Posted on 19/05/2017

Are ultra-low interest rates a curse on the economy?

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The productivity puzzle

In recent years, the UK has been in the grip of what’s been termed the ‘productivity puzzle’. Labour productivity, as defined by the Bank of England, is: “the quantity of goods and services produced per unit of labour input.” Essentially – measured as output per worker or output per hour. It’s important because, as a macroeconomic indicator, it signifies the quantity of output an economy can generate with its available resources.

Back in 2014, the Bank of England released a paper on the topic to try and uncover what was behind the country’s reduced productivity. Analysts have pinpointed the onset of the financial crisis as the point at which labour productivity became exceptionally weak and the productivity puzzle began. What’s surprising is that, fast-forward to the central bank’s 2014 report, and the whole-economy output per hour is still around 16 percent lower than before the crisis. A full decade later, we’re still beset by low productivity – the question is: why?

Contributors to low productivity

When it comes to the cause of the UK’s low productivity, it seems that a combination of factors is at play.

In a recent speech at the London School of Economics, Andrew G Haldane, Chief Economist at the Bank of England, argued that mismeasurement probably plays a relative role in the appearance of a productivity puzzle, as official statistics likely underestimate economic activity. However, he also acknowledges that there is still an underlying productivity problem.  

He went on to highlight another problem: that the financial crisis – the largest in a generation – likely constricted financing for new and existing companies, especially young companies, which would typically display rapid productivity growth.

Another hypothesis Haldane brought to light was that innovation may be slowing down. He explained:

“Some economists believe that the type of technological progress behind productivity growth over the past two centuries may not continue at the same pace in the future. One argument is that the current wave of innovation, grounded in ICT, does not have the same potential as past innovations. A second is that the ICT revolution is already quite mature and that future progress is likely to be slower.”

However, as Haldane pointed out, this angle may not hold up, as many would argue that we are on the cusp of a new phase of innovation, stemming from robotics, artificial intelligence, big data and the human genome.

Other potential factors include stifled competition, poor company management and slower diffusion of innovation to other companies and countries. However, one of the most widely debated issues is the extent to which monetary policy impacts productivity.

The problem with ultra-low interest rates

Since last August, the UK has had record low official interest rates of 0.25 percent. On 11th May, the Monetary Policy Committee voted to maintain this – and to continue other economic stimulus programmes including corporate bond and UK government bond purchases.

The markets don’t expect a rate rise until 2019, which will be a decade after the central bank first implemented ultra-low interest rates. With the Q1 GDP figures this year showing growth of just 0.3 percent, continued ultra-low interest rates seem a foregone conclusion. And while it appears to have helped lessen company bankruptcies, redundancies, unemployment and mortgage repossessions during the recession, others argue that it stalls the economy.

It certainly hinders the process of natural selection, where weak companies would have gone to ground and been replaced by stronger, more productive companies. What’s more, as those dealing with zombie companies can be susceptible to higher levels of doubtful debt, this can increase supply chain insecurity. Haldane acknowledges that had interest rates risen, so would productivity – potentially at a rate of 2 percent, but this would have been accompanied by the loss of 1.5m jobs. Despite the drawbacks of ultra-low interest rates, widespread unemployment was something Haldane was keen to avoid.

It’s clearly an incredibly fine balance to maintain, but with labour productivity growing by just 0.4 percent in the third quarter of last year according to the Office for National Statistics – which is tantamount to a flat rate – the question is: is our ultra-low interest rate environment sustainable?

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