If real pay is rising again, what does that mean for growth in productivity?

Recently, these factors have faded, thereby allowing inflation to fall. But there is another macro factor of overwhelming importance which may yet hold back the growth of real pay – productivity. If there is no favourable shift in the terms of trade, (due to lower oil or other commodity prices), there is no large-scale tax cut, and there is no scope for profits to be squeezed, then the prospects for real pay to rise depend upon productivity increasing. It is as simple as that.

Over the past few years, three of the great surprises of the British economy have been the major increase in employment, the fall of real pay and the drop in productivity. These are closely related. The drop in productivity implied by the sharp rise in employment at a time of depressed demand and output has been a major force behind the fall in real pay. But it has also meant that the pain of recession has been spread more broadly across the working population rather than being narrowly concentrated on those losing their jobs while those in continued employment continue to do relatively well – as happened in the 1930s.

With the economy now well into its recovery phase, the productivity debate takes a different twist. The uncertainty is now about whether, for whatever reason, the sustainable rate of productivity growth has dropped back from 2pc to 1pc – or even zero. If that is true, then the scope for rises in real pay will be minimal.

There are a host of reasons why the sustainable rate of productivity growth may have dropped: increased regulation; poor prospects for traditionally high productivity growth sectors; weak capital investment; the damage done by the financial crash and recession; a drop in the rate of innovation and technical progress.

If, for a mixture of these reasons, there really has been a falling-off in underlying sustainable productivity growth, then governments and oppositions can witter on until the cows come home about the squeeze on living standards and the cost of living crisis, but there will be next to nothing that they can do about it.

As it happens, I am more than hopeful that the doomsters will be proved wrong. It is far from uncommon for there to be a drop in productivity after the sort of recession that we have passed through. The fall in real pay has made it cheaper for employers to take on more labour and to hoard it than was true in earlier recessions. There is certainly a problem about inadequate investment in this country, but there are some hopeful signs that investment is starting to rise. To some extent, the outcome of this issue depends upon what happens to manufacturing – and that is tied to prospects for exports.

For manufacturing is typically the sector where productivity growth is highest. The decline in the relative importance of manufacturing in this country is one of the reasons why productivity growth has been low.

Once exports pick up – which is largely dependent upon the world economy, and in particular on the eurozone – then as manufacturing rises as a share of GDP, so the rate of productivity growth should also rise.

But more important than this will be the pace of innovation and technological change. I just don’t buy the argument that it has slowed sharply. People have been repeatedly saying that for the past 200 years. I suspect that what we are about to witness is a period in which real pay rises at an increasing rate and before long it will be back to rates close to the historical norm of 2pc. That would have a major impact on the political debate.

Roger Bootle is managing director of Capital Economics

roger.bootle@capitaleconomics.com

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