The productivity puzzle continues to puzzle. It seems to be too puzzling for our politicians to talk about but lots of other people are on the case. Duncan Weldon wrote a piece earlier this week looking at both the economic and social factors.

This comment set me thinking:

It could be that the nature of Britain’s recovery explains the low productivity growth. Rather than lower productivity leading to lower real wages (as companies cannot afford to increase pay), it may be that lower real wages have encouraged firms to hire workers rather than investing in new equipment. This could have lowered productivity.

Where are Britain’s startups in all this? Entrepreneurs are supposed to come into the market and disrupt it, investing, innovating and bringing in new ideas which eventually improve productivity. At least, that’s the theory.

But there is little evidence that new firms are doing much to improve productivity. If anything, they are making things worse. As this NESTA research by Albert Bravo–Biosca and Stian Westlake found:

Most start-ups were not particularly special from an economic point of view. The average new British business was no more productive than the average existing business, either at its foundation or after five years of existence. While some new firms contributed positively to labour productivity growth during this period, this was offset by the negative contribution of other new firms. So, while some new firms might have been highly productive, their contribution was more than cancelled out by those that weren’t. The net effect of new firms coming into the market was to reduce productivity.

A recent Bank of England paper on firm level productivity found something similar and suggests that the trend has continued through the recession. For most years over the past decade, the overall contribution of new firms to productivity has been negative.

Back to Duncan’s comment then. If existing firms are hiring cheaper workers rather than investing in technology, might a similar process of labour substitution be going on among startups? Perhaps new firms are coming into the market not because they have developed new products or services but simply because they have found a way to make a profit by exploiting cheap labour.

Mike Haynes gave an example of this a couple of weeks ago when he discussed the rise of the hand car wash.

A hand car wash is labour intensive and forgoes technology that has been developed to replace it. Normally technology is used to increase the efficiency of output and make an economy more productive – economists call this capital deepening and it’s traditionally a marker of good economic growth. As the economies of wealthier nations evolved, the machine car wash was one of many technical changes that accompanied capital deepening. Major garages and petrol stations are equipped with expensive machines that now stand idle, while people queue for the hand car wash. This, despite the machines being good at what they do. They are unlikely to scratch your car. They wash it cleaner, use less water and the detergents are more safely taken away. Some countries even ban hand car washing because of the waste and pollution involved. The return to an inefficient, labour-intensive model – as with the hand car wash – is therefore an odd regression. It is only possible in a rich economy like the UK’s because labour is relatively cheap – and those working in hand car washes tend to be paid at the minimum wage or below it. They experience long periods of under-employment as they wait for customers and few have proper contracts or conditions. People working these kinds of jobs, in part, explains the UK’s productivity problem.

In other words, it’s easier to make money by using cheap labour than by investing in machinery. Furthermore, in this example, people would be mad to invest in new machinery because they would be unlikely to make enough to cover their investment. The media love to talk about high-tech entrepreneurship. There may be a few such firms but most of Britain’s startups are low tech or no tech.

Has this county become an El Dorado for cheap labour? Does the business opportunity now lie in setting up a business to exploit what the Economist described as Britain’s pitiful pay and its even more impoverished freelancers? That might explain why, far from improving the country’s productivity, Britain’s startups are making it worse.