Last night, at a speech at the London School of Economics, the Bank of England’s Andy Haldane suggested that the bank could raise interest rates to 4.25%. The effect of that, he said, would be catastrophic in the short-term: an extra 10% of British companies would go bankrupt because their profits aren’t large enough to cover interest payments on their debt.

It would cost 1.5 million jobs.

But the UK would improve total productivity across the entire country, he said, by 1% or 2%.

And that, he suggested, might well be worth it.

The logic of his argument — which was purely hypothetical — is that investors would stop pouring money into marginally profitable “zombie” companies, leaving only the gazelles to speed ahead. In the short-term, there would be mass closures and layoffs. But investment would go quickly into the high-profit gazelles, and productivity nationwide would increase from the current stagnant rate of 1.2% per year.

Adding another one or two percentage points to productivity at a cost of 1.5 million jobs sounds like a lousy trade.

But the short-term pain might have a historic effect on the UK, the Monetary Policy Committee member argued. Productivity — the ability to eke out sustained gains in wages and profits — is the thing that determines whether you have a better standard of living than your parents, whether your children live more comfortably than you. Without it, we’d still be living like characters in a Dickens novel, Haldane said:

“Since 1850 UK living standards, as measured by GDP per head, have risen roughly 20-fold, a huge gain. How much of that gain can be attributed to higher productivity? Well, if productivity had flat-lined over the period, UK living standards would only have only doubled. Or, put differently, in the absence of productivity growth, UK living standards would be an order of magnitude lower today, stuck at late-Victorian levels.”

Here is the problem on a global scale. Across a range of developed countries, productivity is in decline and heading toward zero. Low productivity is one of the main reasons that Millennials are the first generation since the 1800s to do worse than their parents:

The discussion about productivity has suddenly become a huge issue because inflation in the UK just went up to 2.3%.

There is only one way for the Bank of England to combat inflation: raise interest rates. The Bank won’t sit still for inflation over 2%, so a rate rise is now more likely than ever.

When it comes, it will be a scary test of how well-prepared British businesses are to deal with interest rates that aren’t zero. Interest has been set effectively at zero in the UK since 2008. It has been nine years since UK companies had to budget for significant interest expenses. An entire generation of managers has grown up knowing nothing about the effect of having to pay significant sums of interest on debt.

For them, this is uncharted territory.

Haldane thinks that a large number of British companies might fail the test.

He looked at the ONS’s Annual Respondent Database, which covers 40,000 companies per year, or about 80% of UK GDP. Then he charted them based on how much gross added value (GVA) they returned per worker:

The problem with the shape of that curve is that it shows a long thin tail of companies on the right side of the chart that get above average returns when they employ new workers. On the left side, there is a fat lump of companies that get much lower GVA returns. “This shape means that modal productivity among UK companies is around 50% lower than mean productivity,” Haldane said. To put that in plain English: The
most common type of UK company has lower productivity than the
average company, because a small number of highly productive companies at one end of the scale are skewing the average. That makes the average misleading — it is the mass of companies on the left that get below-average returns that you ought to worry about.

Now, Haldane argues, assume that the low-productivity companies whose profits won’t cover increased interest payments fail to improve their revenues or get new loans, and something very dramatic happens. They all go the wall.

That leaves only the higher-productivity firms companies to survive. The before/after scenario looks like this:

Now, all the zombies are dead (the green line) and the investment is going only to the gazelles. The level of destruction is greater, but the productivity gains are greater too, Haldane says: “If we assumed instead that only the lowest-productivity firms went bust, the boost to productivity is around 3%.”

Haldane doesn’t put a number on the number of jobs that would be destroyed and/or created in that scenario. The implication is that it would be far more than 1.5 million — but the generational gains would be far greater, too.

Haldane is not sure it is worth the cost:

“The positive impact of higher interest rates on aggregate productivity is significantly tempered by the bankruptcy of some high-leverage, high-productivity companies [who fail to refinance despite their high productivity]. The overall effect of higher interest rates in the simulation is to boost the level of productivity by around 1 or 2% relative to the baseline. This is a significant productivity gain. … [but] it comes at a hefty employment cost. Should monetary policymakers have sacrificed 1½ million jobs for the sake of an extra 1 or 2% of productivity? Hand on heart, I can tell you this one would not knowingly have done so.”

That’s a nice counterfactual. Economists love counterfactuals. The real-world problem is that inflation functions in a similar way to a rise in interest rates. Inflation is often followed by an interest rate rise in order to cure it. Inflation, like interest, increases the cost of everything, including, eventually, the cost of borrowing money.

Now, inflation is at 2.3% and rising. The test is already underway. Pretty soon, we’re going to see who are the zombies and who are the gazelles.

Haldane’s numbers suggest it won’t be pretty.

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