The outlook for British households and firms will not improve unless productivity growth increases, writes Thomas Aubrey.
The Chief Economist at the Bank of England, Huw Pill, recently hit the headlines after mentioning in a podcast that British households and businesses need to accept they are poorer due to inflation. Pill stated that: “if the cost of what you’re buying has gone up compared to what you’re selling, you’re going to be worse off.”
While the debate about how policymakers should bring down inflation will continue, unless the UK’s dismal rate of productivity growth starts to accelerate, British firms and households will almost certainly not experience any significant increase in living standards even when inflation starts to fall.
Between 1997 and 2006, private sector productivity growth (excluding real estate) grew by 1.7% a year. This slumped to just 0.2% a year between 2010 and 2019. Since 2019 things have improved, but only marginally, rising at a rate of 0.6% per annum.
A breakdown of the contributions to this growth in Table 1 indicates that 45% of the private sector has experienced positive productivity growth since 2019 (in green), while 22% has stagnated (in blue), while 33% of the economy has contributed negatively to productivity growth (in red).
Productivity can increase when either the value added per hour increases (known as the ‘within’ effect) or labour moves into higher value added sectors (the ‘between’ effect). While most sectors did experience an increase in value added per hour, there was an overall shift across the economy of workers into lower value added services.
Table 1: Sectoral productivity disaggregation 2019 – 2022[1]
Source: ONS
The most recent quarterly productivity data indicates that between Q4 2019 and Q4 2022 the electricity sector experienced the fastest increase in productivity growth, followed by computer programming and financial services, as set out in Table 2. The reason for the boost to productivity in electricity has been the result of a significant reduction in the number of suppliers from 58 in 2020 to just 23. The number of hours worked has fallen without proportionately impacting the sector’s value-added output. While competition is generally considered a good thing in driving innovation, the recent energy crisis has indicated that firms were actually just competing on price. Their focus on driving down costs to keep prices down meant that some firms did not fully hedge the risk of a jump in gas prices, which is why so many suppliers exited the market.
Conversely the automotive and aerospace sectors continue to act as a drag on growth given the increasingly uncompetitive trading environment for UK firms now outside the European single market. On the one hand, the government recognises that the cost of multiple regulatory frameworks is a concern, which is why the use of the European trademark has been extended until 2024 – pushing back the date when domestic firms must apply for the new UK mark. At the same time, the UK government is nevertheless superimposing a regulatory framework and extra costs for UK firms resulting in a fall in competitiveness and therefore lower productivity growth. The trade policy that was pursued by the UK government with the European Union (EU) has been and will continue to be damaging for manufacturing and therefore productivity growth, given that manufacturing is a high value added sector. This was a deliberate and damaging policy choice rather than an inevitable consequence of Brexit.
Table 2: Subsector disaggregation Q4 2019 – Q4 2022
Source: ONS
A strategic approach to productivity growth
Turning to the longer term prospects for productivity improvements, although governments will always make economic policy errors, the lack of detailed sectoral plans, owned by industry, which articulate a pathway for growing value added remains a significant policy omission. Such plans would clearly stipulate their ask of government, which might be regulatory, trade related or agreeing to use procurement policy to buy innovative products, not just tax breaks for higher investment that are typically discussed. At least then politicians in favour of growth will know what policies they might need to introduce to help increase the living standards of the UK population.
While there is growing interest by governments in pursuing an industrial policy, which is to be welcome, it must not ignore the colossal policy failures made during the 1960s and 1970s. Moreover, any adjustment to global supply chains to mitigate exposure to authoritarian regimes should not result in increased protectionism, which will merely result in higher costs thereby limiting any increase in Gross Value Added (GVA) and wage growth.
The US CHIPS and Science Act, which provides $53bn of subsidies for research and new fabrication plants in the United States (US) to diversify away from Taiwan and China, has merely resulted in increased subsidies in other major chip producing countries including Korea and Japan. The real lesson from the semi-conductor industry is that to innovate and improve products requires significant cooperation across the global supply chain, not a subsidy arms race. When the Dutch firm ASML was asked by Intel to produce the next generation lithography machines, it ended up working with around 800 of the most technologically advanced firms in the world to improve the quality of components and provide ASML with the best high precision products for them to assemble the required machines for fabrication plants.
It is just not possible for a single economy, even one as large and technologically advanced as the US, to do everything efficiently. This is also why China’s 2025 Made in China strategy which aims to shift towards a more autarkic economic model is flawed.
Rather than government deciding what is best, industry should develop their plans to grow value added, indicating what support is required. Given that firms will place their own capital at risk, this should help limit policy errors. Governments can then assess these plans and provide support where it believes that value added can be increased rather than just boosting an individual firm’s profits. Until such plans or transformation maps are developed and which the government has agreed to support, the outlook for firms and households is unlikely to improve.
[1] The disaggregation uses Tang & Wang 2004
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.
