Economic Theory

Yes, we have a productivity problem. No, we don’t need an ‘industrial strategy’

As the US economist Paul Krugman once famously remarked, ‘productivity isn’t everything, but in the long run it is almost everything.’ Improvements in productivity are indeed the key to sustained increases in real wages and living standards. At face value, then, the UK has a major problem: productivity has stagnated since the recession of 2007-08.

Data published today show that output per hour worked was 0.4% lower in the first quarter of 2017 than at its peak in the final quarter of 2007. This contrasts with average annual growth of 2% or more during each of the last four decades (the 70s, 80s, 90s and the 2000s – at least until 2008).

What’s more, the UK’s productivity performance appears to be much worse than most comparable countries. The data here are not so timely, but in 2015 output per hour worked in the UK was nearly 16% below the average for the rest of the G7, with particularly large shortfalls relative to France (22.7%) and Germany (26.7%). And while growth in productivity has slowed in almost all countries since the mid-2000s, the deterioration relative to the earlier trend has been much greater in the UK.

There are several plausible explanations. It is always worth asking first whether the data are reliable. One possible failing is the under-recording of output. Improvements in the quality of goods produced or increases in the less tangible outputs of service sectors (particularly the digital economy) are not always accurately captured in the official statistics. However, it is unlikely that these measurement problems have become significantly worse since the recession, or that they are much greater in the UK than in other major economies.

The focus on averages could also be misleading. The international data are often used to make unfavourable comparisons, such as ‘it takes a German worker only four days to produce what a British worker makes in five’. But relying on an average from aggregated data is not necessarily comparing like with like.

For example, a country suffering from high unemployment where jobs are concentrated in more productive sectors might report a higher average level of productivity than a country nearer full employment where a wider range of people are in work. However, people in comparable jobs in these two countries might still be equally productive. This could help to explain the difference in reported productivity between the UK and France, where unemployment is much higher (though not between the UK and Germany, where unemployment rates are much the same).

Hours worked are also a factor. Countries where people work fewer hours (or take longer annual holidays) typically have higher levels of productivity, measured in output per hour. This makes sense, as the longer someone works, the less they are likely to produce in each additional hour. Indeed, OECD data suggest that people in the UK, on average, work 14% more hours per year than those in France and 23% more than those in Germany. Focusing instead on output per worker, the productivity gap between the UK and France narrows to 12.7% and between the UK and Germany to 10.4% (again, using 2015 data). Nonetheless, this is still a sizeable gap and, presumably, many people in the UK would rather work fewer hours too.

A final issue is the sectoral pattern. Part of the UK’s relatively poor performance can be explained by declines in sectors where productivity has traditionally been higher – notably finance & insurance and oil & gas –  and by shifts in economic activity towards labour-intensive service sectors where the scope for productivity improvements is generally lower. These factors have been more important in the UK than in most other countries, but they cannot be the whole story.

So accepting that there is something more to explain, what are the main economic drivers of the UK’s low productivity growth? There are two key points. First, the most important factor distinguishing low-productivity and high-productivity countries is usually (though not always) the level of investment. Here it is surely no coincidence that investment accounts for a relatively small amount of UK GDP.

There are plenty of explanations here too – leading to potentially very different solutions. One view is that the low rates of investment in the UK are largely the fault of short-sighted managers in the private sector and that the answer is therefore new forms of ownership, including more cooperatives and more state intervention. Unsurprisingly, this interpretation is finding increasing support within the Labour Party. But there also appears to be a cross-party consensus that the UK needs a more activist ‘industrial strategy’, where government increasingly takes the lead.

However, market-oriented solutions are likely to be more effective. It is far from clear that the state is any better at allocating resources – or making investment decisions – than the private sector. Indeed, there is a danger that the government simply diverts resources to relatively uneconomic projects, undermining productivity further. (Germany, it is worth noting, does not have a particularly activist industrial policy –  unless one counts their high levels of support for the renewable energy sector, which has hampered the country’s productivity overall.)

An alternative approach would focus on lowering barriers to increased investment, whether public or private, including further reform of corporation tax and investment allowances, reductions in energy costs and liberalisation of planning laws. There is also a strong case for removing support from relatively unproductive ‘zombie’ firms that have only been kept going by very low interest rates, while at the same time freeing up banks to lend more to new companies at the productivity frontier.

The second distinguishing feature of the UK is its relatively flexible labour market. Again, there is a widespread view that this has contributed to the problem by allowing the UK to settle into what the National Institute of Economic and Social Research has called a ‘low wage – low productivity – high employment equilibrium’. In a nutshell, it has been more attractive for firms to employ people at relatively low wages (and even keep them on when they might otherwise have been let go) rather than invest in more capital. This is good for jobs, but potentially bad for productivity and real wages.

Nonetheless, it would also be perverse to conclude from this that the solution is more regulation. UK productivity is lower than in the US – where labour markets are at least as flexible. The ongoing tightening in the labour market in the UK is still likely to put upward pressure on wages over time. If the government attempts to kick-start this process – for example by further large increases in minimum wages – the result is only likely to be a large increase in unemployment. Achieving higher productivity ‘the French way’ would be a hollow victory.


Julian Jessop is an independent economist with over thirty years of experience gained in the public sector, City and consultancy, including senior positions at HM Treasury, HSBC, Standard Chartered Bank and Capital Economics. He was Chief Economist and Head of the Brexit Unit at the IEA until December 2018 and continues to support our work, especially schools outreach, on a pro bono basis.

2 thoughts on “Yes, we have a productivity problem. No, we don’t need an ‘industrial strategy’”

  1. Posted 05/07/2017 at 21:01 | Permalink

    I wonder how the productivity of government is measured. One of the major differences between the UK and Germany is how health care is run. The UK has some very bad taxes e.g. that low rate of 5% VAT on domestic energy is hardly conducive to investment. And the UK has at least one hand out which has zero productive outcome in the winter fuel allowance, compared to the counterfactual of sticking £6/week on pensions and pension credit and the relevant applicable amounts.

  2. Posted 06/07/2017 at 08:37 | Permalink

    If you have to invest more per worker in order to get higher productivity per worker, is this necessarily desirable? You might get more output but you also have a higher cost for that output.

    Is it not possible that the UK specialises in areas where lower capital investment is necessary? We might actually be getting a higher return on investment, despite lower output.

    I haven’t seen any analysis of this. Does any exist?

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