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Mind The Productivity Gap

by Paddy Hirsch

On Thursday, British Prime Minister Liz Truss resigned after just 44 days. To some she was an economic naif, brought down by delusions of resurgent Thatcherism; to others she was a conservative clown, who had turned the United Kingdom into a laughing stock. The turmoil in the UK economy caused by her budget prompted European newspapers to mock Britain for leaving the European Union. American media outlets wondered if she could last until the end of the month. Britain’s own newspapers compared the Prime Minister to a rotting head of lettuce — and then noted the lettuce outlived her. Italy’s leading daily, Corriere Della Sera, ran with the headline “Panic in London: ‘We have become the new Italy’.”

This last jab was particularly galling for Truss, and not just because it nodded at how politically unstable the UK has become (Italy went through six prime ministers in the ten years between 2006 and 2016: when Truss’ successor is named, that will be four in four years for the UK). The comparison also points to the UK’s economic malaise: its low growth, its bloated public services — and its sluggish productivity, a long-lived feature of the UK economy that Truss vowed to reverse.

Daniel Leal/Getty Images

Busting Loose

Truss and her ill-fated finance minister, Kwasi Kwarteng, were two of the five co-authors of Britannia Unchained, a booklet published in 2012 warning that the UK was mired in a slough of low productivity, lack of ambition and an inability to compete with fast-growing Asian economies.

"The British are among the worst idlers in the world,” they wrote. “We work among the lowest hours, we retire early and our productivity is poor. Whereas Indian children aspire to be doctors or businessmen, the British are more interested in football and pop music."

Truss telegraphed her intent to tackle Britain’s culture of unproductive laziness during the race to replace Boris Johnson, so it was no surprise to anyone who was listening when she burst out of the gate, guns leveled at Britain’s low productivity and growth. Her mini-budget, released on September 23, promised the biggest tax cuts the UK had seen since 1972, as well as an energy price freeze, all to be paid for with a massive borrowing spree.

It all went as her opponent for the leadership, Rishi Sunak, had predicted: markets freaked out, the pound fell to an historic low, bond yields flew higher and the Bank of England had to step in with an emergency bailout package to protect funds managing the assets of British retirees. Within a month, both Truss and Kwarteng were gone.

The Productivity Problem

Productivity is important to an economy: it’s how you make more with less, and it's vital to improving a nation’s living standards. Britain was a highly productive country in the 1800s — if not the most productive — thanks to the Industrial Revolution and colonialism. When the 20th century rolled around, however, Britain lost its place to the US, and — thanks in part to two World Wars — never won it back.

Productivity languished for years. Margaret Thatcher made improving it one of her missions, urging people to “Travel abroad, and see how much better our neighbors are doing,” while she was in opposition. Once in power, in 1979, she ushered in a series of reforms that cut taxes, empowered employers over unions, dismantled public ownership of assets and deregulated much of the economy.

And productivity did improve, relative to other European nations. The downside was that the hollowing out of unions and manufacturing depressed wages, stifled innovation, and left the UK overly dependent on the financial and services sector. That kept a lid on productivity and growth right through the millennium. Still, by the early 2000s, productivity was growing at a rate second only to the US. When the financial crisis hit in 2008, however, productivity hit a wall. Diane Coyle, a professor of public policy at the University of Cambridge, says it has never really recovered.

“We've had flat lining productivity since the mid-2000s,” she says. “And while compared to other countries, they've had slowdowns, we've just had a much worse slowdown than anybody.”

Between 2009 and 2019, Britain’s productivity growth rate was the second slowest in the G7, just ahead of Italy. Coyle says there are plenty of factors to blame for Britain’s weak productivity growth; there are so many in fact that she likens the search for a culprit to the conclusion of an Agatha Christie mystery: Everybody turns out to have done it.

“It's a system problem,” Coyle says. “And I can give you a list of things that have gone wrong: low investment, very centralized government decision making, really inadequate skills, training, constant chopping, and changing of policies; an economy that's much too weighted towards financial services and professional services at the expense of manufacturing.”

Blaming Brexit

One suspect that a lot of people are pointing the finger at: Brexit. Soumaya Keynes, an editor for The Economist, says Britain’s departure from the EU undoubtedly had an effect on productivity.

“That created all sorts of uncertainty and stability, and that made it harder for businesses to plan in the kinds of productive investments that would be good for the economy,” Keynes says.

That uncertainty may have depressed business investment by as much as 11 percent in 2019. A study from the Bank of England estimated that the Brexit process has cut the productivity of British companies by between 2% and 5% since the 2016 vote to leave. Output per hour worked in Britain is around 15% below that in the United States, Germany and France.

Brexit’s effects on the UK economy, however, may only be short term. That’s because much of the productivity drain came from executives spending time on planning and preparation, and the uncertainty over Brexit should fade over time.

Other potential causes of a lack of productivity in the UK are more entrenched. Soumaya Keynes says the lack of investment in business and industry by both the government and the private sector is one of the most affecting. And not just the kind of investment that acquires new equipment that helps people do their work better.

“There's intangible investment that you can't touch so easily, like building brands or intellectual property or designing better processes; that other kind of investment that's much harder to measure, but is very important in a services-based economy like Britain.”

Keynes says the amount of money the UK government spends on investment in businesses is relatively small, compared to the private sector, but the government has the vital role of creating the conditions that encourage spending by private sector companies.

“A necessary condition for healthy investment is certainty and stability, and an expectation from businesses that there's going to be a strong economy and healthy demand,” Keynes says. “It's really those necessary conditions that haven't really been satisfied over the past few years.”

That lack of investment has put the UK on the back foot, compared to its peers. A report from the London School of Economics and the Resolution Foundation think tank found that business capital investment in Britain was 10% of gross domestic product in 2019, compared with 13% on average in the United States, Germany and France. And the UK government spends a lot less on research and development, too.

Low investment, along with an education shortfall, a skills gap and deep regional inequality is further complicated by a byzantine planning system that is so devolved and bureaucratic that it makes it really, really difficult to build anything in Britain. Altogether these barriers represent a severe, long-term and systemic obstacle for improvements in the UK’s productivity. And to be fair to Liz Truss, she did want to address these issues in her mini-budget. The problem, Keynes says, was that she tried to combine reforms directed at this barrier with a package of big tax cuts all at the same time.

“I think her sequencing was wrong,” Keynes says. “If you step back, her primary objective was going for growth, and that is admirable. Well done, Liz Truss, identifying this huge problem and really trying to fix it.”

But Truss was naive, Keynes says. “There are huge vested interests that want to see the current planning system kept as it is. And with her announcement of lots of unfunded tax cuts, investors took fright. We've got a hostile global economic environment: It was a very risky environment in which to try to do that.”

Stuck in an unproductive rut

The UK is caught in a bind over its low productivity and growth, which have been exacerbated by external issues in the global economy — particularly the war in Ukraine. If the UK wants to increase productivity, it needs to boost investment. But within the current economic context of high inflation and budget woes — and a bond market that won’t permit much more borrowing — that means cutting domestic spending, which will squeeze households at a particularly difficult time and cause pain for years to come. The LSE-Resolution study estimated that increasing business investment funded by domestic resources could generate an extra 8 percentage points in GDP growth over 20 years, but it could take 15 years before household consumption recovered from an initial fall.

Another path to take is to attract foreign investment, but a big part of that will involve lowering taxes. The demise of Liz Truss shows how tough it is to get that kind of policy passed when inflation is high, and citizens are bracing for a hard winter.

Poor Liz. She was dealt a bad hand from the get go. Her successor isn’t likely to do much better in the shuffle.

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Planet Money - Britain’s Productivity Problem

Mind The Productivity Gap

Busting Loose

The Productivity Problem

Blaming Brexit

Stuck in an unproductive rut

Access Bonus Content

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