If The UK Economy Is Doing So Well, Why Does It Feel So Bad?

Answer: Poor productivity. And the signs are not good for future growth.

The UK election campaign is underway and the Conservative-lead government is keen to explain how well the economy is doing. Indeed, some of the statistics are impressive. The UK economy grew by 2.8 percent last year — that’s not too special by historical standards but much better than most European countries are managing these days.

The unemployment rate is 5.7 percent, which is close to pre-crisis levels and the fraction of people aged 16–64 in employment is at an all-time high.

Despite these figures, my impression is most British people feel their economy has done pretty badly in recent years. And a closer examination suggests they’re right: The economy has failed to return living standards to their pre-crisis levels and the current pace of growth is unlikely to be sustained.

Perhaps surprisingly, the key problem afflicting the UK economy is not austerity or the cost of living but something that hardly ever gets mentioned in British political debates: Productivity.

A Fall in Living Standards

Look at the graph below and you can see one of the reasons why the British public isn’t enthusiastic about this recovery. Last year, real GDP (the blue line) was almost 4 percent above its pre-crisis peak in 2007. That’s a lot better than most euro area economies.

But the UK population has grown by over 5 percent over this period, partly due to relatively high rates of immigration. This means that last year, real GDP per person (the red line) was still 1 percent short of its pre-crisis peak. This seven year period without an increase in living standards is unprecedented in modern British history and is the reason people are dissatisfied with the current recovery.

Unsustainable Trends

Still, real GDP per person grew 2.2 percent last year and if that pace could be sustained for a number of years, it would generate large improvements in living standards. However, the evidence does not point towards this growth being sustained over the next few years.

GDP per person is the product of two different economic series: The fraction of people employed and the average amount of GDP produced by those in employment. Economists call this latter series labour productivity or sometimes just productivity.

The limited economic growth in the UK in recent years has been almost completely driven by the first of the two factors — a rising employment share. It may be possible to eke out another percentage point or so in the fraction of the population employed but there appears to be limited scope for further reductions in either the unemployment rate or the fraction of people who are outside the labour market (which has tended not to change much over time.)

Other aspects of recent UK economic performance also point to the current pace of growth being unsustainable. The household savings ratio had increased somewhat during the recession as households looked to reduce the ratio of their debts to their incomes. However, the savings ratio is back near historical lows and, as Duncan points out, the UK Office for Budget Responsibility now expects household debt-to-income ratios to rise back above their pre-crisis highs. (Apparently increased house prices will make this all sustainable — what could go wrong?)

Even if you aren’t worrying about these developments triggering a new crisis, they certainly limit the pace at which consumer spending can grow and thus trigger further demand-lead declines in unemployment.

Productivity: Spectacularly Awful

These considerations mean future growth in real GDP per person will have to be driven by productivity growth. Alas, the UK’s productivity performance in recent years has been spectacularly awful. After growing at a fairly steady average pace of about 2 percent for decades, UK productivity growth has been slightly negative in the seven years since 2007. Real GDP per hour worked grew by only 0.2 percent in 2014 and remained 0.6 percent below its 2007 level.

It is this failure of British businesses to become more productive over such a long period of time that is responsible for the slump in living standards. However, productivity growth has barely featured in British public debate about economic policy, which has focused intensely on issues like fiscal austerity and quantitative easing.

There is little doubt that fiscal policy had an influence on the length and timing of the UK economy’s recovery but the current level of employment suggests the cyclical element of the recovery is now more or less over and weak productivity needs to be the focus when discussing why the recovery has failed to make people better off.

Is Low Investment the Culprit?

Digging a bit deeper, it may be possible to view the current weakness in productivity as a hangover from the Great Recession. The recession lead to a long period of low rates of investment and if this reduced the amount of capital that British employees had to work with, then this could lead to poor productivity growth. As I understand it, this is the explanation put forward by LSE economists, Joao Paulo Pessoa and John Van Reenen.

This is a tricky area. The capital stock series that are published by statistical agencies such as the Office for National Statistics don’t always match up with the concept of a productive capital stock that economists would like to use. And we don’t have great information on how fast capital loses productive capacity or is scrapped over time. Still, the estimate of the capital stock published by the ONS does not decline outright after the recession, as Pessoa and van Reenan’s does.

My own “growth accounting” exercises in my recent paper with Kieran McQuinn suggests that UK capital stock growth has swung from about 4 percent prior to the crisis to about 1 percent in recent years. We estimate that this swing is subtracting about 1 percent per year from current productivity growth but that still leaves a lot unexplained.

We estimate that “total factor productivity” — the part of productivity growth not explained by capital — declined by 1.1 percent per year from 2007–2013. Even over the longer time period of 2000–2013, we estimate average growth in UK total factor productivity of only 0.2 percent per year.

These calculations suggest to us that weak labour productivity growth in the UK may be a long-term phenomenon rather than a hangover from the recession.

Structural Reforms and Techno Pessimism

At this point in a discussion of growth prospects, most battle-hardened bureaucrats at the European Commission or OECD will state grimly that what is needed is “deep structural reforms” to boost productivity. But the UK case is in many ways similar to Finland, which I wrote about recently.

Like every country in the world, there are many things that could be done better in the UK. But, like Finland, the UK scores very well on the kind of business-friendly policies OECD and European Commission apparatchiks like to recommend, ranking 8th on the current World Bank Doing Business survey and scoring very well on the OECD’s product market regulation indicators. It also ranks well in international surveys of education systems and has a high number of elite research-intensive universities.

One possibility is that the UK is now suffering from already being close to the world’s efficiency frontier. Northwestern’s Robert Gordon, an experienced documenter of historical productivity trends, is now firmly pessimistic about the prospects for future productivity growth in the US. He believes the great efficiency-improving technological inventions are largely played out and that other trends that have boosted productivity growth (such as increasing educational attainment) have also peaked. The UK seems just as likely to be subject to this techno-pessimism scenario as the US.

There are other possible explanations but my sense from reading papers like this and this from the Bank of England is that the UK’s policy economists are pretty confused about why productivity has been so poor. Indeed, much of the analysis reminds me that Robert Solow once said

Every discussion among economists of the relatively slow growth of the British economy compared with the Continental economies ends up in a blaze of amateur sociology.

The only thing different now is that amateur sociology is now also being deployed regularly to explain the poor growth of Continental economies.

For the UK, one might hope the election campaign will bring forward concrete policy proposals from political parties on how to boost productivity. This could help to provoke a public debate about what is the key economic issue facing the country. Given the famously poor quality of British economic discourse, I doubt if that’s what we will get in the coming weeks.