Published on 14 August 2023
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Productivity puzzles and monetary policy mysteries

What will it take to turn the UK into a productive and innovative economy? Craig Berry argues that policy needs to focus on demand as well as supply, and that the bluntness of monetary policy as a tool for this demand management is increasingly clear.

Productivity has (rightly) been a fixation of UK economic policymakers for years, but the results have been, at best, underwhelming. Productivity levels have remained largely stagnant since around 2008. This outcome is a marked change from the 50 years before, when productivity grew slowly but steadily at an average rate of around 2% per year. UK governments since the mid-2000s have produced few policies which respond to disappointing productivity with the seriousness required. Other things being equal, without productivity growth, living standards usually cannot rise.

Economic policymakers have relied principally upon (extraordinary) monetary policy — i.e., very low interest rates and quantitative easing — to restore economic growth. This approach has been focused, ostensibly, on both demand and supply. On the one hand, monetary policy has sought to compensate for the impact of fiscal contraction — deemed necessary to protect the public finances — on demand. It was also designed to encourage more private investment through access to cheaper credit.

The wrong kind of investment

The relationship between monetary policy and productivity is the focus of my research (conducted with John Evemy and Ed Yates, and funded by the ESRC’s Productivity Insights Network), looking at the relationship between interest rates and firm investment behaviour. We asked how firms’ financing strategies shape investment behaviour in a very low interest rate environment.

We sampled FTSE 250 firms across the food production and construction sectors to study whether and how credit conditions in 2012 –2016 encouraged firms to invest in either ‘enhanced’ or ‘expanded’ production (ending in 2016 because of the more volatile investment conditions since the Brexit vote). The former is defined as the adoption or development of new technologies, and improving processes of production, while the latter is defined as applying existing techniques at a larger scale, via a larger workforce or new sites.

An enhanced production investment strategy will increase the firm’s productive capacity and therefore, other things being equal, contribute to increasing productivity at the aggregate level. But an expanded production investment strategy is less likely to boost productivity as firms will use cheap funds — in a lightly regulated labour market — to grow without having to become more efficient.

We found that monetary policy has ‘very little direct effect’ on firm-level investment at all. In fact, operational cash flow (rather than borrowing) served as the main source of investment funding. Generally speaking, it is investment strategies which drive firm financing models, rather than vice versa.

Low interest rates did nevertheless facilitate certain forms of financing. The use of external funds is more strongly associated with ‘expanded’ production investment strategies rather than productivity-enhancing ones.

In our sample of firms, both expansion- and enhancement-focused firms engaged in the longer-term refinancing of existing debt. However, expansion-focused firms were more likely to use low borrowing costs to, for example, acquire other firms and new production facilities. Accordingly, low interest rates directly facilitated scaling-up, often lower-margin, investments and acquisitions, but did not encourage productivity-enhancing investment.

Business as usual is not working

We also conducted interviews with firm executives to help us understand why external finance is associated with expanded rather than enhanced investment strategies. Productivity-enhancing investments are generally seen as ‘business as usual’, factored routinely into operations. This is because it is funded by internal cash flow: as one director explained: “It’s regarded by the markets as disorderly to raise external capital for business as usual.”

Another told us:

“I think as business leaders we’re very reluctant to go and spend money on R&D or new technology or improving facilities unless we’ve got the capital structure to do it, within the firm, rather than going out and borrowing money to do it that you then think is going to increase productivity.”

On the other hand, it is seen as justifiable to use external finance to fund expansion, which is a less regular move, but with more predictable outcomes.

The implication is that, other things being equal, the minority of firms which are already performing well are more likely to be able to invest in enhancing productivity because they have the internal cash. The ‘business as usual’ approach has become unusual in the UK, and cheap credit has helped to entrench business activity which is less likely to improve productivity. So, in so far as low interest rates are, to some extent, facilitating investment, they tend to facilitate the ‘wrong’ type.

A downward demand-supply spiral

In theory, inflation of the kind the UK is experiencing now also helps to incentivise investment; real interest rates are lower than nominal rates (or even negative), so loans are easier to repay in real terms. Inflation is not good for demand, though, unless incomes keep up with inflation. There are no ‘ideal’ solutions here, but increasing taxes on the wealthiest to help to mitigate inflation, while supporting the purchasing power of those more likely to spend in the real economy – the lowest income groups –  is the least-worst way of supporting demand (as well as being the fairest way by far).

This is not happening. While the UK economy remains afflicted by a lack of demand among low- and middle-earners, the Bank of England is, counter-productively for demand, urging pay restraint. This might in theory help to prevent a wage-price spiral, although there is little sign of this anyway.

What the Bank is recommending will be slow and painful, rather than quick and painful. According to its July 2023 Financial Stability Report, the Bank expects higher mortgage payments will make millions worse off but the impact will only materialise over several years as many mortgage-holders have fixed-rate mortgages for the time being. And the proportion of owner occupiers with a mortgage has been declining anyway for many years. In other words, using higher interest rates to control inflation is not as easy as it used to be.

Second, with supply-side constraints, we are only making the economy more vulnerable to inflation driven by supply shocks. The UK needs to enhance its domestic productive capacity so that it is more insulated against production shortfalls elsewhere. But this requires more private investment, driven in part by firms’ confidence in likely demand. In attempting to avert a barely identifiable wage-price spiral, economic policymakers are risking a downward demand-supply spiral.

A way forward?

As well as a focus on investment, there are other policy options:

  • Significantly increased public investment, as part of an industrial policy;
  • A more strategic approach to business finance, through public investment operating at a larger scale, to drive productivity growth;
  • Corporate governance reforms which, for example, give workers a stronger voice in investment strategies — this will help to mitigate against suppressing labour costs being seen as the default.
  • A reopening of the UK economy to our main European trading partners through a more effective trade policy.

In terms of monetary policy, specifically, the Bank of England needs on the one hand to introduce a broader set of tools, both to control inflation, and to address the coming climate crisis, which will inevitably make inflation considerably worse. A reformed Monetary Policy Committee with a wider remit to consider the long-term health of the UK economy could play an important steering role in this regard. Yet we also need to recognise the limits (and flaws) of monetary policy, returning fiscal and industrial policy (and indeed social policy) to the fore in the hope of improving the lacklustre productivity performance of the UK economy.

Image: “Bank of England / Threadneedle St.” by Images George Rex is licenced under CC BY-SA

The views and opinions expressed in this post are those of the author(s) and not necessarily those of the Bennett Institute for Public Policy.


Craig Berry

Dr Craig Berry is an experienced academic researcher and policy practitioner. He is a political economist with expertise in economic policy, including industrial policy, and welfare provision, principally pensions. His...

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