One of the first articles discussing the UK ‘productivity puzzle’ was published by the Bank of England (Batten et al, 2013) in a Quarterly Bulletin. This drew attention to the weakness in the recovery from the 2008 recession. The authors compared the recovery for 24 quarters since the start of the recession using data from 1961, 1973, 1979 and 1990. The striking difference was the lack of recovery from the 2008 recession. Productivity growth had indeed declined. They also compared this result with the expected recovery based on productivity data from 1997 to 2008. This showed a gap of 16% in expected output per hour from trend.

After such a dismal recitation one might turn to the rest of the world to look at global productivity trends. The World Bank 2020 forecast (Figure 1) shows the extent of the global decline in productivity growth in advanced economies since 1990, from 2% per annum to 0.8% per annum in 2018. They have also extended their survey to include emerging markets and developing economies (EMDEs), which include China and India (Figure 1). We would expect these countries to be catching up with the advanced economies: their productivity grew from 1.4% per annum in 1990, to a peak of 5.4% in 2008. Since then, they too have declined, to an annual rate of 3.5% productivity growth.

Figure 1: Productivity change per year. Source: Penn World Table; The Conference Board; World Bank. Note: Aggregates calculated using GDP weights at 2010 prices and market exchange rates. Figure shows 5-year moving averages. Productivity is defined as output per worker. Sample includes 75 Emerging Markets and Developing Economies (EMDEs) and 29 advanced economies.

By 2019 the UK economy was still performing below its 2% trend, but it was no worse than most European countries, all of whom were lagging behind the US. But the Covid pandemic of 2020 and 2021, the implementation of the Brexit agreement with the European Union in May 2021 and the invasion of Ukraine by Russia in February of 2022 had a severe impact on the UK economy. According to the most recent forecast by the International Monetary Fund (IMF), the UK is not recovering from these events at the same rate as EU countries (IMF, 2023). The IMF forecasts a decline of 0.6% in 2023 and a return to slow growth of 0.9% in 2024 — compared to an EU growth of 1.4% in 2023 and 0.9% in 2024. Portes (2022) argues that leaving the EU has already had a negative impact on the value of sterling and the supply of labour. Over the longer term, the reduction of demand from our closest trading partners will further reduce gross domestic product (GDP) growth in the UK relative to the EU and US.

The short-term view of the UK economy published by the Office for Budget Responsibility (OBR) (Hughes et al 2022) makes grim reading:

Rising prices erode real wages and reduce living standards by 7 per cent in total over the two financial years to 2023-24 (wiping out the previous eight years’ growth), despite over £100 billion of additional government support. The squeeze on real incomes, rise in interest rates, and fall in house prices all weigh on consumption and investment, tipping the economy into a recession lasting just over a year from the third quarter of 2022, with a peak-to-trough fall in GDP of 2 per cent. Unemployment rises by 505,000 from 3.5 per cent to peak at 4.9 per cent in the third quarter of 2024.

To make matters worse, half a million people have left the labour market since 2000, there have been strikes across the public sector asking for higher wages to compensate for high inflation in 2022, government borrowing is over 90% of GDP, taxation is at the highest levels since the 1950s, interest rates are still rising, and the healthcare system is facing a systemic crisis following the Covid pandemic.

The lack of productivity growth has two impacts. The first can be seen in Figure 2, prepared by the Institute for Fiscal Studies (IFS) for the March 2022 budget. This shows that average earnings reached £30,000 in 2008, but the recovery from the financial crisis has been extremely slow and earnings have been essentially flat since then. The IFS then use the forecast from the Office for Budget Responsibility (OBR) for the following five years to show that the wage gap between 2008 to 2027 will reach £11,000 a year — caused entirely by poor productivity — a 36.6% loss compared to the pre-2008 trend.

Figure 2: Average real annual earnings forecast in Q1 2022 prices. (Joyce, 2022)

The OBR is required to produce a five-year forecast of the output potential for the UK economy, which it defines as follows:

Potential output (or ‘potential GDP’ or ‘productive potential’ or ‘supply potential’ or sometimes simply ‘supply GDP’ or ‘trend GDP’) is the value of goods and services that an economy can generate when its productive resources are being utilised at their maximum sustainable rates. We often find it useful to consider potential output as determined by three influences: (i) the available supply of labour; (ii) the available stock of capital; and (iii) the efficiency with which those two ‘factors of production’ can be combined to generate a unit of output, known as ‘total factor productivity’ (OBR 2022b).

The OBR 2022 forecast set the expected growth in TFP at less than 1% (0.7%) per annum. By comparison, before the 2008 financial crisis, the expected rate of TFP growth was 2% per annum. Over a decade, the pre-2008 economy would have grown 20% (plus any additional labour and capital growth) but in real terms the post 2008 economy has actually not grown at all. As the chart indicates, we are experiencing stagflation.

Possible Explanations for the UK Productivity Puzzle

There has been no shortage of books, articles and conferences attempting to explain the UK productivity puzzle, but two sets of explanations provide some helpful insights. The first is from Andy Haldane, formerly Chief Economist at the Bank of England. He spent considerable time on analysing the productivity puzzle and offering some diagnoses.

In a speech to the London School of Economics, Haldane dug into both the secular productivity trends and the differences in firm level performance (Haldane, 2017). His analysis of the productivity performance of the UK economy and its position in the broader international economy was both detailed and comprehensive. He observed that the rate of productivity growth had been declining in all countries (both developed and less developed) and that, in addition, there seemed to be a market failure in the diffusion process. The diffusion argument refers to economic theory which suggests that, in open and competitive markets, the success of the leading firms will encourage a combination of imitation, innovation and take-over from both leaders and followers which will, over time, reduce the productivity gap between the leaders and the laggards. He cited evidence from the UK (using ONS firm level data) that the top 1% of firms have managed to grow productivity at 6% per year while the bottom 30% have seen no productivity gains since 2008. He also reviews data from studies by the Organization for Economic Cooperation and Development (OECD), which suggests that the same lack of diffusion is not just a UK phenomenon but can be observed right across the OECD.

In a subsequent article, Haldane explains that the main difference between UK and continental firms is that the UK has a much larger ‘long tail’ of poorly performing firms within industry sectors. He analyses the productivity performance of three sets of firms — the top 0.1%, the top 1.0%, and the remaining 99% of firms — and looks at the picture by industry sector and by geographic region. The results are quite striking. Over the ten-year period from 2004 to 2014, the top 0.1% of firms grew productivity at 12% per annum; the top 1.0% grew productivity at 8% per annum, and the bottom 99% grew at only 1% per annum. Of the 14 industry sectors in the sample, only 4 increased productivity, 10 experienced no (zero) or negative productivity growth (Haldane, 2018).

A more recent study by Goodridge and Haskel (2022), who have analysed the role of intangible assets in the UK economy for more than 15 years, set out their explanation for the slowdown in the UK economy following the 2008 financial crisis. They looked at investment levels of both tangible and intangible capital, both of which declined after 2008, and found that reduction in capital deepening accounted for over 30% of the slowdown. Furthermore, these declines occurred in a small number of industry sectors which had accounted for most of the total factor productivity (TFP) growth before 2008. These sectors included finance, IT and information services, manufacture of transport equipment, manufacture of ICT equipment, and publishing and broadcasting. This loss of TFP growth in formerly high-growth sectors combined with Haldane’s long tail of poorly performing firms would appear to provide quite a good working hypothesis for the causes of the UK Productivity Puzzle.

In addition, there are several Government policies implemented over the last 20 years which might, inadvertently have contributed to reducing labour productivity. The introduction of the minimum wage has clearly benefited the lowest paid workers. By increasing the minimum wage above the cost of inflation input costs have been raised for all economic sectors. Where firms can increase output prices to cope with these costs there will be no impact on productivity, but for those firms who cannot, labour productivity will be reduced.

The same logic applies to employee pensions. With an aging population the Government calculated that many workers were not contributing into any kind of occupational pension. To assist employees in this regard the Government introduced occupational pensions to be paid for by contributions by employees, employers and the government and based on the auto-enrolment approach. These arrangements were phased in over a number of years but resulted in additional costs to employers which increased input costs.

Two further examples will suffice. These are the introduction in London of 20 mile an hour zones and the extension of the ULEZ scheme for improving air quality to outer London. While there clearly health and safety benefits from both measures there are also quite significant impacts on productivity. If it takes up to 50% longer to drive anywhere that directly reduces labour productivity of those who have to do the driving. If the vehicles of a large number of these workers are no longer driveable due to emissions, they have to bear the cost of replacing these vehicles well ahead of when this might be expected.

If the UK really does have a productivity puzzle (and all the published data says that it does) then it would make sense for someone, perhaps the OBR, to provide soundly researched advice to Government Departments on the productivity impact of legislation.

3.3 Macro-Economic Perspective on Productivity Growth Potential

OBR also produced a productivity potential forecast for the UK economy (OBR 2022b) entitled, ‘International comparison of the post-financial crisis productivity slowdown’, which can be seen in Figure 3:

Figure 3: International comparison of the post-financial crisis productivity slowdown.

This contrasts the growth rates among G7 countries during the 1998-2007 period with the 2008-2019 period. In all countries (apart from Japan), the growth rates in the first period were much higher than growth rates in the second period. But the UK’s decline in the second period was much worse than that in the US, France, Germany, Canada, or Japan, and only slightly better than that in Italy.

Figure 4 looks at the OBR’s productivity growth potential projections for 2023 to 2027:

Figure 4: Potential output growth: latest vs. pre and post financial crisis averages.

A Sector Perspective on Productivity Growth Potential

As things stand, even if the OBR’s 0.7% growth in productivity can be achieved, the impact on real wages will be modest compared to the high-growth years from 1998-2007. We have looked at the economy from two perspectives — regional and industry sector — but there is a third perspective that is relevant from the productivity perspective. This is to look at the economy by employment category and assess the productivity growth potential for each category.

Table 1: Productivity Growth Potential by Employment Category. Source ONS, Statista, author’s calculations.

In order to return to 1998-2007 trend growth rates, only two categories would seem to have serious potential. The first is large firms with above 250 employees, which were significant contributors to productivity growth during that time (particularly in the five growth sectors identified by Goodridge and Haskel). Given that this cohort of large firms will mostly include the 0.1% and 1% of very high growth firms (and that many of them are multi-national) this should be within the bounds of possibility.

The second category is larger SMEs with between 20 and 250 employees highlighted in yellow on the chart. These firms have relatively poor management practices scores and some use of digital technologies but are large enough to adopt richer management practices and digital technologies. If these can be combined into a cost-effective package this could enable these firms to close the 31% productivity gap between them and the large firm category.

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