The British Government’s approach to the economy’s productivity problem needs a rethink

By Derek du Preez

August 6, 2021

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It is widely acknowledged that the UK has a productivity problem. After decades of growth, the financial crisis of 2008 led to productivity flatlining for years to come. Whilst employment has continued to grow just as strongly as before the financial crisis hit, GDP growth has slowed to approximately 1.5 percentage points less than the decade before 2008. 

It is widely accepted that increases in productivity - achieving more output from less input - is what drives prosperity. This is why the ‘productivity problem' has been a central focus of government policy and investment in recent years. However, it's become even more critical in recent months as a result of the challenges facing the UK in the face of Brexit and the COVID-19 pandemic. 

Prime Minister Boris Johnson has made clear that in his mind the key to solving this challenge is prioritizing sectors that are highly skilled and high growth - such as science, technology and the green economy. Johnson has made comments about turning the UK into a ‘scientific powerhouse' and a key part of the government's agenda has been to ‘level up' all parts of the country. 

We've seen sector specific deals carried out - including in fields such as AI - and there has been a number of innovation policy investments announced. 

However, a new report out this week released by think tank Institute for Government (IfG) provides some interesting food for thought about the government's approach, which upon reading in full, speaks to the heart of the problem with the Prime Minister's approach. 

At a top level, IfG debunks the myth (and the government's obsession with) that a decline in manufacturing investment is the source of the UK's productivity pain, pulling data that suggests that even if the UK had kept up with Germany's growth in manufacturing, that it would only account for a fraction of productivity growth. 

Equally, it rightly notes that productivity can't be tackled on a sector by sector basis. So many of the challenges associated with improving productivity are interconnected and economy-wide, and policy intervention should instead focus on agendas that cut through all aspects of the UK's economy. 

And whilst the government appears to want to be at the center of technology creation, it would do better to focus on technology adoption and structural changes within sectors to drive productivity. In addition, focusing on improving skills across the UK would have a greater impact than being the country that cracks the next big high-tech innovation. 

Simply put, the government's current productivity policy agenda is struggling to see the wood for the trees. IfG does an excellent job of detailing the data about why an economy-wide approach is superior. We will outline the key points below, but anyone working in these policy areas should be encouraged to read the report in full. 

It's complicated

IfG notes that it must be tempting for government and policy makers to place the blame of a decline in productivity on the UK's failure to nature high-productivity sectors, favouring a growth in service-led sectors. 

Hence why we see the Treasury, for instance, making calls to focus on "high-growth, innovative sectors" - the implication being that these are the ‘right' sectors for the UK's future. But in reality it's not so black and white. Sectors such as retail and hospitality have actually have the potential to deliver high levels of productivity gains, which has been helped by the shock of the COVID-19 pandemic and the adoption of new tech and business models.

Equally, the research shows that this is an international trend and whilst some of the UK's peers may have outperformed in certain areas, when you look at the totality of the impact on productivity, the likes of the US, Germany and Italy are facing the same problems. The IfG report notes:

Moreover, the country's shift towards services should not be portrayed as a productivity-sapping strategic mistake. The shift was seen across many countries and is natural during the evolution of advanced economies, which as they age spend more on services.5 The government should treat it as an invitation to take services - even the traditionally low value-add ones - more seriously as a potential source of growth.

The analysis presented here shows that the productivity malaise that took root after 2008 has little to do with the failure to pursue the ‘right' sectoral shape for the economy, or to support the right sectors with the right technologies. The slowdown is far too large, international, and spread across the sectors for that to be a convincing thesis. Differing sectoral shapes are not sufficient to explain the regional gaps in productivity that preoccupy policy makers. 

Although the UK has shifted employment away from manufacturing to some lower-value services, the timing of this shift does not match the worst spell of productivity weakness that began after 2008. Even if the UK could have stemmed the erosion of its manufacturing share, as Germany has managed to, most or all the past decade's weakness would remain.

Sector boundaries are not the key

The IfG's sector analysis shows that the shortfall in productivity growth that occurred post-2008 was skewed towards a few industries, such as ICT and professional and business services, as well as the financial sector. But weaker performance was seen right across the economy - most employees worked in a sector that grew less in the 10 years after 2008 than in the 10 before - and as such economy-wide perspectives are needed. 

IfG states that sector boundaries are "often arbitrary" and the sectors themselves are interdependent. It adds:

A narrow sector-by-sector examination risks focusing upon individual economic areas to the detriment of macroeconomic insight - to ‘miss the wood for the trees'. The state of aggregate demand is one variable that might be overlooked. 

A broad productivity crisis hit many developed countries at the same time as the financial crisis damaged global demand and confidence. Sharp movements in aggregate demand land unevenly across sectors and are often highly correlated with shifts in productivity. The persistence of these effects must be considered before the performance of any sector is accorded a purely sectoral diagnosis.

The report goes on to say that whilst Johnson's government puts a heavy emphasis on innovation policy as a tool for driving economic progress, the sector-level relationships between technology, innovation, productivity and livelihoods are far from straightforward. 

In essence, it states, more technology does not always lead to a large market, more pay or higher jobs. You only have to look at the US economy which has generated $6 trillion of extra equity value in just four giant digital tech companies. 

What's the solution?

If a sector by sector approach isn't what's needed, how should policy makers be thinking about improving productivity? The key message to takeaway is that productivity cannot be solved by focusing in on certain sectors, such as high technology. The efforts need to be much broader in scope. 

The objectives also need to be considered. For instance, the report adds:

It is also a mistake to see growth or productivity as the only objective for innovation. Energy sector innovation is a clear example; this is going to be vital for the transition to net zero and, done well, will have a positive effect on myriad other parts of the economy. But it might do this without having any direct perceptible effect on the GDP figures, as lower CO2 emissions do not count towards GDP.

Some of the things the government is currently doing will likely have a greater impact on productivity, than its sector-specific deals and investments, and these should be scaled up. For instance, the government's ‘Help to Grow' scheme, which is aimed at improving management skills, or its policy interventions to encourage the adoption of digital tools across all businesses - these are far more strategic in achieving higher productivity gains. Again, it's the *use* of technology that will make the most fundamental difference, not its creation. 

As noted above, we've seen drastic changes in recent months across the economy as a result of the COVID-19 pandemic - the changes happening in retail and office spaces would have likely taken years to occur without the ‘shock', but could well have positive impacts on productivity. 

IfG adds that the government should also consider ‘running the economy hot' as a method to stimulate productivity growth. The report states:

The economy-wide factor that policy makers should be most concerned with is the state of aggregate demand, which may be crucial to explaining shifts in productivity. Although it goes beyond the remit of this paper to ask whether the UK's macroeconomic framework needs re-examination, policy makers must keep this factor in mind - particularly as the UK is about to undergo a real-life experiment. Demand growth is poised to outstrip recent records, buoyed by supportive fiscal and monetary policy. 

An economy that is ‘running hot', and where labour is not as cheap and plentiful as it has recently been, could encourage many of the activities needed to end the long productivity slump - training, investment and innovation. Most of what the economy needs to do to become more productive will happen from the decisions of private sector actors, responding to their environment, and not some government programme. The most important feature of this environment is the growth of spending power. In this regard, the long-term agenda of boosting the UK's economic potential coincides nicely with the short-run imperative to ensure a robust recovery from the pandemic.

My take

A more difficult approach to take than solving the challenges of one specific sector, when you're considering the structural formation of the entire economy. But it's a far more compelling argument and one that is supported by extensive data. Again, read the report in full, and next time the government says all our problems will be solved by encouraging one specific industry, keep in mind that won't go anywhere near far enough.