Musical example
The services sector cannot raise productivity as a factory can
Once again, we received disappointing news on UK productivity this week. Output per hour worked fell by 0.5pc in the first quarter, even though it is still a little higher (0.3pc) than a year ago. This continues a pattern of weak productivity growth since the financial crisis. UK output per worker in the past decade has been just 0.2pc a year, a fraction of the 2.1pc per annum achieved from 1980 until 2006.
This is not just a UK phenomenon. All the G7 economies have experienced a sharp productivity slowdown since the financial crisis. Germany has seen no increase in productivity over the past 10 years and in Italy, output per worker has been falling on average by 0.5pc a year. The UK is not the worst G7 performer. Even the US – top of the G7 productivity growth table since the crisis – has seen less than 1pc annual productivity growth since 2006.
It seems unlikely that the whole of the western world has decided to stop working so hard, or that businesses have voluntarily slackened in their drive to improve efficiency. So how do we explain this persistent productivity slowdown across so many countries?
There have been three factors at work – which have affected all the richer advanced economies in the world to some degree.
The first is the shock of the financial crisis in 2008-9 and the volatile and uncertain period for the major economies since then. Unexpected political events – Brexit, the election of Donald Trump and the outcome of the recent general election – have added to this feeling of uncertainty.
Businesses find it much easier to raise productivity – by investing in new plant and equipment and employee skills – when economic growth is steady and predictable. They can then plan sensibly for the future. It is much harder to do that in an uncertain and volatile climate.
The second influence has been the policies that central banks and governments have adopted to deal with the aftermath of the financial crisis. We have had extremely low interest rates for nearly a decade and large injections of quantitative easing.
While these policies may have helped to support employment and business activity in the short term, they are not good for long-term productivity growth. Productivity tends to improve most rapidly when businesses are challenged to make a substantial positive financial return, not when interest rates are exceptionally low and negative in real terms.
Another area where post-crisis policies have not helped is the increase in regulation. Banks and financial institutions have faced a new wall of regulation, and there has been a general mood to use regulatory interventions to tackle other areas of business. Well-designed regulation is essential for a healthy economy and society. But excessive and poorly designed regulation dampens business dynamism and flexibility.
Third, the UK faces an inevitable productivity slowdown as we shift to a more services-oriented economy. About 80pc of UK employment and output is now in services, compared with 10pc in manufacturing. Construction, agriculture and energy make up the other 10pc.
Historically, the manufacturing industry has delivered much stronger increases in productivity than services. A large proportion of services activities rely on a personal interaction with an individual or group of individuals, who provide the service required – whether in retailing, restaurants, health or education. This limits the scope for productivity growth as conventionally measured.
William Baumol, the US economist who sadly passed away recently at the grand age of 95, highlighted this issue
‘We need a much more committed approach to skills development and infrastructure investment’
in the Sixties. He pointed out an orchestra could not achieve the same productivity growth as a manufacturing plant. His insight became known as “Baumol’s cost disease”.
The application of technology may generate more productivity growth in some services industries but this relies on statisticians calculating the economic benefits of these new technologies properly – a major challenge in the rapidly changing 21st century economy. It is a lot easier to measure the output of factories than to calculate the way the internet may or may not be boosting living standards.
Some of these factors that are dampening productivity growth may be short term, but others are clearly long term, especially the impact of the move to a more services-oriented economy. We used to regard 2pc annual productivity growth as the norm in the UK, US and the best-performing economies in Europe. Now it looks like 1pc productivity growth would be a good performance in the “new normal” for major economies in Europe and North America.
Can we do anything to reverse this declining productivity trend? The answer is yes – but it requires much more bold and radical policies than we have seen in the UK in recent times.
Investment in skills and education is vital – but not just at the university level. We have a long-standing weakness in technical and vocational education that needs to be corrected. That means putting much more support behind apprenticeships and further education colleges.
Investment in transport and other aspects of infrastructure is another way to improve efficiency and productivity in a modern society. However, it takes the UK a long time to agree and develop plans for major transport infrastructure projects – and then we often see further planning and construction delays before we put concrete and steel on the ground and deliver economic benefits.
In 2000, the then Labour government launched a consultation on airport capacity – and the current plan is to have the new Heathrow runway operational by 2025. But this whole process takes too long. In China, dozens of new airports are being built and many others expanded every year.
A further area where the UK could act to boost productivity is through tax reform – making the tax system more simple and conducive to productivity growth. Yet there has been little appetite for radical tax reform in the UK since Nigel Lawson was chancellor in the Eighties.
The shift to a more services-oriented economy may limit our scope for boosting productivity growth in the UK. But many of the key levers are in our own hands. We need a much more committed approach to skills development, infrastructure investment and tax reform if we are to reverse the trend towards declining productivity performance.