Productivity and Growth: Priorities for the new Parliament

Dr Gerard Lyons

Friday 20th March 2015: The Budget confirmed that the economy is recovering, inflation is low, the deficit is falling and low borrowing costs have allowed old debts to be refinanced at cheaper rates. Also, according to the Chancellor’s plans, there will be a budget surplus by the end of the next Parliament which would then allow the national debt to start falling from a higher level. That was the good news, says Dr Gerard Lyons, commenting on this week’s Budget.

By sticking to his plans, the Chancellor has put a marker down for the Election with the post Budget debate focusing almost exclusively on deficit reduction and whether planned spending cuts outside the ring-fenced areas are justifiable or credible, who has suffered or gained and asking questions as to what would be the alternative.

Whereas the BBC has recently sparked an unnecessary and misleading comparison of public spending levels with the 1930s – not comparing like with like – perhaps it is the 1950s that warrants more attention. For, in that decade, Britain’s post war debt levels became less of a worry, because of strong economic growth. Just as a mortgage needs to be looked at in relation to the value of a property, so too should debt be seen in relation to the size of the economy, as measured by debt to GDP.

In recent years Government debt has been at its highest peacetime level. Hence the focus on reducing it. But after the Second World War, debt was considerably higher in relation to the size of the economy, about three times as big as now. Obviously the reasons for that post War debt were understandable, as opposed to what happened ahead of the 2008 crisis when a debt fuelled binge had taken place. Have we learned the lessons? Trouble is, household debt is forecast by the OBR to exceed its pre recession peak later this decade, despite the Chancellor’s new incentives to save. Also, we still appear obsessed by buying properties, when the focus should be building more supply. Yet we haven’t done enough of that for fifty years, although at least in London there are now attempts to address this, with people needing affordable rents and homes. As the Bank of England has previously pointed out, every UK economic boom and bust since the 1930s has been associated with a housing boom and bust. Yet, in what is, by international measures, already a high tax economy, the best way people in the UK know how to accumulate some wealth is by buying property. So the cycle persists, but it needs to be broken.

An economy does not get rich by selling houses to itself or to foreigners. Its people should not think the only way to get rich is by buying property, nor have to spend excessive amounts on rents.

The UK needs to compete more, and while recent years have seen progress as we export more to the emerging economies there is some way to go, as the high current account deficit testifies. We can’t return to the pre crisis days where the only parts of the economy that grew were driven by debt. Growth is key and this links directly into productivity, which matters because it drives an economy’s output, its potential growth rate and in turn living standards. So low productivity economies find it hard to keep up with high productivity economies. In turn in low productivity economies you have more people working or people working longer or both to produce what high productivity economies do with less.

Also, productivity affects how we view the budget deficit, and national debt. A deficit has two parts: a cyclical component that will be reduced by stronger growth; and a structural component that requires action to eradicate it namely spending cuts or tax increases. So if potential growth is lower, the cyclical component is smaller and the structural part higher. Growth, again, is key.

As we saw in the 50s, stronger growth helps make big inroads into the deficit and overall level of debt. Likewise now. Slower potential growth not only makes it harder to reduce the deficit, but it also implies that a higher proportion of the deficit is structural and needs to be addressed by spending cuts or tax increases. That is what the latest official thinking is, but it could be wrong. Potential growth may, indeed, be much higher, as the tech, scientific, digital and innovation economies kick-in, reinforcing our other areas of strength.

An economy can grow in many ways, but usually it is a combination of perspiration and inspiration. Currently the UK is seeing a big impact from the former as the size of the population soars, both because of demographics and immigration. That is fine, but what we need is more of the latter too in the form of innovation and investment, helped by much needed infrastructure spending.

The UK has a productivity gap in that historically our productivity has been less than the US or Western European economies, although prior to the crisis this was closing. The recovery has also led to much talk of a productivity puzzle, as in this recovery productivity has remained low, but then given how many jobs have been created this doesn’t strike me as a puzzle at all.

Trouble is, measuring productivity is a nightmare especially in a service sector economy, and it should not be the only gauge of how well an economy is doing. The public sector is becoming more productive but that is because jobs are being shed. You can’t keep doing that as the recent debate on defence spending suggests. In contrast private sector employment has soared. That should be good news but big parts of the economy are low paid with low productivity. Again not a surprise when you see how many work in the service sector such as in restaurants and coffee shops. From what I can see most of such staff are excellent but there needs to be more demand and spending for this to translated into higher measured productivity.

There are a combination of explanations for low productivity. Firms have held onto staff waiting for demand to recover; a flexible labour market has meant that wages have not risen and thus firms find it easier to add cheap workers; a lack of investment so workers produce less than if investment had taken place; a switch from high to low productive jobs; misallocation of capital based on the argument that low interest rates and the reluctance of banks to pull the rug out from under firms for fear of seeing bad loans rise means that zombie firms are being kept alive; as a result capital is not being allocated to potential new firms as you would expect to see in a recovery; finally it is hard to measure productivity in the financial sector and some believe that it is low and diverts resources from other areas of the economy.

The UK economy is a low wage economy in too many areas. Hence it is necessary to push up the minimum wage and to raise tax free allowances for those in work, as happened this week, ensuring also that safety nets are in place to help where needed. At the same time the UK is also a high skilled and high wage economy in other areas and the next task will be to promote high levels of skills pre- and post- 18, with the same emphasis as on raising educational standards since 2010. For these we need to remain a competitive economy for skilled and potentially internationally mobile workers and that requires taxes to stay low. And that brings us back to the need to enjoy stronger economic growth and keep the deficit down.

*Dr Gerard Lyons is chief economic advisor to Boris Johnson and author of The Consolations of Economics (Faber&Faber, 2014).