Productivity at heart of UK decline

Weak productivity shrinks the economy’s supply potential, which means that interest rates must rise even if growth is relatively meagre.

You can tell a lot about political eras by the words that define them. As New Labour sought to establish its economic credibility, ‘‘prudence’’ dominated. Embracing business in its later years, ‘‘deregulation’’ became the watchword. In the financial crisis, ‘‘CDOs’’ and ‘‘sub-prime’’ were conversational staples at the pub, let alone Westminster.

That goes double for ‘‘austerity’’, the catch-all term for national decline since 2010.

Just as Britain’s social history can be traced through updates to the Oxford English Dictionary, economic history can be neatly spliced by its language. Today, the one word other than ‘‘Brexit’’ that has settled on our tongues is ‘‘productivity’’. Quite how is surprising. It’s a slippery word that defies easy definition but carries enough pessimistic baggage to suggest that something very fundamental has gone wrong with the economy.

It was George Osborne who inserted productivity into the national vernacular in June 2015 when he earmarked it as the new government’s priority. Philip Hammond took up the baton, mentioning ‘‘productivity’’ 10 times in his March budget, as often as ‘‘growth’’ and twice as often as ‘‘wages’’. The British public is being schooled in sophisticated economics and, if it hasn’t caught on yet, it is about to. Britain’s productivity demons are coming home to roost. Just wait for November.

So far, weak productivity has been felt in falling living standards. Since 2008, wages have risen at half their precrisis average because today’s workforce is 16 per cent less productive than it should be. Companies have been unable to raise pay faster than prices without cratering their bottom line. As a result, real average annual salaries have shrunk by almost £800.

That’s just the start. Productivity hits the economy in numerous ways, but most severely in its impact on potential GDP. Potential output is a measure of how fast an economy can expand without inflationary pressure, and is determined by population and productivity. Britain’s growth has largely been a product of the former. The economy is 9.3 per cent bigger than it was in 2008, but only 2.1 per cent larger on a per-person basis.

After years of overly optimistic miscalculations, the Office for Budget Responsibility made a monumental decision this month. It will ‘‘significantly’’ downgrade its productivity forecast in next month’s budget. With the economy expanding more slowly than thought, the new projections will show the government collecting less in tax and spending more in future. The Organisation for Economic Co-operation and Development (OECD) put some numbers to it. ‘‘If trend productivity and GDP growth were just 0.3 per centage points a year lower than assumed, half the fiscal buffer would be lost,’’ it said.

In March, the chancellor had £26 billion of headroom, of which about a third has gone on pledges and failed policies. Long-term, the new forecasts will mean one of two things – more borrowing or more austerity.

Small adjustments to productivity have other dramatic effects. At the Bank of England, policymakers measure the economy’s supply capacity (roughly, companies’ ability to grow) to work out how rapidly it can expand before inflation overshoots 2 per cent. Weak productivity shrinks the economy’s supply potential, which means that interest rates must rise even if growth is relatively meagre. In less than a fortnight, the monetary consequences of poor productivity may be laid bare with the first rate increase in a decade.

In other words, a chronic problem masked by the persistently rosy assumptions of the bank and the OBR is about to become an acute crisis. Weak productivity is unrelenting. First, it depresses real wages, then it strikes at living standards with higher interest rates and, finally, it demands more tax or cuts to public services. It is slow-burn robbery, like living with a thief whose fingers are forever in your wallet.

Blaming productivity for Britain’s woes is all well and good, but it’s not like the housing crisis. You can’t simply build more homes and cap credit. No one knows exactly what the problem is. All that can be identified is trouble with the supply side of the economy. Demand is fine, the UK consumer is a happy spender, the issue is with skills and investment.

On that, the OECD’s paper last week made for particularly bleak reading. Numeracy among British adults is ‘‘low relative to other OECD countries’’ and worryingly so among 16- to 24-year-olds compared with ‘‘most other OECD countries, where younger cohorts are better-educated than older ones’’.

Immigration has papered over the cracks. Not only have foreign workers increased the size of the workforce, so raising potential output, they also accounted for the bulk of the productivity improvement since 2010. Britain has not invested in its people’s future and is paying the price. Brexit, which has already resulted in immigration dropping by a third, looks like aggravating the sore.

Equally pathetic has been capital investment, by the state and business combined, which stands at 16 per cent of GDP, compared with 21 per cent on average among the other G7 nations and the OECD’s 35 members. There has been a five-point gap all millennium. UK factories are far more reliant on manual labour than automation, making the country look Third World against its neighbours. The density of industrial robots is the lowest of 20 leading nations surveyed by the International Federation of Robotics, at just 80 per 10,000 employees, compared with 520 in South Korea, 300 in Germany, 190 in the United States and 120 in France.

Investment by business is so feeble that it has fallen even below the rate of depreciation, meaning that the capital stock of the country – the sum of all our machines, factories and buildings – is not being replaced as it wears out. On an industrial scale, the UK is shrinking.

What makes the investment picture so perverse is that the UK is the global capital of finance. A country more flush with money than it could ever use is not spending enough on either people or technology. That can be nothing other than an economic design flaw. If you’re looking for the right word to define that, you could do worse than productivity.