Press release

19 May 2020 London, GB

UK productivity deteriorated in first quarter as economy contracted, EY ITEM Club comments

UK productivity suffered a relapse in the first quarter of 2020 as economic activity contracted markedly more than hours worked.

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  • UK productivity suffered a relapse in the first quarter of 2020 as economic activity contracted markedly more than hours worked
  • While the coronavirus impacted productivity in the first quarter, the UK’s productivity performance has been weak for some time and has been a source of concern. In January, the Bank of England downgraded its productivity forecasts and hence its estimate of the supply side potential of the UK economy – the Bank took the view that the UK’s supply side capability is annual average GDP growth of just 1.1% over the next three years
  • Output per hour fell 1.1% quarter-on-quarter and was down 0.4% year-on-year in the first quarter. Productivity had previously shown some much-needed improvement over the second half of 2019, although output per hour worked was only flat over the year as a whole
  • A major concern is that the impact of coronavirus on the UK economy has a lasting negative impact on productivity. In particular, business investment looks certain to be pared back substantially in the near term
  • Part of the UK’s recent poor labour productivity performance has undoubtedly been that – where possible – companies preferred to take on labour rather than commit to costly investment. Heightened concerns over Brexit clearly caused companies to limit their investment with damaging implications for productivity

Howard Archer, chief economic advisor to the EY ITEM Club, comments:

UK productivity – measured in terms of output per hour worked – suffered a marked weakening in the first quarter as it fell 1.1% quarter-on-quarter, according to a preliminary estimate by the Office for National Statistics.

Output per hour worked was down 0.4% year-on-year in the first quarter. The Office for National Statistics has observed that quarterly movements in productivity measures can be erratic, so year-on-year rates gives a better indication of trend.

Output per hour worked fell 0.4% year-on-year in the first quarter of 2020 as gross value added (GVA) contracted 1.6% while hours worked declined 1.2%.

Output per hour worked had previously been flat overall in 2019 after a small gain of 0.5% in 2018. There had actually been modest improvement in productivity over the second half of 2019 after weakness over the first half of the year and the second half of 2018.

Specifically, output per hour worked had risen 0.3% quarter-on-quarter in the fourth quarter of 2019 following a gain of 0.5% quarter-on-quarter in the third quarter. There were drops of 0.1% quarter-on-quarter in the second quarter and 0.4% quarter-on-quarter in the first quarter. Year-on-year growth in output per hour was limited to just 0.3% in the fourth quarter of 2019, as it had been in the third quarter. While slight, these were the equal strongest annual gains since the second quarter of 2018. Prior to the third quarter of 2019, output per hour had fallen year-on-year for four successive quarters, including a drop of 0.5% in the second quarter of 2019 which had been the sharpest annual drop since the second quarter of 2014. Output per hour worked had previously been flat year-on-year in Q1 2019, while it fell 0.1% in Q4 2018 and 0.2% year-on-year in Q3 2018. In contrast, output per hour had been up 1.4% year-on-year in Q2 2018 and 0.8% in Q1.

UK has a lot of catching up to do on productivity

While the coronavirus impact magnified the problems in the first quarter, the UK’s productivity performance has been weak for some time and a source of concern. Indeed, the flat overall productivity performance over 2019 after an underwhelming 2018 extends the UK’s overall poor productivity record since the deep 2008/9 recession.

When releasing the fourth quarter of 2019 data the ONS observed that labour productivity has demonstrated weak growth since the 2008 economic downturn, while in the previous 10 years it was close to historical long-term average growth rates of 2.0% per year. This sustained period of minimal labour productivity growth has been labelled the UK's "productivity puzzle", and is arguably the defining economic question of our age.

In January, the Bank of England downgraded its productivity forecasts and hence its estimate of the supply side potential of the UK economy. The Bank took the view that the UK’s supply side capability is annual average GDP growth of just 1.1% over the next three years. The Bank of England cut its forecast for output per hour worked to flat in 2020 (from 0.75%). It sees it rising 0.75% in 2021 and 1.25% in 2022. Of course, this was before coronavirus hit the UK economy.

Number of factors may have held back UK productivity

The UK’s “productivity puzzle” is a source of much debate and analysis. Part of the UK’s recent poor labour productivity performance has undoubtedly been that low wage growth has increased the attractiveness of employment for companies. This helped employment to hold up well during the 2008/9 downturn and to pick up markedly as growth returned.

Employment may have been lifted in recent times by some UK companies being keen to take on workers – or at least hold on to them – given increasing concerns over labour shortages in some sectors.

It also is apparent that many companies have taken on labour rather than committing to costly investment, given the highly uncertain economic and political outlook. The low cost and flexibility of labour relative to capital has certainly supported employment over investment.

Extended uncertainties and concerns over Brexit clearly caused some companies to limit their investment which has implications for productivity. Significantly, business investment has been largely in the doldrums since the second half of 2017 and it rose just 0.6% in 2019 after contraction of 1.5% in 2018. This meant that business investment in the fourth quarter of 2019 was 1.3% below its peak level in the fourth quarter of 2017. Business investment was flat quarter-on-quarter in the first quarter of 2020.

Structural factors are limiting productivity

There are a number of structural factors that may have hurt productivity. “Significantly, a report by the NIESR and the Joseph Rowntree Foundation in 2018 concluded that productivity is particularly poor in low-paid jobs in the UK compared with other major economies, lagging up to 20-30% behind similar roles in Germany, France and the US.

Similarly, analysis in 2018 by the ONS concluded that much of the slowdown in UK productivity was due to the changing composition of the UK economy with workers moving from more (such as mining) to less efficient sectors (food & catering). The ONS observed that there had been a slowdown in productivity growth in a number of sectors.

In a speech in 2018, the Bank of England’s chief economist Andy Haldane argued that the UK’s productivity problem was influenced by an unusually wide gap between Britain's most productive firms and the much longer tail of its least productive companies.

In addition, there has been concern about the impact of so-called “zombie” companies that have been supported by very low interest rates.

Outlook

The impact of Covid-19 on the UK economy and how it may impact productivity remains a source of concern. In particular, business investment looks likely to be pared back in the near term and there is the risk that companies are then cautious about new investments for an extended period.

In its May Quarterly Monetary Policy Report, the Bank of England observed that a sharp near-term fall in business investment “will permanently reduce the capital stock and productive capacity of the economy if it is not recovered after the pandemic ends. Productive capacity could be particularly affected if investment in research and development (R&D) falls. This type of investment may be hit hard during a pandemic since firms are likely to be particularly uncertain about future demand, and that may discourage them from innovating. Studies show that lower spending on R&D can have long-lasting effects on the economy through reduced productivity growth.