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One thing economists agree on is that productivity, output per worker, “is almost everything”, as Robert Peston, BBC economics editor, puts it. Productivity, agreed former Labour leader Ed Miliband in March, “is key to the country we wish to be”. Just how key is underlined by a calculation from the Resolution Foundation think-tank. While productivity increasing at the present 0.5 per cent a year would leave a new government in 2020 with £104bn to find to meet pre-election debt-reduction targets, a rise to 4 per cent a year would mean a lucky chancellor would have £18bn to give away.

Similarly uncontroversial is that UK productivity is poor, some 20 per cent lower than G7 counterparts, according to the Office for National Statistics data. Economists call mostly for supply-side improvements: upgrading skills, boosting lending to small businesses for investment and bringing forward infrastructure projects.

Unfortunately productivity growth is not an arithmetical function of combining capital and labour. Supply-side improvements are pushing on string without equivalent take-up from the other end. This is borne out by a report from the UK Commission for Employment and Skills, which found that what the UK lacks is not a highly qualified workforce but the ability to organise and deploy it productively. In other words, better management.

But what management chooses to do is not just a matter of technical ability. Economic motivation, curiously ignored by most economists, is an equally influential factor. Consider a benign productivity puzzle: the UK motor industry. UK carmakers are on a roll — productivity is high, on a par with anything in Europe, and the industry has announced £1bn of new investment in the past month alone, on top of £7bn in the previous two years, to keep it there.

So how come cars are driving on a different planet from the rest of the economy? One obvious difference is that most of the “UK” motor industry is foreign-owned — Germany and Japan to the fore. Both are, of course, renowned for their manufacturing prowess. But while foreign owners are undoubtedly good at translating high UK workforce skills into productivity, the key distinction may lie elsewhere: the way their managements are paid.

City economist Andrew Smithers formulates it like this: to get managers to act like shareholders, over the past 20 years their pay (at least in the US and UK, much less so in Japan and continental Europe) has switched from consisting mainly of salaries to mainly bonuses (83 per cent of the total in the US), based on their achieving share price-related goals. Given the leverage, small changes in success measures trigger large changes in total pay.

But while the prize is great, shrinking top-management tenure (now down to about four years) means the time to win it is short. The implications are clear: in effect, managers are rewarded for avoiding actions that might hit quarterly earnings and thus the share price. So that is what they do. Chief among those actions is capital investment, which — though essential for long-term productivity and survival — to a manager in a hurry to hit an earnings target is just a cost. No surprise then that, as research confirms, profitable investment is routinely passed up, while private companies, exempt from such incentives, proportionally invest much more.

Viewed through the prism of managerial incentives, the post-crash economic puzzles of flat productivity, surprisingly low unemployment and dawdling recovery evaporate like a puddle in the sun. Managers balk at investment that will damage short-term earnings, instead meeting extra demand by hiring more bodies. So unemployment has not risen, as it has in previous recessions.

But without capital investment, productivity flatlines — and so do wages and growth. The deficit refuses to fall. Another economist, William Lazonick, has shown companies are spending up to 100 per cent of earnings on dividends and share buybacks to keep share prices high — a financial-engineering substitute for productivity growth that can only end in tears. For Smithers, Lazonick and a growing band of similar thinkers, reforming management pay to remove the perverse incentives that skew their capital allocation decisions is not just vital to rebooting productivity growth, it is the most important issue facing economic policy makers today.

Copyright The Financial Times Limited 2017. All rights reserved.
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