Banks may be to blame for Britain’s measly productivity growth

COMPARED with most other rich countries, the British economy looks strong. In 2015 GDP grew by 2.2%, more than the 1.5% seen in the euro zone. And yet, nearly a decade after the financial crisis began, there is one serious weakness: productivity (defined as the amount each worker produces in a given period of time). In the period 2000-08 annual productivity growth was nearly 2%. In 2009-14, though, it was pretty much zero, far below what rivals like America and Germany have achieved. Stagnant productivity growth explains why British real wages are still 5% below their pre-crisis peak.

On February 24th the IMF released its yearly assessment of the state of the British economy. It zooms in on the productivity slowdown. Using a fine-grained dataset, containing over 30m observations of British firms between 2005 and 2014 (including their location and income statements), the IMF looks at different explanations for what is going on.

One explanation popular with economists is that British firms are not investing enough. Workers are cheap and desperate for a job; managers respond accordingly, the argument goes, by delaying expensive investments and instead working employees and existing equipment harder (say, by putting on night shifts). Lower capital investment keeps employment up but output down. However, the IMF finds little evidence to support that hypothesis. They study 17 sub-sectors of the economy, and show that capital investment played little role in driving down productivity growth; in many sectors, it pepped it up.

The answer to the productivity puzzle may lie instead in the “misallocation of resources”, which sounds complicated but is actually fairly simple. When a recession hits, it takes time for declining parts of the economy to shed labour and capital. It also takes time for new, fast-growing sectors to mop up these resources. Until that reallocation is complete, economic output will be less than it could be.

As economists like Ben Broadbent of the Bank of England have suggested in the past, Britain’s economy is bad at reallocating resources. In the recent recession, just 0.2% of firms went bust each year, compared with 0.7% a year in the downturn of the early 1990s. A lower bankruptcy rate has in part reflected a willingness of banks, supported by ultra-low interest rates, to cheapen or extend old customers’ credit—keeping alive inefficient, dying firms (“zombies”, in the jargon) to avoid taking a loss themselves. At the same time, credit for new firms with better prospects has been tight.

All this means that capital gets locked up in the wrong places; Britons end up working, less productively, in firms that should not exist. The IMF’s bean-counters calculate about a third of the slowdown in productivity growth since the recession is down to misallocation of resources (though they struggle to explain the rest). Firms with fewer than ten employees, responsible for a third of employment, have suffered most, because in recent years banks have been particularly stingy about lending to them. Britain has seen a more acute misallocation of resources than the average G7 economy, which may reflect the acute damage done to its financial sector during the crisis.

The problems identified by the IMF may slowly be getting better. Interest rates on business lending are below pre-crisis levels. This makes it easier for new businesses to get off the ground: the rate of startups is now above pre-crisis levels (though this will include some backlog from the crisis period). The number of business “deaths” has been rising too, suggesting that banks are no longer happy to keep zombies alive. Britain’s financial system is not fully repaired, but it may now be helping productivity growth, not hindering it.