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UK productivity growth stalls – does this threaten future economic growth?

Economics Weekly: UK productivity growth stalls – does this threaten future economic growth?

Why is productivity so important?
UK productivity growth has been in the news a lot in recent months. Partly, this is because the UK Chancellor, Gordon Brown, has made improving UK productivity one of his main stated aims of giving the economy long term stability and strength. However, another reason is that recent data have not supported this vision of an improving UK productivity performance, least of all in the last decade, and certainly not in the period that labour has been in power (since May 1997) or against other major economies. This week’s briefing looks at some detailed UK productivity figures for clues about what has been happening at the industry level in the last few years.

To start with, however, why is productivity growth deemed so important? The short answer is that economic growth can be viewed as being composed of 2 main elements: growth in labour force and productivity. The latter being the ability of the labour force to utilise technology, management techniques, etc, to produce goods and services. Therefore, if productivity gains slow, then economic growth slows and living standards do not rise as quickly. This means a reduced tax take for the authorities and less to spend on things like health and education. It also implies higher and perhaps more variation in interest rates on average over time, as decreasing productivity growth will reduce the speed limit of the economy and its ability to grow without generating inflation pressure.

...it generates economic growth, raising living standards and tax revenues
According to latest data from the Bank of England, annual UK productivity growth was just 1.6% in 2005, well down from the 2% plus rates seen in the early 1990s and the slowest increase since 1993. More worryingly for the authorities is the fact that in the December 2005 pre-budget report, the government assumed that productivity would grow by 2.2% a year, underpinning a view that economic growth would be 2.5% a year, which in turn underpinned the assumptions made about tax revenues and so public spending. But if productivity is only growing by 1.6% a year and assuming that the labour force expands by 0.5% (the same as in the last 10 years, which may be too optimistic), then trend economic growth would only be 2.1%. This is well down on the 2.8% a year recorded in the last decade, which some had estimated to be the trend.

Why has productivity growth slowed?
In recent months, figures have shown that the UK economy’s success in growing at a 2.8% rate since 1992 has been more down to working longer hours and to an increase in the number of people employed, rather than to increasing productivity. The UK is simply not as good as the US, for example, in utilising new technology and management skills in organising employees at the company level. This is also true for other European countries, like Germany and France, where lack of labour market reform seems to have hampered their economies. But UK productivity growth has not pulled ahead of either of these two economies in the last 10 years, even if its rate of economic growth has been faster.

Recent research at the London School of Economics suggests that up to 80% of the productivity difference between the UK and the US is down to the use of computers, so this is not a quickly reversible situation. Moreover, the UK has deficiencies in educational skills, research and development spending and innovation and transport. All this means that there may have to be tough choices about public spending made in the years ahead. If the tax take is reduced, then public spending has either to be cut or borrowing has to be increased. Perhaps there will be an increase in public sector debt issuance in the years ahead, which may raise yields from their current exceptionally low levels.

Chart a and table 1, on page 1, show that UK productivity growth has averaged 3.6% a year in manufacturing since 1996, but just 1.6% in services and the same rate for the overall economy. But this analysis is usually concerned with aggregate measures of productivity and not with what is happening at the industry level. To get a better idea of what may have caused productivity to weaken in the last four years, we have estimated productivity by industry sectors in the UK using workforce employment trends relative to output growth. Chart b shows the result of this for some key manufacturing sectors and chart c for the key service sectors.

Productivity by industry sector shows some surprising results
Productivity is one area where manufacturing can point to some success; it has actually been improving its productivity strongly in the last 10 years, as employment has fallen. Textiles and clothing, the most international of sectors, have been growing productivity the fastest, but the chemicals industry and food, drink and tobacco are not far behind. It is in the services sector, normally seen as the bulwark of the economy, that productivity growth has been weakest, particularly in public services. Chart c shows that transport, storage and communication services are the industries that have made productivity gains comparable to those in manufacturing, with financial services close behind and showing faster gains than the overall UK average of just 1.6%. In public services, however the increase in productivity was 0.6% a year from 1996 to 2005 and since 2000 annual growth has fallen further to just 0.3% a year.

Summary & conclusions
Business investment spending has been weak in recent years. This may help to explain weaker productivity growth and hence weaker growth in the economy. A switch to labour intensive public sector jobs may lie behind some of the overall weakness of productivity in the last few years. Since the 1999/2000 financial year, public spending has risen by some 5 percentage points of gdp, or roughly £55bn. The challenge for the UK authorities is to increase public sector efficiency and to encourage an increase in private sector business investment, so as to kick start productivity growth. Otherwise, there will be less of the gains made from economic growth for the authorities to share out in terms of public spending, whichever government is in power in the years ahead.

Trevor Williams, Chief Economist
trevor.williams@lloydstsb.co.uk
www.lloydstsbfinancialmarkets.com
Lloyds TSB Bank,
Financial Markets
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Faryners House,
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London EC3R 8BQ
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