The UK steel industry’s decline has made for for high direct job losses and indirect economic effects

Zombie nation: the challenge to tackle the UK’s productivity slump

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Boris Johnson recently claimed improving productivity would lead the UK into a golden post-Brexit future - but the UK has more than one productivity problem.

Things seemed to be going so well. From the mid-1990s, productivity improved by a third for two decades helped by automation and computerisation, figures produced by the Office for National Statistics (ONS) show. Even the bursting of the dot-com bubble was little more than a blip on the graph. Then the 2007 credit crunch clamped down on investment plans as the world’s economy hurtled into the Great Financial Crisis (GFC) of 2008.

As companies struggled to make sales in 2009, the common productivity measurements of output per hour and output per worker both fell by 5 per cent. But the fear began to dissipate, helped along by cheap lending supported by central banks around the globe. The central bank governors expected some and ideally most of this easy money to find its way to companies that would use it to invest in equipment and skills to make them more competitive. By buying up bonds and other debt, banks were meant to take more risks and fund this presumed demand. If it all worked, these more productive companies would propel the economy forward.

Now fast-forward a decade. The easy money is still there: central banks are still trying to work out if they can finally turn off the tap. After ten years, surely companies in the UK have filled their boots in order to invest in labour-saving technologies and advanced skills? Reality did not turn out that way.

It was not until 2015 that output per hour finally surpassed the 2007 peak. According to the figures released by the ONS that cover the period up to the start of the Covid-19 pandemic, had pre-GFC trends continued, labour productivity would be 14 per cent higher than the actual number. What went wrong has been puzzling economists for half a decade. It became apparent that the problem is deeper than simply being the consequence of the GFC – though it does seem to play a major role in suppressing productivity growth.

The UK is not alone in seeing a drop in productivity growth, but of the developed economies the problem seems to be worse than most. According to figures from the Organisation for Economic Co-operation and Development (OECD), the UK ranked 31st out of 35 countries in growth of output per hour from 2008 to 2017.

Why is that? Just before the pandemic hit, the Centre for Macroeconomics surveyed its panel of economists on what they saw as the causes of the productivity slowdown since the GFC. Though they identified five main culprits and there was not a complete consensus, the winner among the senior economists was low demand and its effect on efficiency. Some highlighted the austerity policies instituted by the 2010 coalition government and its successors, with uncertainty over the post-Brexit course of the UK further dampening the recovery process.

The other four main factors the experts cited were: poorly trained workers; low investment in equipment that might save labour, another likely consequence of low demand; problems with the labour market itself; and the problems of measuring productivity in an economy much more reliant on services and IT than many of its peers.

The UK is not alone in seeing investment weakening in recent years. Largely unaffected by local issues such as Brexit, Australia saw business investment weaken after 2016 in a process economists call capital shallowing. According to the country’s Productivity Institute, 2017-2018 was the first year since the mid-1990s that it had occurred. Though some of the weakening could be blamed on the mining sector getting badly hit when metals prices collapsed towards the end of 2015, the institute found investment for productivity weakening across the board.

The mining slump is also one factor in the UK’s productivity problems. Along with resource extraction, the financial, pharmaceutical, and telecom sectors loom larger in the UK economy compared to many developed nations. In a paper published in May 2018, Economics Statistics Centre of Excellence director Rebecca Riley and colleagues found that these sectors, along with the electricity and gas utilities, were responsible for three-fifths of the post-GFC productivity gap at least as far as 2016. The slump in those sectors, however, was not confined to the UK. A further irony is that UK industries that saw the biggest reductions in productivity growth tended to be major exporters and, by and large, already internationally competitive: their scope for improvement would have been limited in any case.

The figures on either side of the GFC may reflect some reversion to the mean taking place: correcting an over-inflated contribution driven by sky-high profits during the good times. Professor Jagjit Chadha, director of the National Institute of Economics and Social Research, pointed out in his 2018 Gresham Lecture that gross value added for the finance sector swung from 2.4 per cent to -2.8 per cent. Compare that to the overall pre- and post-GFC averages of 1.4 per cent and -0.9 per cent respectively. Even within finance, the figures vary dramatically. Although banking productivity declined in the past decade, possibly because of a major drop in demand coupled with a reduced willingness to lend at interest rates suppressed by the quantitative easing performed by central banks, the insurance and pension providers were among the best performers in terms of productivity growth during the past decade, according to figures from the ONS.

The boom and bust in productivity may also be partly due to measurement errors. Economists generally agree that sectors with a heavy reliance on information and communications technologies (ICT) cause more problems for conventional estimates of productivity. Many of the formulas used by economists to estimate economic growth rely on imputation rather than direct measurement. One example of this is the use of imputed rents – estimates of the rent homeowners would expect to pay for the property they own – to feed into the estimation of gross domestic product (GDP), the key metric used today for economic growth.

One source of correction may come from London School of Economics (LSE) Professor Philippe Aghion, who with three colleagues from other European institutions tried in 2017 to find a way to make the estimation of productivity more accurate in areas where upstarts replace incumbents in what Joseph Schumpeter termed “the gale of creative destruction”. Their hunch was that the way imputation was being used by statistical offices was hiding some of the growth that came about through this replacement process, which generally relies on much greater and often deflationary use of ICT by the upstarts. Focusing their work on French companies, the economists estimated that conventional calculations miss around half a per cent of output growth each year.

For the UK’s productivity problem, a revision of growth estimates that favours the high-fliers is unlikely to help propel the country higher up the league tables. The most troubling part of the productivity puzzle lies in companies that were already lagging behind.
A couple of years ago, economists working for the OECD took a closer look at what they called the laggards. Research had been piling up that pointed to a growing gap between the efficiency leaders and those who were falling behind – a divergence that started well before the GFC. In a 2019 paper written for the Centre for Economic Performance at the LSE, Dan Andrews, head of the OECD’s structural policy division, with LSE academic Chiara Criscuolo, and OECD colleague Peter Gal, argued that bigger organisations do not owe higher productivity to an ability to set higher prices but because they are able to improve efficiency faster than their smaller competitors. And the gap has been widening, particularly in services, an area where the UK has a larger number of companies.

Management quality seems to be a major factor in determining winners and losers. Stanford University professor Nicholas Bloom and LSE professor John Van Reenen, analysed performance in Europe, Asia and the US and found in their 2010 paper a growing gap since the beginning of the millennium.

Countries with a long tail of badly managed companies did the most to suppress the average score for a country, with the UK winding up ahead of France but behind the US, Germany, Japan, Sweden and Canada.

This gap may have worsened in the post-GFC climate. Because of the artificially low interest rates that have endured for more than a decade, one theory of why the gap has remained so persistent is that many of the less efficient companies are those that in a harsher economic environment would simply fold, to be replaced by nimbler competitors. But with access to cheap finance, they could limp on as “zombie firms”. The reality is more complex. The OECD team found, mixed in with the zombies, are many young start-ups and small- and medium-sized enterprises (SMEs) where the company is competing well, but the staff are putting in long hours and find it difficult to bring in the productivity investments that would let them work smarter.

Historically, these companies have grown and adapted quickly, making them ready sources of productivity growth for the aggregated statistics. The OECD found that many of these companies have in the past decade found catching up with larger competitors to be more difficult than it used to be.

The problems facing SMEs in the digital-intensive sectors when it comes to investing in productivity fall into two main categories though there seems a good chance they are related. One is that many of these companies are working in digital- and skills-intensive areas where catching up with the more efficient, more established players is becoming harder to achieve. Bloom and Van Reenen found more than a decade ago that, overall, multinationals tended to perform better in terms of management efficacy. And they generally transplanted their approach to management to the national firms they owned and acquired. This has helped drive the impression of a winner-takes-all environment, one that is only reinforced by the way in which the FAANG companies of the US have each become organisations with valuations running to more than a half-a-trillion dollars apiece.

Larger organisations may continue to pull ahead. A survey commissioned by consultancy Studio Graphene late last year found the biggest companies were far more enthusiastic about taking on digital projects than SMEs. Managers at the majority of mid-sized companies in the survey indicated that bad experiences with previous projects were acting to dissuade them from investing heavily in the current climate. Conversely, though the managers at larger players acknowledged there could be problems with these programmes, they were more willing to press ahead with new ones. The smallest companies seemed to have fewer bad experiences, possibly because they are generally younger organisations, but also indicated they were far less likely to commission these projects.

A second issue facing SMEs, and this may be a bigger problem in the UK compared to other countries, is that they have been finding it harder to raise cash they can use to invest in productivity improvements. The financing problem has raised concerns at the Bank of England as well as the Commons Treasury Committee. Philip Duffy, director of enterprise and growth at HM Treasury, told the committee in 2018 that compared with Australia, the US and some European countries, businesses in the UK look for less external finance. “When they do seek equity, they do not do as well in later rounds of equity raising and they exit the market sooner,” he said.

Duffy warned that the government-supported British Business Bank would not be enough to fix the problem and that more needed to be done to encourage pension funds to invest more in these smaller businesses. Stephen Welton, CEO of the Business Growth Fund, agreed. However, despite cajoling by government in recent years, pension funds found reasons to be even more cautious about ploughing money into UK start-ups following the problems encountered by Neil Woodford’s highly publicised Patient Capital Trust only a couple of years after its launch. Ultimately taken over by the bank Schroders in late 2019, the investment trust’s shares continue to trade at less than a third of their value at the 2015 peak, shortly after what was the biggest investment-trust launch in the UK up to that point.

It is not just equity financing that smaller companies in the UK tend to avoid trying to use. Surveys conducted by the Competition and Markets Authority and Business Development Research Consultants since the mid-2010s found that only just over a third of SMEs actively seek external finance, and when they do half consider only one provider, usually their regular bank. Close to three-quarters said they would rather grow more slowly than go through the pain of trying to borrow cash. Banks have not been keen to get involved either. A Bank of England report found it took seven years since the GFC for lending to return to pre-crisis levels. But for the big banks, even that recovery was short-lived. Since then, the high-street majors have retreated from lending to SMEs, with the slack taken up by new entrants and the tiny but growing peer-to-peer lending market. The Bank of England pushed for greater use of automated services to open up business borrowing in the UK to overcome the major obstacle of providing lenders with sufficient information to make decisions – information that historically has only been available to a company’s primary bank.

Even if they had the money, would many SMEs put it to good use? Not without help, according to some research carried out in the UK over the past half-decade. The University of Gloucestershire’s Centre for Innovation and Productivity interviewed SME managers in 2016, and though many acknowledged the value of improving productivity they lacked the ability to measure it and implement the necessary changes.

Though the picture looks bleak for the UK, there is room for optimism. The productivity puzzle looks as though it might have some solutions, but it’s not down to a single fix. It will probably need to take in everything from labour skills to financing.

A workforce with better skills that is better able to take advantage of technology was the driving force for the government’s recent embrace of the concept of lifelong learning, one that the OECD promoted in its laggards report. However, the main changes do not kick in until the middle of this decade. In November, during his conference keynote to the CBI of which he is president, Cobra Beers chairman Lord Karan Bilimoria demanded: “The lifelong-learning loans are only starting in 2025. Why are we waiting? We must start now.”

Further off is support for business leaders, and it is not entirely clear how well interventions will work. As part of the government’s Business Basics Programme, the Enterprise Research Centre (ERC) at Aston University ran a project called Business Boost a couple of years ago that attempted to teach 150 micro-businesses good practices for expanding but as part of a randomised controlled trial, with another 150 just acting as a control group. Though the trial was too short to indicate a follow-through in productivity, the project showed many of the businesses did engage with better planning and measurement. However, a third of the companies dropped out for various reasons. Finding ways to make the training more practical for managers and owners may prove to be as important as the teaching itself.

When it comes to funding, the growing decentralisation of finance through initiatives such as Open Banking may provide those companies with some of the benefits enjoyed by their much larger peers. Multinationals can sidestep banks and go directly to the bond markets to raise cash without the risk of share dilution that is the inevitable consequence of raising money from private equity.
One issue with finance might be the longstanding focus on R&D tax credits as a means of stimulating investment. The OECD, and a 2020 report prepared by the ERC, recommended direct grants and procurement programmes as more likely to reach the SMEs and other companies that lag behind in productivity.

With so many changes seeming to be needed, the UK continues to face an uphill struggle to improve productivity and with it competitiveness overall, particularly in a world where the giant US-headquartered organisations continue to pull ahead, and pull investor cash with them.

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