Slower growth the ‘new normal’ in our service-oriented economy
Philip Hammond delivered an upbeat assessment of the UK economy in this week’s Budget. He opened his speech proclaiming that the UK was “an economy which has continued to confound the commentators with robust growth”. However, in terms of tax reductions and spending increases he kept his powder dry – probably waiting until he is closer to the 2020 General Election.
So how robust is the growth the Chancellor was talking about? Last year the UK economy grew by 1.8pc, and the average growth projected by the OBR for the next five years is also about 1.8pc. If the OBR forecasts turn out to be reasonably accurate, the average UK economic growth rate for the 2010s will be 1.9pc. That is slightly better than the 1.7pc achieved in the previous decade, but that performance was badly dented by the financial crisis. Taking the 2000s and 2010s together, the latest OBR forecasts suggest that the first 20 years of this century will be the weakest two consecutive decades of growth since the Twenties and the Thirties.
So the Chancellor could have begun his speech very differently – pointing to the economy’s disappointing longer-term growth performance. In the Fifties and Sixties, the output of the UK economy grew by 3.3pc on average. In the Seventies, Eighties and Nineties, the average growth rate was 2.5pc. Since 2000 it has averaged about 1.8pc – in line with the OBR forecasts for the next five years.
We are not alone, however, in experiencing weak economic growth. Only Canada among the G7 economies has achieved an average annual increase of over 2pc in GDP since 2000. US growth has been roughly in line with the UK and the performance of other major European economies has been even worse than our experience.
There appears to be a growth malaise affecting not only the UK but other western economies. It is tempting to blame short-term problems – the global financial crisis and more recently the Brexit vote. But these explanations are not convincing. By 2019 we will be 10 years on from the depths of the financial crisis and the unemployment rate is now below the pre-crisis level. And yet there is not much sign of a recovery in economic growth.
We may well see some impact from Brexit in the UK growth figures over the next few years. At PwC, we are less optimistic about the short-term outlook than the OBR. But Brexit cannot explain why the long-term growth picture is so subdued across a wide range of western economies.
There are a couple of other potential explanations for disappointing growth in the UK which can be dismissed – demographics and technology. Demographic factors may be holding back the growth rate of some major economies – notably Germany and Japan. But the UK has seen a healthy rate of population increase since 2000, partly supported by immigration. The number of people living in the UK has increased on average by 0.7pc a year since 2000, compared with an annual increase of just 0.2pc in the previous three decades.
A rising population has supported the growth of UK employment, which is expected to rise by over 10pc this decade, according to the latest OBR forecasts. This would make the 2010s the strongest decade for employment growth since the Thirties, when the economy was recovering from the 1929 financial crash and was boosted by rearmament.
A lack of employment is not the main factor contributing to the weakness of growth in the UK. It is productivity which has been the main source of disappointment. Technology and innovation are major factors driving productivity, which has led some economists to suggest that these are the main factors underpinning our growth slowdown.
But this explanation is barely credible in an era which has brought us the internet and a revolution in the way we communicate and work, through mobile phones and email. If anything, these big technological changes should have caused economic growth to speed up, not slow down. It may be that official statisticians are not properly capturing the impact of new technologies in their figures. But even so, it is hard to see how technology can account for a productivity slowdown.
So how do we explain the current era of disappointing growth? The best explanation I can see was advanced by the American economist, William Baumol, in the Sixties. He argued that many services activities have lower potential for productivity growth – because the service delivered is closely linked to the activity of the individual who provides it. Hairdressing, catering, health services and social care are good examples of activities which have low productivity growth. As these activities grow in importance relative to manufacturing, energy production and agriculture, they will drag down the productivity growth rate of the economy.
That is exactly what has happened in economies like the UK. Services activities now dominate our economy, accounting for around 80pc of output and employment.
Indeed, the UK is more services-oriented than any of the G7 economies, with the possible exception of the United States. But even in economies with a stronger manufacturing base – like Germany and Japan – services still account for more than 70pc of the output of their economies.
So if a services-oriented economy is the main reason for our growth decline – what can be done to improve its performance? Trying to turn back the tide and reverse the trend towards more services-oriented jobs is likely to prove futile. Technology and globalisation have reduced the share of UK jobs in the manufacturing industry from around 35pc in the mid-Sixties to about 8pc now.
Instead, we need to turn our attention to making the services sector activities – which dominate the UK and other major economies – more productive.
There are three big investment levers available to do that – better skills, advances in technology and more efficient infrastructure. The good news from Philip Hammond’s Budget this week is that these were the areas where he tried to invest the spare money he felt he had available.
But even with the best efforts of the Chancellor, the shift towards a more services-oriented economy will be a continued drag on economic growth in the UK and other advanced economies. We need to adjust to that, and accept that 1.5-2pc GDP growth is the “new normal” for the 21st century.
Andrew Sentance is a senior economic adviser at PwC and former MPC member
‘Brexit cannot explain why the long-term growth picture is so subdued’