Why the Bank of England must gamble on growth The job of policy makers is to shift the economy on to a better path. This means taking risks For only the third time since the late 1800s - and the other two were just after the world wars - the UK's private sector productivity has fallen over five years. This is why unemployment has remained low. It is also why the coalition government got away with three years of economic stagnation. With normal performance, unemployment would now be more than 15 per cent. But this experience raises questions. What are the UK's economic prospects? What should policy do? In the second quarter of this year, output per worker and output per hour were almost 5 per cent below their pre-crisis peaks. Output per worker was also 17 per cent below its 1987-2007 trend, while output per hour was 19 per cent below it. Have UK businesses and workers forgotten what they could do in 2007? International comparisons are also striking. The Conference Board's data on employment and output (measured at purchasing power parity) reveal that UK output per employee fell by 3 per cent and output per hour by 2.2 per cent between 2007 and 2012. But output per employee rose by 11 per cent in Spain, 5.6 per cent in the US, 1.5 per cent in Canada, 0.9 per cent in Japan and 0.2 per cent in France. It fell by 0.7 per cent in Germany. Italy, with a fall of 4.2 per cent, was the only member of the Group of Seven leading high-income countries to perform worse than the UK. On output per hour, the UK is behind even Italy, in last place. Economists do not understand why this is happening. This is not for lack of trying. Among (overlapping) explanations are: labour hoarding and substitution of cheaper labour for capital; failures of financial intermediation; changes in the composition of output; falls in value added per worker in high- productivity sectors; and unmeasured investment in intangible assets. The labour-hoarding cum labour-substitution hypothesis is supported by the striking fact that real weekly earnings fell by 10 per cent between March 2008 and July 2013. But labour hoarding is increasingly difficult to believe, five years after the worst of the crisis. It is also hard to explain the 1.7m (8 per cent) rise in private sector employment between the fourth quarter of 2009 and the second quarter of 2013 in this way. Why do employers hire people to do nothing? The explanations do all have some degree of plausibility. But they do not seem to add up to a justification of the scale of the productivity shortfall. None of their proponents seems to believe they do, either. But it seems plausible that, apart from the weakness of demand and some labour hoarding, severe impairment of the financial sector and significant under-recording of output may well matter. It is also possible to construct more or less plausible explanations for relative productivity underperformance in the striking flexibility of real wages, exceptional importance of financial output and scale of damage to intermediation. In brief, we understand parts, but far from all, of this striking and disturbing performance. How, then, should policy makers respond? David Miles, member of the Bank of England's Monetary Policy Committee, and Spencer Dale, chief economist of the BoE, have recently addressed this question. Mr Dale argues that the newly adopted policy of "forward guidance" allows the MPC to indicate its willingness to let the economy expand rapidly. Similarly, Mr Miles makes the point that it is the level of output, not its rate of growth, that is crucial. How far growth can be allowed to accelerate depends, in turn, on how far the economy manages to recoup lost productivity growth. Mr Miles adds that, after a huge shock, the UK economy may face two (or more) possible paths. On one path, confidence is weak, investment sluggish, productivity stagnant and growth slow. This, he suggests, "is roughly the path the UK has been on for much of the period since the financial train wreck." On the other path, confidence grows, growth accelerates, finance strengthens and productivity, real wages and employment all rise together. Crucially, inflation might, he argues, be much the same along the two paths: in the lower-productivity path, that would be because unit labour costs do not grow unusually slowly; in the higher productivity path, it would be because higher real wages offset the higher productivity. The job of policy, then, is to shift the economy on to the better path. This means taking risks. But that is true in either direction. If the MPC took a risk on growth, while supply was as rigid and constrained as some fear, it would cause undue inflation. Happily, it could correct this highly visible error later on. But if the MPC validated expectations of stagnation, it would never know it had done so, since inflation would remain quite high. Thus, it would not feel any pressure to change its mistaken policies. For this reason alone, the risks created by what proves to be unwarranted optimism are the ones to take. Moreover, it would also be far better to risk a brief uptick in inflation than semi-permanent stagnation. If forward guidance forces the MPC to take the needed gamble on growth, it is welcome.