Last week I attended a workshop entitled "Enhancing the Bank of England Toolkit," hosted by the Progressive Economy Forum. Presented at the workshop, and underpinning most of the debate, was this report from GFC Economics and Clearpoint Advisers, which was written for the Labour Party and first issued last June. The report was widely criticised at the time, as one of its authors ruefully observed in the introduction to the presentation. Nonetheless, the authors presented it unamended.The report recommends setting a productivity target for the Bank of England in addition to its existing inflation target: An additional target will be introduced: productivity growth of 3% per annum. The Bank of England will be required to explain how its policies are impacting upon productivity and,
Frances Coppola considers the following as important: Bank of England, Capital, investment, labour, manufacturing, production, productivity, services
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Last week I attended a workshop entitled "Enhancing the Bank of England Toolkit," hosted by the Progressive Economy Forum. Presented at the workshop, and underpinning most of the debate, was this report from GFC Economics and Clearpoint Advisers, which was written for the Labour Party and first issued last June. The report was widely criticised at the time, as one of its authors ruefully observed in the introduction to the presentation. Nonetheless, the authors presented it unamended.
The report recommends setting a productivity target for the Bank of England in addition to its existing inflation target:
An additional target will be introduced: productivity growth of 3% per annum. The Bank of England will be required to explain how its policies are impacting upon productivity and, therefore, the potential growth path of the economy.This target is extremely challenging. A footnote in the report notes that labour productivity growth since 1950 has averaged 2.4%, and describes the proposed uplift of 0.6% above this average as a "small increase." Forgive me, but an increase of 25% in the rate of change is not by any stretch of the imagination "small." It's an absolutely whopping hike, particularly when you take into account the fact that in the 1950s and 60s, the labour force was much smaller due to lower immigration and female participation, and the UK was rebuilding after WWII. In a mature economy which is 80% services and which has nearly full employment of both men and women, that 3% target looks well-nigh impossible.
That said, the report doesn't actually define what it means by "productivity," which makes it somewhat difficult to determine whether the target is at all realistic. So here's the OECD's definition:
Productivity is commonly defined as a ratio between the output volume and the volume of inputs. In other words, it measures how efficiently production inputs, such as labour and capital, are being used in an economy to produce a given level of output.Simples. Or maybe not:
There are different measures of productivity and the choice between them depends either on the purpose of the productivity measurement and/or data availability.The OECD goes on to explain the difference between labour productivity, capital productivity and multi-factor productivity (often misleadingly called "total factor productivity," TFP):
One of the most widely used measures of productivity is Gross Domestic Product (GDP) per hour worked. This measure captures the use of labour inputs better than just output per employee....
To take account of the role of capital inputs, an appropriate measure is the flow of productive services that can be drawn from the cumulative stock of past investments (such as machinery and equipment). These services are estimated by the OECD using the rate of change of the ‘productive capital stock’, which takes into account wear and tear, retirements and other sources of reduction in the productive capacity of fixed capital assets. The price of capital services per asset is measured as their rental price....
After computing the contributions of labour and capital to output, the so-called multi-factor productivity (MFP) can be derived. It measures the residual growth that cannot be explained by the rate of change in the services of labour, capital and intermediate outputs, and is often interpreted as the contribution to economic growth made by factors such as technical and organisational innovation.So we have three potential productivity targets: labour productivity, capital productivity, and TFP. Which of these would the Bank of England be expected to target?
If it targeted labour productivity, there would be implications for environmental sustainability. In the absence of measures to improve efficiency of resource usage, raising GDP or GVA increases the rate at which finite resources are used. It is hard to see how this is remotely compatible with achieving carbon neutrality or sustainable use of resources.
The strong investment focus of this report might make it attractive to target the marginal productivity of capital: after all, if you are going to engineer a massive increase in capital investment, you will want to know how effective it is. The fact that the rate of return on capital has been falling for the best part of forty years could suggest that capital is not being deployed efficiently. If the measures outlined in this report significantly increased the marginal productivity of capital, the rate of return on capital should rise, no doubt accompanied by loud cheers from pension funds. But the Bank of England's responsibility is the risk-free rate: the return on risky assets is determined by the market. It is not clear to me why the Bank, or any other public body for that matter, should be targeting a 3% per annum rise in the marginal return on capital.
Total factor productivity is another potential target. But targeting it would be extremely problematic. In the Cobb-Douglas production function, you calculate the combined output of labour and capital, then multiply it by the number needed to make it agree with your GDP figure. That number is "total factor productivity" (TFP). It is a residual, or perhaps more accurately a fudge. It is usually explained as the unknown effect of technological change and other efficiency gains, but the truth is it arises to a considerable extent from measurement problems. And it suffers from the usual problem with targeting a residual, namely too many moving parts. Targeting TFP is as impractical as targeting the velocity of money.
So it is not clear what the Bank of England would be targeting. And it is also not clear how it would meet that target. The report says it would be given new credit guidance tools to enable it to direct bank lending into high value-added sectors. But the Bank would not be allowed to decide which sectors those should be:
...the Strategic Investment Board, an analytical and strategic ‘hub’, must be instrumental in outlining the sectors that should be targeted. It will be in a better position to understand the risk-reward profiles of companies. This would also ensure that any future purchases of corporate bonds by the Bank of England are consistent with the strategic investment required.The Bank would be tasked with directing credit to industrial sectors determined by the Government, and would be held accountable for ensuring that the sectors selected by the Government delivered the desired productivity improvement. I'm really not sure how this is compatible with the report's recommendation that the Bank should continue to have operational independence. The "new tools" would come with very tight strings attached.
The idea that a productivity target can be met entirely through credit guidance assumes that there is a simple linear relationship between the amount of bank credit provided to "productive sectors" and productivity in the economy as a whole. I don't think such a relationship exists. The last decade has shown conclusively that throwing money at businesses doesn't necessarily make them borrow. Yes, many SMEs face high nominal interest rates on borrowing. But SME lending is risky, and managing it is expensive. Lending against fixed assets, especially property, is considerably safer and doesn't have the management overhead, so it is hardly surprising that banks prefer it. It's really not good enough to beat up banks who don't lend enough to SMEs (or rather, to the "right" SMEs). If the Government wants interest rates on loans to its preferred SMEs to reduce significantly, it will have to provide guarantees.
But anyway, what does "productive sectors" mean? I found the chapter on "industrial strategy" deeply disturbing. For me, it was far too narrowly focused on science and technology, and on manufacturing.There was barely a mention of service industries in the entire report, except for financial services which the authors want cut back hard. At one point Nesta's report on the importance of creative arts was cited, but there was no recognition of the need to invest in creativity. Even more seriously, there was no mention of the the desperate need to ramp up and professionalise the care sector in the light of the approaching demographic timebomb.
Arguably we already have a dual labour market, but the high-low wage split is finance/not-finance. I don't really see how replacing one group of highly paid, mostly male workers with another, while doing nothing to raise the wages of women & less skilled men, is progress. Where jobs are concerned, services are the future for most people. The challenge is how to raise productivity and wages in service industries.
Productivity is notoriously difficult to raise in service industries. William Baumol's "cost disease" theory arose from his study of the economics of the performing arts: he observed that although a violinist in 1965 earned a lot more than a violinist in 1865, he didn't produce any more music. And in many service industries, raising productivity has unfortunate welfare consequences. Amazon's "human robots", for example. Or cleaners paid less than the minimum wage because they can't meet productivity targets. Or 15-minute care slots for frail elderly. Is this really what we want?
Realistically, productivity in service industries is not going to rise by anything like 3%, not least because the quality cuts needed to achieve it would be political dynamite. So to have any chance of achieving that demanding 3% target, either there must be a considerable shift away from services or a much smaller workforce. A large increase in capital investment could deliver a sizeable expansion of manufacturing, but there wouldn't necessarily be an associated increase in well-paid jobs. It is all too likely that the capital investment would go into robots and automation.
Furthermore, there would be a considerable temptation for the Strategic Investment Board - stuffed as it would be with people from the STEM sectors - to define "productive industries" so narrowly that funding for important service industries such as the creative arts would be squeezed to death. This is utter folly. Creative people may not be hugely productive in themselves, but without them, manufacturing dies.
The pace of technological change suggest that governments should be aiming for a higher rate of increase in productivity than recent historic averages....The current rapid advances in the global semiconductor industry hold the key to faster productivity growth...Semiconductors alone are to deliver a 3% increase in productivity, apparently. That is one heck of an enormous responsibility for the semiconductor industry.
I suspect this narrow focus on high value-added manufacturing is partly driven by the Left's resurgent obsession with the trade balance, as if the UK were still on a gold standard. Indeed, the report makes some reference to "ending persistent current account deficits." Seriously, guys - a current account deficit is not a big deal for a reserve currency issuer with a floating exchange rate and a centuries-long record of meeting its obligations, and it's mostly outside our control anyway. We really don't need to return to the mercantilism of the past. Let's focus on things that make a real difference to the lives of people in the U.K., such as having a properly funded care system. And let's also focus on the vibrant creative industries in which the U.K. leads the world.
And finally - a warning. The Bank of England's primary job is to manage aggregate demand, and it should have freedom to use whatever tools it sees fit to do that job. It does not, and should not have, any responsibility to deliver, or help to deliver, political promises. But the recommendations in this report would force the Bank to be instrumental in delivering a Labour Government's industrial strategy as outlined in its manifesto. This would amount to politicisation of the central bank. I think it would be a terrible error.
Image from Hyacinth at Wikipedia.