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Something odd has been happening in the UK economy. Normally, when output contracts as much as it did in the 2008-09 recession – and for that matter recovers as weakly as it has done since – you’d expect unemployment to rise and employment to fall sharply. Well, the unemployment rate is certainly higher and employment lower than when the crisis started. But the point is they are not that much above/below their starting points given that GDP is lower now relative to its peak than it was in the 1930s Great Depression.

Another way of putting this is that output produced per person or per hour worked has collapsed – the so called ‘productivity puzzle’. In some countries, such as Germany, unemployment has fallen even further – back below its pre-crisis level, in fact. In the US the opposite has happened – unemployment has stayed high despite a semi-decent recovery in output, prompting the Fed into action again last month in the form of QE3.

While UK productivity doesn’t look so odd compared to average international experience, it does look strange when compared to previous UK recessions. Why are firms holding on to employees – some are even hiring more – when output is so weak?

There are plenty of possible explanations. One relates to labour hoarding – training staff is costly and firms may be reluctant to let go of employees if they think recovery is around the corner. But this suggests there’s lots of spare capacity in the economy, a notion that some business surveys refute. Moreover, it’s getting more and more difficult as time goes by to argue firms are simply playing the waiting game – after all, it’s nearly five years since the recession began in early 2008.

So, I think the most powerful explanation for weak productivity relates to corporate bankruptcies. There have been vastly fewer in this recession than that of the 1990s despite output falling more sharply. And fewer bankruptcies mean less job shedding. This could be because banks are showing more forbearance to borrowers – easing the terms and conditions on existing loans to avoid having to accept the inevitable losses that increased insolvencies would cause.

This presents us with good news and bad. The good news is it keeps firms afloat during difficult times and people in jobs. The bad news is that bank funds which have continued to prop up otherwise insolvent firms could possibly have been put to better use by being lent to fresher, more dynamic and stronger growing companies. By creating zombie companies bank forbearance could be pulling down on underlying productivity even further.

If we’re right, and underlying productivity has been hit, this has important implications for everything from the budget deficit to inflation and monetary policy. Lower underlying productivity suggests supply in the economy, as well as demand, is growing at a slower pace which in turn implies less spare capacity. But it also means higher government deficits and debt as receipts growth is permanently depressed. Inflation might also be stickier than otherwise, limiting how much room the Bank of England has to deliver further support through asset purchases or lower interest rates. Finally, in order to continue to meet its inflation target the BoE will probably have to accept slower economic growth than in the past.

What does this mean for government policy? While I believe it is important to stick to ‘Plan A’ – i.e. cutting the structural deficit – it is also helpful to think about ways to support investment. After all, the collapse in UK investment has been the worst in the G7 – implying that a depreciating capital stock will make it difficult for workers to produce the same as they did before the crisis, thereby exacerbating weak productivity.

With limited available funds the government has few options – divert public money towards government investment projects, or encourage private firms to invest their large cash balances. The latter might be achievable by designing better tax incentives. But with the real enemy of investment being fear, the most effective way to support spending in the economy will be an improvement in the situation in Europe.

George Buckley is Chief UK Economist at Deutsche Bank. He writes in a personal capacity.

Follow George on Twitter: @georgebuckley

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