How the energy crisis will reduce UK GDP Growth, Productivity and Real Wages.

How does an increase in energy affect productivity and output in an economy such as the UK? In this brief note I adopt a national accounts framework to explain how productivity and GDP are affected by an increase in energy prices such as we have seen in the UK, Europe and elsewhere.

The key point to understand is that GDP is a measure of value added. It measures the difference in value of the inputs of goods and services into the economy and the value of its output. There are of course long supply chains stretching across the globe, each stop adding value to goods and services. Those elements of value added that occur within the geographic area of the UK all add to our GDP. This happens even if we do not consume the final outputs, when the value added will be captured as exports of intermediate or final consumption goods. We also import goods, in the form of intermediates that are used to create final consumption and investment in the UK, or in the from of final goods. However, even when we look at the import of finished products such as olive oil from Spain, there will still be some additional steps of value added in the form of transport and distribution in the UK within the wholesale and retail sectors to get the olive oil to the supermarket shelves.  

It should be noted that from the National Accounts perspective, labour and capital are not treated as intermediate inputs. Indeed, from the income side of national accounts, the income of labour and capital is counted as “wages” and “operating surplus” and is the income measure of GDP.

For some countries such as Saudi Arabia, Norway and Russia, who are major energy exporters, an increase in energy prices adds directly to their value added and hence GDP.  However, most European countries, including the UK, are net energy importers. That is, imported energy in the from of natural gas, coal, electricity, oil, petrol and diesel forms is an intermediate product used to create GDP (and some of it is consumed directly by households and the government in the form of heating light and motor fuel).  If we start from the simple national income identity:

Y = C + I + G + X – M

GDP Y is equal to the sum of consumption C, investment I and exports X minus imports M.  An increase in imported energy costs feeds directly into an increase in M, which directly reduces GDP (other things being equal).  There are some technical details here: an increase in the price of imported goods can lead to a decrease in the value of imports for goods that are price-elastic. However, since energy is highly price inelastic (it is a necessity for households and in most production technologies) we can be confident that the higher price will lead to a greater expenditure on imports even if the quantity falls slightly.

We can see the effect of energy on the increase in imports directly in the UK data. As the ONS stated in its Balance of payments, UK: April to June 2022.

“The goods deficit remained at record levels, increasing to £61.1 billion in Quarter 2 2022. High fuel prices continue to affect imports as oil and other fuels imports rose to £29.2 billion in Quarter 2 2022, an increase of £4.4 billion compared with the previous quarter.”

If we switch perspective from expenditure to value added, we can see that an increase in energy will also directly reduce value added.  Value added is measured as the difference between the value of final consumption and the intermediate inputs. For example, if I bake a cake, the value added is the difference between the price I sell it at and the intermediate inputs such as the ingredients I put into it (such as flour and eggs) and the cost of baking it (energy).  Clearly, an increase in energy costs will mean that the cost of baking the cake will have increased and hence the value added will fall. Hence, my productivity will have fallen. The Value added associated with my baking the cake will have fallen with the increase in energy costs. This can be seen with the simple equation:

Value added = Revenue – energy costs – other input costs.

 It is this value added which feeds into GDP, which is reduced by the increase in energy costs. My productivity is the ratio of value added to my labour input, which will also go down (assuming the labour input required to bake the cake is the same).

Lastly, having adopted the expenditure and value-added perspectives, we can look at income. This takes the form of labour income (wages and salaries) and the operating surplus (profits). From the example of the cake, we have:

Wages + Operating Surplus = Value added = Revenue – energy costs – other input costs.

Hence, if rising energy costs reduce value added, then it will reduce the income of households (either in the from of lower wages or lower operating surplus).  Assuming that the reduction is not entirely absorbed by reduced profits, we can see that real wages will fall.

Lastly, my story has been based on real values, accounting for inflation. Nominal GDP in terms of current prices might well rise in response to rising energy costs: indeed, UK nominal GDP is rapidly increasing whilst real GDP is roughly constant or declining. However, this will not in itself “solve” the problem, since energy costs are rising far faster than inflation.