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Does the productivity gap actually exist?

Does the productivity gap actually exist?

Whoever wins the election tomorrow will have to grapple with what appears to be a fundamental economic problem. Estimated productivity growth in the UK is virtually at a standstill.

The standard definition of productivity is the average output per employee across the economy as a whole, after adjusting output for inflation – or “real” output, in the jargon of economics.

The amount in 2016 was the same as it was almost a decade ago in 2007, immediately prior to the financial crisis.

Productivity is not just some abstract concept from economic theory. It has huge practical implications. Ultimately, it determines living standards.

Productivity is real output divided by employment. The Office for National Statistics (ONS) has a pretty accurate idea of how many people are employed in the economy. They get data from company tax returns to HMRC.

What about output? The ONS uses a wide range of sources to compile its estimates. But these essentially provide it with information about the total value of what the UK is producing.

The ONS has the key task of breaking this number down into increases in value which are simply due to inflation, and those which represent a rise in real output.

This problem, easy to state, is fiendishly difficult to solve in practice. To take a simple illustrative example, imagine a car firm makes exactly 10,000 vehicles of a particular kind in each of two successive years, and sells them at an identical price. It seems that real output is the same in both years.

But suppose that in the second year, the car is equipped with heated seats. The sale price has not changed. But buyers are getting a better quality model, and some would pay a bit extra for the seats. So the effective price, taking into account all the features, has fallen slightly.

Assessing the impact of quality changes is the bane of national accounts statisticians’ lives. The car example above is very simple. But how do you assess the quality change when, for example, smartphones were introduced?

The ONS and its equivalents elsewhere, such as the Bureau of Economic Analysis in America, are very much aware of this problem. But even by the early 2000s, leading econometricians such as MIT’s Jerry Hausman were arguing that the internet alone was leading inflation to be overestimated by about 1 per cent a year, and real output growth correspondingly underestimated.

Martin Feldstein is the latest top economist adding his name to this view. Feldstein is a former chairman of the President’s Council of Economic Advisers, so he is no ivory tower boffin.

In the latest Journal of Economic Perspectives, Feldstein writes:

“I have concluded that the official data understate the changes of real output and productivity. The measurement problem has become increasingly difficult with the rising share of services that has grown from about 50 per cent of private sector GDP in 1950 to about 70 per cent of private GDP now”.

The Bean report into national accounts statistics last year acknowledged these problems. It could well be that there is.

As published in City AM Wednesday 7th June 2017

Image: Smartphone by JÉSHOOTS  is licensed under CC by 2.0
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Why companies fail: Don’t look to economic textbooks to master dynamic capitalism

Why companies fail: Don’t look to economic textbooks to master dynamic capitalism

Is setting up a micro brewery a licence to print money? This month, a private equity company acquired 22 per cent of BrewDog for just over £200 million, netting a neat £100 million for the founders. Last year, the owners of Budweiser, AB InBev, bought Camden Town Brewery for a reported £85 million. This follows the sale of Meantime Brewery in 2015 to the global giant SAB Miller for an undisclosed amount.

There has been an explosion in the number of craft beer start ups. The number of micro breweries in the UK has grown from 1026 to around 1700.

But far from replicating the BrewDogs of this world, most of these will fail.

The same thing happens in every innovative market where new products are developed. Between 1900 and 1920 there were almost 2000 firms involved in automobile production in the US. Over 99 per cent of them disappeared. Before the First World War, the European film industry operated on a global scale, supplying half the American market. By 1920, European films had virtually disappeared from the US and had become marginal in Europe itself. Hollywood had taken over.

Being big offers no guarantee against failure. Only this month for example, we have seen the reputation of United Airlines seriously damaged, and Toshiba has projected that is losses this year could be as much as $9 billion. Between 2005 and 2009, MySpace was the largest social networking site in the world. NewsCorp bought it for $580 million in 2005, but sold it in 2011 for just $35 million.

These firms, including MySpace, remain in business for the moment, but many giant companies go under eventually. The failure rate of small businesses is high in the first 2 or 3 years of life, because of elementary mistakes such as, for example, not making provision to pay the tax authorities. But, after that, the probabilities of failure in any given year of small and large firms become very similar.

The basic reason is that there is an inherent level of uncertainty about the future, which no amount of cleverness can reduce. In 1914 Briansk Rail and Engineering in Russia was one of the largest industrial companies in the world. But it disappeared in 1917 after the seizure of power by the then tiny Bolshevik Party. This itself became the giant Communist Party of the Soviet Union until it, too, eventually collapsed.

In the economics textbooks, running a business is easy. One of the basic things which students learn is how to maximise the profits of a firm. Even the more advanced material is set in an essentially static world.

The distinguishing features of capitalism are innovation and evolution, but economics has very little to say about these. Things do not just stand still. Last year, for example, Ford had a global income of $151 billion and Tesla had $7 billion. Yet this month, Tesla’s market capitalisation has overtaken Ford’s.

By all means take early retirement to brew the beer you have always wanted. But don’t expect to get rich.

As published in City AM Wednesday 20th April 2017

Image: Micro Brewery by Bernt Rostad is licensed under CC by 2.0
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