Academic journal article National Institute Economic Review

The Financial Crisis, Bank Lending and UK Productivity: Sectoral and Firm-Level Evidence

Academic journal article National Institute Economic Review

The Financial Crisis, Bank Lending and UK Productivity: Sectoral and Firm-Level Evidence

Article excerpt

I. Introduction

There is a range of cross-country evidence suggesting that long-term growth potential is damaged by major recessions associated with financial crises (Reinhart and Rogoff, 2011). Oulton and Sebastia-Barriel (2013) estimate that each year of a banking crisis reduces output per hour worked by around 1 per cent for each year that the crisis lasts.

Our main focus is on the slowdown in growth of aggregate labour productivity. Labour productivity is estimated to have fallen sharply during the recession of 2008-9, and to have recovered only sluggishly after that. Figure 1 shows the unusually slow recovery of output per worker following the most recent recession when compared with the three other major UK recessions since the beginning of the 1970s. Cross-country evidence suggests that the productivity slowdown has been more pronounced in the United Kingdom than in other countries (Office for National Statistics, 2014).

Understanding the continued weakness of productivity relative to pre-crisis trends and the scope to make up past losses is of key importance to macroeconomic policy. Now that the economy is beginning to recover, a key question is whether any of the lost productivity growth of recent years will be made up.

Any explanation for the recent weakness of productivity growth needs to start from the observation that the macroeconomic position of the UK economy, like most advanced economies during the Great Moderation period, was broadly balanced with growth of around trend, inflation at target and with output close to potential. This was in contrast to the macroeconomic position leading up to all other postwar downturns when there had been a prior imbalance between aggregate supply and demand and the recession was caused by the policy tightening needed to bring inflation under control. On this occasion, monetary policy was loosened to offset the impact of a sharp contraction in global demand, together with the consequences of tight credit conditions and greater uncertainty on demand at home. Low interest rates, together with a lower exchange rate, provided breathing space to incumbent businesses and allowed them to absorb the demand shock. That in itself might have accounted for weaker productivity in some businesses. But low interest rates would typically encourage businesses to increase their capital intensity and boost productivity. So it is unlikely that low interest rates alone could account for the weakness in aggregate productivity.

[FIGURE 1 OMITTED]

Against that background it is possible to distinguish two broad explanations for the weakness of UK labour productivity following the financial crisis.

The first broad explanation emphasises the impairment of the banking sector and the effect of tight credit conditions on the supply side of the economy. (1) Figure 2 shows that bank lending to companies fell more sharply in the aftermath of the most recent recession than it did in the three other post-1970 recessions. According to this view, a lack of credit availability stunted the development of high-productivity, mainly young and small bank-dependent firms. The absence of competitive pressure from such companies, together with low interest rates and bank forbearance, then provided protection for older established companies. Their continued survival led to congested markets and reduced the profit opportunities available to more dynamic businesses with the result that the normal reallocation of capital towards stronger businesses did not happen and aggregate productivity stagnated. According to this explanation, productivity would pick up and wages grow without generating additional inflationary pressure once the banking sector was repaired. Simply stimulating demand without repairing the banking sector would be inflationary because the stagnation of productivity reflected a weakness on the supply side of the economy.

[FIGURE 2 OMITTED]

The second broad explanation for the weakness of UK productivity emphasises labour market flexibility and the willingness of workers to accept nominal pay freezes in some instances and real wage reductions more generally in order to keep their jobs in a weak demand environment. …

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