The United Kingdom’s economy is in great trouble. The inflationary effects of the energy crisis, the credibility loss due to the former Prime Minister, Liz Truss’ mishandled ‘mini-budget’ and the negative global economic outlook all pose serious challenges to those who are responsible for implementing British economic policy. Although the effects of Brexit, the COVID-pandemic and now Russia’s war in Ukraine are all negative factors in the United Kingdom’s economic malady, Britain has been struggling with a defining structural problem for a very long time. Namely, the United Kingdom has a very serious, decade-long labour productivity problem, something that underlies all its temporary economic turbulences. Where does Britain’s productivity problem come from? How could it be addressed? What lessons does Britain’s example provide to small, open, emerging economies like Hungary? Let’s dive in!
The Determinants of Long-Term Economic Growth
Labour productivity represents the total volume of output produced per unit of labour (hours worked.) Intuitively, labour productivity is calculated by dividing a country’s annual real GDP by all the hours worked during the year. To put it simply, labour productivity is a measure of how smart one country’s labourers work, instead of how much they work. Higher labour productivity is associated with higher wages and fewer working hours, two very important determinants of one’s perception of quality of life. Higher labour productivity is also associated with higher international competitiveness.
Higher labour productivity is of great importance not only to individuals but also in terms of a country’s economic performance as a whole. In the short term, economic growth can be achieved through fiscal and monetary policy or through excessive lending, but in the long term these options are unsustainable. The only factor that contributes to sustainable, long-term economic growth is increasing (labour) productivity. Namely, how well an economy uses the available but limited resources.
What are the determinants of labour productivity? At first glance, we can identify three factors that are of utmost importance. The first is capital accumulation and investment. To put it simply, the more capital a country has per capita, the higher labour productivity it achieves. Therefore, capital accumulation and investments are of paramount importance. That is a basic tenet of supply-side economics, namely that capital formation can be incentivized through low taxes and deregulation. Overtaxing capital and unnecessary regulations lead to lower investment rates and therefore lower labour productivity and decreased competitiveness. Obviously, only sound investments contribute to increasing labour productivity, therefore (at least according to free market thinkers) the state’s role in investments should be limited.
The second most important factor is the quality of human capital. Labour productivity can also be increased through investments in human capital, namely through investments in a better and widely available education system and healthcare. Whether such a system should be operated by the state or by private providers and some state support is up to debate.
The third important factor is technology and science. More innovative countries with higher research and development spending have higher labour productivity and therefore higher competitiveness.
To sum up, countries with higher investment, better education, better healthcare and more technological innovation have higher labour productivity and therefore a better shot at being internationally competitive. The means of achieving this are debatable, but free market thinkers (such as Adam Smith as he elaborated in the Wealth of Nations) generally favour low taxes, a limited role of the state, investment in education, infrastructure and technological development. Through the combination of these, higher labour productivity, therefore higher long-term, sustainable economic growth can be achieved.
The British Productivity Puzzle
British labour productivity grew steadily, by a 2 per cent annual average, between 1990 and 2007. Although the 2008-2009 global financial crisis was a huge blow to the previous years’ productivity surge in most advanced economies, the UK economy was especially impacted by the troubles. Between 2010 and 2019, labour productivity grew by an annual 0.6 per cent on average. That equals an approximately 20 per cent loss compared to where British productivity could be had the pre-financial crisis trend continued. Although the United Kingdom strongly outperformed its main European competitors during the Eurozone crisis, growth rates have started to converge in the past five years. The UK had an especially tough time recovering from the COVID crisis, being the only G7 country the economy of which has not already reached its pre-pandemic level. The OECD published quite gloomy growth forecasts for the next two years, predicting that the UK will most likely become the worst performing country amongst the G7.
Where does the United Kingdom’s productivity problem come from? To answer this question, we need to take a look at the determinants of labour productivity mentioned above. It’s not an exaggeration to say that Britain has a very serious underinvestment problem. The investment to GDP ratio grew from 17.5 per cent to more than 25 per cent between 1980 and 1990, mainly due to the highly successful free-market reforms of the Thatcher government. Since then, investment to GDP has been in steady decline with levels similar to that of 1980. Although the post-financial crisis years brought some dynamic rebound, the over-the-trend growth ended by 2016, with many putting blame on the outcome of the 2016 Brexit referendum. Although Britain’s exit from the European Union certainly did not help the underinvestment problem, it is important to emphasize that blaming the UK’s economic problems solely on Brexit would be, to say the least, ill-advised.
Britain’s productivity problem is certainly an issue, given how cheap capital goods have become and how low interest rates have been in the past ten years. Both conditions should have contributed to a persistent, long-term growth in investments and labour productivity, but as we have seen, labour productivity mostly stagnated during this period. The UK also has a problem with regional differences in labour productivity. Whereas labour productivity is more than 30 per cent higher in London than the UK average, Wales, Scotland and Northern Ireland differ by approximately 15 per cent to the negative. It is hardly conceivable how Britain’s problems could be solved without revitalizing the low-productivity regions. In the meantime, workers moving to London could somewhat improve the situation but high rents and the housing crisis in general inhibits worker flows and social mobility to a great extent.
What is to be done about the underinvestment problem? The government could both incentivize private investment through lower taxes and deregulation, or it could undertake certain infrastructure and human investments itself. Liz Truss’ stillborn mini-budget was a definite step in the direction of the former, but the timing and the composition of the package led to its early fall and the prime minister’s resignation. The fall of the low-tax Tories certainly killed the prospects of major supply-side reforms in the UK economy. Still, government investment is a highly feasible and politically much more popular option, even if it’s usually favoured by the left.
Boris Johnson’s previous levelling up agenda serves as a great example. Support for Northern revitalisation and government investments make sense economically and contributed to the Tories’ massive election win in 2019. Still, this second option has its own downsides as it can easily turn politics into a bidding game where those who promise the more win—a game the populist left is certainly a black-belt champion of. Also, increasing government investment requires additional taxation, which is highly problematic in a country where taxation is already at historical highs. Free-marketeers generally raise the point that the government is usually highly incapable of undertaking sensible investment, and imposing extra taxes would only inhibit more growth.
The bottom line is, something must be done about Britain’s underinvestment problem, otherwise the prospect of economic growth will surely fade away. Cutting taxes and deregulation are much closer to the Conservative agenda (and were the main reasons of Margaret Thatcher’s success), but politics seems to turn towards more state intervention and government investment. The Tories have a good chance of playing such an agenda well politically, just as Boris Johnson’s results have proved. Still, in this domain, Labour is a serious contender with poll numbers already well-ahead of the Conservatives’. This prospective bidding war might give unusual dynamics to British politics, but it is certainly bad news for free marketeers. Besides, there is much doubt whether it can solve Britain’s very serious underinvestment and labour productivity crisis.
The Lessons to Learn
Increasing labour productivity is the most important determinant of sustainable, long-term economic growth. More investment, both in human and physical capital and technology, are of paramount importance in order to achieve it. The United Kingdom has had a very serious underinvestment problem that has been going on for decades now. The reasons of it are unclear, as capital goods have become much cheaper and interest rates have been low for quite some time. The free marketeer answer to increasing investments is to reduce taxes and deregulate the economy, but Liz Truss’ mishandled mini-budget and her resignation served a huge blow to the appeal of free market solutions. The alternative is state-run investment that is much more feasible politically but might easily turn to a bidding contest between political rivals and more taxation that inhibits further growth.
The British example is also a great case study for emerging, open market economies like Hungary. Such countries can only grow sustainably through export-driven investments that contribute to increasing labour productivity and finance its foreign capital imports. Therefore, countries like Hungary definitely have to create a business-friendly environment with low capital taxation, limited state intervention and a competitive labour force. Technological innovation can also serve as a great contributor to increasing labour productivity. By taking these aspects into consideration, countries like Hungary can avoid the British malady of stagnating productivity and sluggish economic growth.