The UK’s productivity puzzle

As the UK leaves the EU this week, we look beyond Brexit to discuss a key long-standing challenge facing the UK economy – the ‘productivity puzzle’. Since the Great Financial Crisis, UK productivity growth has been exceptionally weak. More than a decade after the Crisis, UK labour productivity remains ~20% below its pre-Crisis trend[1]. In other words, had productivity grown as fast as it did pre-Crisis, the average UK worker would have been ~20% richer today. To make things worse, the UK’s productivity slowdown appears to be deeper than that experienced by its developed world peers.

Why is productivity important?

In economics, productivity is simply the amount of output a worker can produce. It’s a bland definition, but the link between productivity and human welfare is anything but. It’s been said that ‘productivity isn't everything, but, in the long run, it is almost everything’[2]. That truth can hardly be overstated. Productivity growth affects every facet of our lives, from our wages to our pension returns. Over the long-run, a society’s standard of living is largely dependent on its productivity. Whether tomorrow’s generation will be better off than the current one, hinges on whether they will be more productive.

What’s behind the productivity puzzle?

There are two fundamental parts to productivity growth – technological innovation itself, and then the adoption of that technology by the masses. A helpful analogy would be the way in which office workers moved from working with pen and paper to laptops. Someone first needs to invent the laptop, alongside all the helpful labour-saving tools contained within. Then, firms need to equip their workers with these laptops, who then need to work out how best to use them. Explanations for the productivity puzzle usually claim that some part of that process has gone wrong. The prominent ones include[3]:

1.      Mismeasurement of productivity

As the tech sector occupies an increasingly large share of the economy, it’s possible that economic growth has been underestimated. It’s not easy to measure the contribution of Facebook or WhatsApp to the economy. If growth is indeed higher than suggested by official measures, productivity growth is likely understated as well. Using the laptop analogy, there’s nothing wrong with the process. Rather, it’s just that the statistics are failing to recognise the extra output achieved by switching to laptops. The productivity puzzle is a benign statistical illusion.

2.      Slowing technological innovation

As noted above, productivity growth is at least in some part dependent on technological progress. An office worker is likely going to be more productive using a laptop today rather than just pen and paper a 100 years ago. Some argue that the pace at which new productivity enhancing technologies are developed has slowed. This may sound like bunkum in a world where technological marvels seem to hit the stores on a daily basis. However, it may simply be hard to replicate the revolutions in human affairs that were driven by seemingly prosaic innovations such as indoor plumbing. So goes the argument anyway.

3.      Lack of investment

The problem isn’t that we have stopped developing new technologies. But rather, we’re investing less in them. For example, the finance sector (still reeling from the Crisis) may have become less willing to provide funding for business investment. New ‘laptops’ are always being invested, but firms just aren’t providing them to workers.

The above are just some of more widely known explanations for the productivity puzzle. There are many others, but beyond the scope of this discussion. Today, most economists agree that all explanations are at play rather than a single one.

What can we do about it?

Proposed solutions to the productivity puzzle usually focus on tackling the second and third causes listed above.

The second cause is harder to tackle, because it is somewhat beyond our control. Yes, we can invest more in startups and education. We can encourage more R&D from companies through tax incentives. We can make the UK a more attractive place for scientific talent. But technological breakthroughs owe as much to luck as to effort (e.g. penicillin, X-rays, the microwave oven). Measures to spur innovation can make the next productivity-boosting invention likelier, but it doesn’t pre-ordain them. The economy isn’t a giant mechanical clock. There’s no inherent reason why the world will undergo a new industrial revolution every century. It’s also worth noting that productivity growth has slowed throughout the developed world, not just the UK. This suggests that the problem doesn’t just lie with UK inventors, but the wider world as well. Spending more on domestic innovation probably wouldn’t move the dial much.

The third cause is of particular interest to the UK. It seems that the UK has a higher proportion of underperforming firms relative to its developed peers[4]. This tail of underperformers explains a large part of the UK’s productivity slowdown. Furthermore, there seems to be a link between their dismal productivity growth and a slower adoption rate of new technologies. Thankfully, more can be done to fix this. Policymakers can incentivise firms to adopt new technology at a quicker pace. New institutions can be set up to encourage the diffusion of technology among firms, as seen in our peers (Germany is a good example). Links can be strengthened between university research hubs and the private sector. The point is that there are feasible ways to raise productivity growth, without having to wait for the next technological breakthrough.  

Investment conclusion

We don’t pretend to know whether productivity growth will eventually rebound in the UK. Nevertheless, we should be wary of extrapolating a lull into a depression. Past productivity growth often comes in waves, so looking at the rear-view mirror doesn’t tell us much about future productivity trends. For all we know, the next productivity growth spurt may just be around the corner, driven by new technologies in the fields of robotics and artificial intelligence. Investors who want to benefit from any potential productivity boost are best served by owning a diversified stake in its main beneficiaries – the corporate sector.

[1] Britain’s productivity crisis in eight charts – Financial Times (Aug 2018)

[2] The Age of Diminished Expectations: U.S. Economic Policy in the 1990s – Krugman (1997)

[3] The UK productivity puzzle – Bank of England Quarterly Bulletin (Q2 2014)

[4] The UK’s Productivity Problem: Hub No Spokes – Haldane (Jun 2018)