Productivity: the UK's No.1 Challenge
In the third of its pre-election briefings, the LSE’s Centre for Economic Performance (CEP) identified the UK’s poor productivity as “probably the greatest challenge facing the UK economy”.
As this chart from CEP’s paper shows, from 1979-2008 UK productivity (GDP per hour) grew faster than in France, Germany and the United States, reversing a century of relative decline. Improvements in higher education, tougher product and labour market competition, the adoption of information and communication technologies, and innovation policies all contributed.
Then the financial crisis happened. Most developed countries suffered a fall in productivity as a result of that cataclysmic event, but while the US and to a lesser extent Germany and France have recovered, and now enjoy rising productivity, the UK’s productivity has stagnated. UK GDP per hour is currently about 17% below the G7 average and 15% below historical trends:
This is the famous “productivity puzzle”. Exactly why the UK’s productivity since the crisis has been so poor is unclear. Some argue that the UK’s poor productivity since the crisis is a structural supply-side problem (and therefore permanent), while others argue that there is an important cyclical, demand-driven component (and therefore temporary).
CEP’s researchers think it is very unlikely that structural supply-side problems are the sole cause:
The idea of a long-term global productivity slowdown (Gordon, 2014) is simply not credible and reflects the same intellectual malaise felt after the Great Depression that global innovation was slowing.
They also dismiss the notion that the UK’s pre-crisis productivity growth was abnormally high due to a finance ‘bubble’, pointing out that between 1997 and 2007, finance contributed only 0.4% of the annual 2.8% growth in market sector output per hour (Corry et al, 2011).
Cyclical factors identified by the researchers include restricted access to finance, particularly for SME’s, due to a badly damaged and risk-averse financial sector. Business investment has been very poor since the crisis. This should improve as the financial sector heals.
The UK’s flexible labour market, too, has enabled the pain of recession to be distributed more widely: real wages have fallen by 8-10%, in part due to surprisingly high inflation, but the UK has experienced unexpectedly strong employment. Employment is now back to pre-crisis levels: unemployment remains slightly elevated, but this is due to an increase in the size of the workforce due to net migration and a rising participation rate, especially from older people and women. However, substitution of cheaper labour for more expensive capital has inhibited business investment. Substitution should decline as the economy approaches full employment and nominal wage growth becomes stronger. There is however a concern that low pay and low productivity could become entrenched.
Structural factors include inadequate investment, poor management and weak intermediate skills. Particularly significant is the UK’s historically low fixed capital and R&D investment. Business R&D investment, in particular, lags well behind the UK’s principal competitors:
There are many long-standing factors contributing to poor capital and R&D investment, including political uncertainty and short-termism in financial markets and businesses (for example, Kay Review, 2012; Besley and Van Reenen, 2013). Government outlays on R&D are also low by international standards and have been falling as a fraction of GDP in recent years.
Management quality is also an issue. The researchers observe that the UK scores much worse than the United States, Germany, Japan and Sweden in terms of management quality: Bloom et al (2014) estimate that about a quarter of the UK’s productivity gap with the United States could be down to poor management. Poor skills, weak competition, and a greater preponderance of family firms appear to be the major factors holding the UK back.
Cyclical factors would be expected to unwind themselves as the economy improves. However, removal of structural impediments to productivity growth require government action. There have been a number of initiatives in recent years with varying degrees of success. The researchers note, for example, that tax credits for R&D investment have been successful, but the “patent box” which provides a tax incentive to keep intellectual property rights in the UK unfortunately subsidises existing royalties rather than encouraging innovation. Measures to improve SME access to finance have proliferated in recent years, but the researchers express concern that they may simply be throwing money at the problem rather than providing effective support:
The myriad schemes for improving access to finance, expertise, and information for smaller and innovative firms are in principle valuable, but generally they have not been rigorously evaluated. This needs to change if we are to know whether they work.
Since the global financial crisis, more targeted industrial policy aimed at specific sectors or technologies has made a comeback after decades of being out of favour. In 2012, the business secretary Vince Cable introduced support for key sectors and technologies seen as crucial for the success of the UK economy. There is now broad cross-party consensus on the need for support for key industries via the new form of industrial policy.
All parties also agree on the importance of improving the UK’s productivity performance through business policies that boost innovation and investment, particularly through improving firms’ access to finance, information and expertise. Sadly there is less agreement on the need for government investment, where the Conservatives’ fiscal plans currently leave much less room for public investment than the plans of other parties. The parties also diverge on policies with regard to corporate governance and business taxation, where Labour appears to be more interventionist than other parties. Political uncertainty discourages investment and innovation: where there is independent regulation, it is essential that this is protected from political interference.
Perhaps most worryingly, though, no party so far has committed to maintaining the value of the science budget in real terms. The long-term decline that this implies would place a “chill” on innovation.
Anna Valero, co-author of the report, concludes:
The UK’s longstanding productivity underperformance has been heightened since the global financial crisis. ‘To meet this central policy challenge, the UK needs a long-term framework for investment and innovation. This ties in with many other policy areas, not least ensuring that there is an adequate supply of skills and a strong infrastructure network.
Clearly, with only two months to go before the election, it is unrealistic to expect concrete proposals at this point. However, all parties should incorporate into their manifestos plans for long-term investment in infrastructure, innovation and skills to improve the UK’s dismal productivity and help to restore both wage growth and international competitiveness. It is to be hoped that the adequacy (or otherwise) of those plans will help to inform people’s voting choices in May 2015.
Budget 2015: Plans leave no room to achieve ambitions - The Exchange, FT (paywall)
Britain can only walk tall if productivity is reignited - Martin Wolf (paywall)
Immigration and the UK's labour market (Pieria's review of the first of CEP's pre-election briefings)
The authors have also produced a short video outlining their key findings.
Objective, brief and non-technical, CEP Election Analysis is a series of background briefings on the policy issues in the May 2015 UK General Election.
The series discusses the research evidence on some of the UK's key policy battlegrounds, including immigration, austerity, living standards, business, Europe, health, education, crime, inequality,
regional policy, housing and planning, climate change and energy, infrastructure and gender.
These analyses are provided by some of CEP's expert researchers and draw on past and current research.
Anna Valero and Isabelle Roland's paper on productivity and business policies is the third in this series, the first being on immigration and the second on austerity, growth and post-election fiscal plans. All the briefings can be downloaded from the CEP website here.
Image from Getty Images.