Written on 22 Jan 2021 by Thomas Aubrey

Why policymakers must focus on sectoral productivity dynamics

Looking at sectoral productivity performance can help policymakers fully understand how they might support potential growth sectors, writes Thomas Aubrey, Founder Credit Capital Advisory.

Since the financial crisis, UK national labour productivity figures have fallen dramatically below their long-term trend. Between 1997-2006 labour productivity grew by 23%, but only by 3% between 2010-2019. This has led to much hand wringing amongst policymakers and economists as to why this has happened. The CFM survey has produced a very useful summary of economists’ views as to what has caused this slowdown, which mostly focus on falling demand followed by labour market and training issues. Hence many economists have argued that the best policy to transform productivity is to invest more in human capital.

Chart 1: UK output per hour

TA Chart 1

Source: ONS

However, this approach to public policy assumes that policies to improve productivity can be reduced to broad national levers such as better training or more capital investment. Productivity growth tends to be concentrated in certain sectors, so the aggregate figures do not provide sufficient insight into what is happening inside firms of different kinds. Hence it is critical to look at what is happening in different sectors of the economy and understand why they are changing.

Earlier work has undertaken a sectoral analysis (Riley et al (2018) and Tang & Wang (2004)). This methodology decomposes aggregate, national productivity growth by sector. Furthermore, this disaggregation looks at whether changes in productivity growth are caused by changes in value added by firms in the sector, or by them getting bigger as measured by employment share. Without understanding these drivers, it is hard for policymakers to provide much of a boost to productivity. 

Although the comparison of productivity growth between 1997-2006 and 2010-2019 of 23% and 3% growth suggests a huge negative productivity shock in the latter period, a sectoral analysis indicates the need to take a more nuanced approach.

Firstly, the real estate sector is removed from the comparison given that its output is largely composed of  imputed rent from owner occupied dwellings which is generally not regarded as productive capital.

Secondly, the public sector is also removed given the complexities of measuring output and productivity in public services. When these two sectors are removed from the analysis the relative rates of growth over the two periods are 14.9% for 1997-2006 and 2.2% for 2010-2019. These levels then form the basis of an appropriate productivity comparison between the two periods.

The disaggregation shows that the extraction of oil & gas and financial services (excluding insurance) along with ‘Auxiliary Services to Financial Services’ significantly outperformed in the earlier period and then significantly underperformed in the later period. Between 1997-2006 oil & gas and financial services productivity grew by 3.7% and then fell by -2.3% between 2010-2019.

Chart 2: Labour productivity growth of financial services and oil & gas extraction

TA Chart 2

Oil & gas production reached record levels in the first period but then fell by over a quarter in the second period. Given the downward pressure on the oil price and the relative lack of competitiveness of the industry in the UK due to higher extraction costs and diminishing reserves, there seems little chance of the sector’s productivity growth reviving.

Financial services were boosted in the first period through economies of scale by becoming the financial hub of the European Union (despite being outside the eurozone). In addition, the credit boom prior to the financial crisis resulted in high demand for new financial products, some of which were not sustainable. Revenues of the leading listed four UK banks fell by 17% in the second period.

Another sector that has seen a dramatic shift in the rate of productivity growth is construction, where it rose by 2.9% in the first period, slowing to just 1.1% in the second period. Residential dwelling construction was 14% lower in the second period, which may have reduced economies of scale. Despite the fall in the rate of productivity growth, profitability has reached record highs in the sector, possibly due to decreasing competition. Between 2008 and 2015 the market share of the volume housebuilders nearly doubled from 31% to 59%.

Chart 3: UK construction sector

TA Chart 3
Source: ONS, Refinitiv Datastream

Removing these three sectors, which have had large effects on productivity growth for quite specific reasons, leaves a residual productivity growth of 8.3% for 1997-2006 versus 3.4% in the latter period. So while productivity growth was higher in the earlier period, the difference between the two periods is not as significant as the national figures suggest. Further analysis of the remaining sectors, which account for 56% of the economy, highlight a number of other important factors.

First, a large number of sectors, accounting for 21.5% of GDP, showed a change of less than 0.2% in productivity growth between the two periods. This demonstrates that the productivity slowdown has not been spread across the economy, but instead concentrated in sectors.

Table 1: Sectors with minimal change

TA Table 1

Source: ONS

Second, a handful of sectors saw a relative improvement in productivity in the latter period, although accounting for just 5.5% of the economy.

Table 2: Sectors that had faster relative growth in 2010-2019

TA Table 2

Source: ONS

This leaves 28.9% of the economy that has seen a relative deterioration in labour productivity growth in the more recent period.

Table 3: Sectors that had faster relative growth in 1997-2006

TA Table 3

Source: ONS

From a public policy perspective, the challenge ought to be to assess the potential of each sector and understand how policies might be able to improve a sector’s competitive advantage either through increased efficiency or - more importantly - through innovation.

For example the pharmaceuticals industry, despite its recent lower rate of productivity growth, still creates a higher value added per capita in the UK than in France and Germany. The ongoing COVID-19 pandemic has demonstrated that the UK’s science base and pharmaceutical sector has huge potential to help solve global health issues. Table 4 indicates the sector has experienced a fall in value added, something which innovative new products would drive back up.

The computing sector has seen the largest increase in productivity growth, with a rise in both value added and relative size over the last decade, even though its rate of growth has slowed. However, this fast-growing sector is plagued with skills shortages, with firms creating jobs faster than they can be filled, particularly in data centres. Between 2015-2018, there was a 150% increase in demand for roles within the digital tech sector, but according to a recent British Chambers of Commerce survey three in four businesses are facing a shortage of digital skills in their workforce.

Table 4: Disentangling the between and within effects

TA Table 4

Source: ONS

Looking at sectoral productivity performance can help policymakers fully understand how they might support potential growth sectors. This might for example include support for new drug developments or ensuring that local economies are able to supply sufficient numbers of digital workers. Other areas that are likely to become relevant include reducing frictions to trade for manufacturing which have arisen as part of the UK’s withdrawal from the single market and customs union.  Purely assessing the productivity challenge in terms of broad-brush national policies fundamentally misses the point of what generates productivity in the first place, which is what takes place day to day in firms in different industries across the whole country.

  • About the author

    Thomas Aubrey

    Thomas Aubrey is the founder of Credit Capital Advisory. He has written widely on financial and economic issues including Profiting from Monetary Policy (2012) and co-authored Prediction Markets: The end of the regulatory state? (2007) with Professor Frank Vibert. He has also acted as a senior policy advisor for a number of British, European and Asian public bodies on areas including capital markets, corporate governance, housing and industrial strategy.