Although UK productivity growth has been persistently disappointing, the impending security decoupling of the United States from Europe may provide a boost to productivity growth. Higher defence spending and a shift towards European countries buying European products may raise the rate of productivity growth for those parts of the Manufacturing and Information & Communication sectors involved in defence. Thomas Aubrey argues that the Government should look to exploit the opportunity in its industrial policy.
The most recent productivity data published by the Office of National Statistics (ONS) indicates that output per hour fell by -2.3% between Q3 23 and Q3 24. Moreover, the Q4 23 to Q4 24 flash estimates shows output per hour fell again by 0.8%. This poor performance also casts doubt on the Office of Budget Responsibility’s (OBR) productivity forecast for a sustained rebound in productivity growth of 1.2% pa by 2029, which has come under fire for being too optimistic.
The OBR’s potential output forecast has productivity growing in 2024 by more than 0.5%. But the data from ONS suggests a negative outcome for productivity in 2024 – not a positive one. The OBR, however, did state that the outlook for total factor productivity – which is the efficiency of combining capital and labour to produce output – “is one of our most important and uncertain forecast judgements.”
Chart 1: Potential output growth forecast from OBR
While these headline figures provide an indication of the dire state of productivity growth across the UK economy, they provide little insight as to what is driving this negative performance. Productivity growth occurs when firms are able to sell their products and services at higher prices as a result of increased value added – while improving the efficiency of factor inputs such as labour and capital.
For example, the iPhone commands a premium price in the mobile phone market because of the value added that has gone into its design and product quality. In addition, Apple has made advances in supply chain management that have contributed substantially towards its competitive position.
The challenge for UK companies is that they have become far less competitive across many sectors of the economy. Hence, not only should the lower rate of productivity growth be unsurprising, but unless this decline in competitiveness is reversed, it is hard to see productivity growth rebounding to anything like the levels expected by the OBR.
In order to provide some insight into this competitiveness issue, the most recent ONS labour productivity data are disaggregated in Table 1 to understand which sectors are contributing positively and negatively to productivity growth, and whether the drivers of that growth are related to rising value added within the sector or the reallocation of labor between sectors with different levels of productivity.
Due to ongoing issues with the Labour Force Survey, it is not possible to undertake a complete disaggregation as there is insufficient data for A (Agriculture) and L (Real estate activities). Hence the following disaggregation covers the economy minus these two sectors.
Table 1: Sectoral productivity disaggregation Q3 2023 – Q3 2024[1]
The data indicates that only two sectors, constituting just 18% of the private sector economy, have experienced positive growth over this 12 month period (in green). Although a number of service sectors remain stagnant (in blue), which amounts to just over a quarter of the private sector economy, more than half of the private sector economy has made a negative contribution to labour productivity growth (in red).
Table 2: Sectoral productivity disaggregation Q3 2019 – Q3 2024
The longer time period shown in Table 2 between Q3 2019 and Q3 2024 indicates just how uncompetitive UK firms have become over time with just over half of the private sector contributing negatively to labour productivity growth.
In terms of the sectors in the red, it is particularly important for the UK to be able to reverse the trend those sectors which are high in value-added per hour, including Manufacturing and Information & Communication.
But unless these sectors come up with plans to grow value-added and jobs, then the OBR’s forecasts do indeed appear optimistic. Productivity growth is the outcome of what happens in firms and the extent to which they are able to generate a competitive advantage and scale up to exploit that advantage.
Despite this rather grim outlook for the UK, President Trump’s desire to end the United States’ role in European security may provide a boost to productivity growth in both Manufacturing and Information & Communication. This is because the UK still has one of the largest defence sectors in Europe with significant capabilities that can exploited and scaled up. Given the increasing rift between Europe and the United States, European countries are not only going to ramp up their defence spending, but they will now want to buy European products rather than US ones.
According to the Ministry of Defence (MOD) equipment plan for expenditure on equipment between 2023 and 2033, after spending on the nuclear deterrent, the next two largest spending commitments are on Defence Digital or cybersecurity and Ships.
Crucially, cyber security is a rapidly growing area of expertise for UK firms which now play a critical role in protecting the UK and its allies from attacks by hostile actors on core public services including hospitals, universities and utilities infrastructure. Cyber security not only accounts for 65% of UK defence exports but is growing much faster than physical products. Hence, the UK should look to support this competitive advantage and become the leading provider of cyber security products and services across Europe.
Table 3: UK Defence Equipment Expenditure
In addition there may be other areas of physical products in which the UK might become the leading European player, such as naval drones which are needed to protect Europe’s offshore energy and information infrastructure. What is also clear is that for Europe to be able to protect its citizens from external threats, the weapons platform duplication that exists across the continent will need to be significantly rationalised. Hence, those defence firms with less of a relative competitive advantage will struggle to compete in this new world.
Michael Porter one of the great writers on competitive advantage argued that “A nation’s competitiveness depends on the capacity of its industry to innovate and upgrade.” This requires firms to develop specialized factor creation which is an inherently localized process. The government should also take note of Porter’s warning that the traditional policy focus on generalized efforts at factor creation such as infrastructure, skills and general research rarely produces a competitive advantage. The government’s industrial strategy needs to therefore embrace this localised or bottom-up approach and work with firms across the sector to understand what specifically needs to be done for them to capitalize on their existing advantages.
[1] The sectoral disaggregation uses GEAD (Generalized Exactly Additive Decomposition) based on Tang & Wang (2004). The ‘within’ effect is productivity growth in activities within the sector whereas the ‘between’ effect measures the change in relative size of sectors taking into account the reallocation of labour between sectors and changes in real output prices. e = estimated as ONS does not publish these values.
The views and opinions expressed in this post are those of the author(s) and not necessarily those of the Bennett Institute for Public Policy.
