Solving the United Kingdom’s productivity puzzle in a digital age

Declining labor-productivity growth characterized many advanced economies after a boom in the 1960s, but since the mid-2000s that decline has accelerated. Against that backdrop, the United Kingdom stands out as one of the worst productivity performers among its peers. Its absolute level of productivity has persistently ranked toward the bottom of a sample of advanced economies. Moreover, in the aftermath of the crisis, the United Kingdom, along with the United States, recorded one of the lowest productivity-growth rates and steepest declines in productivity growth, falling by 90 percent. Between 2010 and 2015, UK productivity growth flatlined at 0.2 percent a year, far below its long-term average of 2.4 percent from 1970 to 2007.

Boosting productivity growth is important for all advanced economies as they navigate potential economic headwinds, such as an aging population and an ongoing shift to low-productivity services, but particularly for the United Kingdom, with an uncertain outlook for trade and investment after Brexit.

In a new paper, Solving the United Kingdom’s productivity puzzle in a digital age (PDF–749KB), we identify key reasons for the United Kingdom’s recent weak productivity performance by analyzing cross-country, regional, and sectoral patterns as well as other decompositions of aggregate statistics (see sidebar, “Our methodology”).

We find that four phenomena—financial sector boom and bust, employment growth, investment decline, and uneven digitization—explain the UK’s larger decline in labor-productivity growth. Across all the countries we analyzed, we identify the potential for at least 2 percent productivity growth a year over the next ten years. However, capturing that potential in the United Kingdom will take time and require policy makers and businesses to take decisive action in key areas. These include skill building for the existing and future workforce and managers; accelerating adoption of digital technologies through better information, access to finance, collaborations, and a favorable policy environment; and promoting additional investment and exports.

What happened to UK productivity growth after the crisis

The United Kingdom went into the financial crisis with low labor-productivity levels compared to peers, about 20 percent lower than for Germany and France and in line with Italy, and this remains the situation today. Indeed, during the crisis, the decline in productivity growth in the United Kingdom was more severe than in Europe (Exhibit 1). Between 2010 and 2014, UK productivity growth averaged –0.2 percent a year. Since 2014, the productivity picture has improved somewhat, and from 2014 to 2017 productivity growth averaged 0.9 percent a year. Despite this improvement, UK productivity growth remains below that of European peers such as France and Germany.

Exhibit 1

The United Kingdom’s productivity-growth slowdown was broad-based across regions and sectors. Every single UK region saw a productivity-growth slowdown relative to the period before the crisis. This suggests that, even though productivity levels between regions and local areas in the United Kingdom are very different, the underlying reasons for the productivity slowdown were common across geographies. The decline was also broad-based across sectors, with 83 percent (24 of 29 sectors) experiencing a productivity-growth slowdown. While this was in line with the United States, the slowdown across sectors in the United Kingdom is broader-based compared to its European peers.

Although the slowdown was broad-based, finance and manufacturing had an outsize impact relative to their share of the economy in the United Kingdom as did a drop in total-factor productivity (TFP) growth. Despite making up less than 20 percent of UK value added and employment, the decline in productivity growth in these sectors combined accounted for nearly half of the productivity-growth slowdown. This reflects the fact that these two sectors were the largest contributors to a wave of particularly strong productivity growth pre-crisis and saw a particularly dramatic slowdown post-crisis. We also find that declining TFP growth, which reflects the efficiency that inputs including labor, capital, energy, materials, and purchased services are combined to produce output was a discernible drag that either did not occur at all in other countries or did not occur to the same extent.

 

Why UK productivity growth slowed so much

We find that four phenomena explain the UK’s larger decline in labor-productivity growth: financial sector boom and bust, employment growth, investment decline, and uneven digitization.

The boom–bust cycle in finance played a more significant role in the UK productivity-growth slowdown than in Europe or the United States

Annual financial-sector productivity growth slowed 6.1 percentage points in the United Kingdom in the post-crisis period compared with the pre-crisis period, more than double the slowdown in the US financial sector. Even in the United States, which also experienced a significant boom–bust cycle, the financial sector accounted for only about 10 percent of the productivity-growth slowdown, compared to 20 percent in the United Kingdom.

The outsize impact of finance in the case of the UK productivity-growth slowdown is partly due to the extent of the boom ahead of the financial crisis. In the period 2000 to 2005, productivity growth in the financial sector in the United Kingdom was on average 5.4 percent a year, compared with 2 percent in the economy as a whole. This boost was associated with accelerating value-added growth as loan and deposit volumes grew, helped by leverage.

Then came the crisis, and with it a significant demand shock to the UK financial sector. The result was a severe decline in productivity growth to an annual average of –0.7 percent a year in the 2010 to 2015 period. When loan and deposit volume growth fell, UK banks could not readily reduce hours worked to match that decline. High fixed costs in banking, such as IT infrastructure and branch networks, make it hard to reduce staff quickly in the face of declining loan and deposit volumes. For example, loan volume growth dropped from a rate of 12 percent pre-crisis to –1 percent post-crisis, but from 2010 to 2015, UK banks reduced hours worked by only 0.2 percent a year. In addition, banks needed to add staff in response to regulatory changes, particularly in areas involving risk and compliance.

The outsize role of finance in the UK productivity-growth slowdown also helps explain the large drop in the UK’s TFP growth, a drop that was not common in peer countries. We calculate that the financial sector accounted for about one-third of the total decline in TFP growth, manufacturing a quarter, and the information and communications sector another quarter.

As demand recovered, growth in hiring was far ahead of European peers and exceeded pre-crisis rates, pointing to an employment puzzle

UK firms hired labor nearly as fast as output grew across regions and sectors, rather than investing in capital or improving efficiency. This focus on employment over investment acted as a broad-based drag on productivity growth. Why did UK firms add hours at such a high rate while demand growth recovered only moderately? We believe explaining this “employment puzzle” is key to understanding the UK productivity-growth slowdown.

The increase in hours worked growth reflected not merely a rebound from the financial crisis but additional hiring, especially among the young and old. Today the UK employment rate stands at a 50-year high. Hours-worked growth in the period after the financial crisis was about three times the average rate of our sample of advanced economies (Exhibit 2). Both labor supply and demand factors contributed to this employment puzzle. An expansion in labor supply, with more people willing to work for lower wages, may have been influenced by policy initiatives such as new apprenticeships, an increase in the state pension age, and rising university tuition fees. In an environment of increased employment and flexibility of the labor market, wage growth was also slow. This in turn encouraged companies to hire labor instead of investing in capital—especially in the post-crisis environment of uncertainty.

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