pay is higher than theirs, it won't be as much as the total cost of a navvy gang for the employer.  I wrote before about how wages historically have never kept pace with productivity. Of course they haven't. If all the benefit from productivity increases went to the workers, there would be no incentive for employers to invest in productivity-enhancing technology.

Technological advancements have the potential to create massive productivity increases. They also reduce the need for workers. Indeed, the story of the Industrial Revolution is one of declining need for workers. As technology increased worker productivity,  first children, then women (some occupations), and then the old, sick and disabled, left the workforce.

And this brings me to where we are in the UK today. We are going backwards. In the last ten years, the Government has systematically forced back into the workforce the old, the sick, the disabled, and single mothers of young children. The current government continues to insist that as many people as possible must work, and that work must pay. As I have pointed out before, the combination of "everyone must work" with "work must pay" inevitably results in increasingly harsh treatment of those who are unable to work. The imperative to accept any job, however badly paid, puts downward pressure on wages: this, in combination with the belief that those who work must be seen to be better off than those who don't, forces ever-deeper cuts to benefits for those unable to work.

The OBR notes the inverse correlation of high employment (high participation rate) with poor productivity. Indeed, this must be so. For when there is a glut of low-wage, low-skill labourers, and the economic outlook is uncertain, employers have little incentive to invest, whether in fixed assets or human capital. It is much easier to hire and fire unskilled workers at will than to mothball plant or write off investment in training. The flip side of high employment is weak business investment, and this is exactly what we see. The OBR has substantially reduced its forecast for business investment.

The Government seems intent on creating a low-skill, low-wage, high-employment economy. And if that is what we want, I suppose that is what we can have. It would be a stable equilibrium. But it would not be a prosperous advanced economy. That combination is characteristic of poor countries with large populations and wholly inadequate safety nets. Just like 19th century Ireland, in fact.

Related reading:

The Financialisation of Labour - Pieria
Bifurcation in the labour market
The Graves Are Walking - Kelly

The econ nerds among you will note that this post is really an historical deconstruction of the Cobb-Douglas production function. 

Image at the head of this post is of the "Famine roads" in Dingle. The visible vertical and horizontal lines on the hills are the scars left by the "roads to nowhere" built by forced labour in the Irish potato famine. Interestingly, there are similar roads in Scotland from the same time: "Destitution road" was built by Scottish potato famine victims.