Fill the productivity gap and the growth will follow

Our economy is running below a sustainable level in the long-term. We need a stronger service sector if it is to recover to something like full health

What is the UK’s sustainable long-term growth rate and has it changed for the worse? It is a question for the entire developed world but it’s a particularly important one for us since we are wrestling with the largest public-sector deficit, relative to GDP, of any large Western economy. If growth remains achingly slow, the burden of that debt becomes all the harder to tackle.

For the past century, the underlying growth rate of the UK has been around 2.25 per cent a year, a rate of course affected by wars and recessions but evening out over the years. Growth has been driven mostly by increasing productivity and participation in the labour force but also by steady rises in population. So improvements in living standards have been somewhat slower than growth in the total economy.

Nevertheless, we have not had to face, at least until recently, the possibility that there will be no overall rise in living standards for the next generation, something that seems to have happened in the US. Indeed, in the middle 2000s the Treasury wondered whether there had been a long-run upward shift in Britain’s growth potential, with the underlying rate more like 2.75 per cent.

At the time it seemed plausible, for we seemed to be managing that sort of growth without too serious inflationary pressures, but it’s now accepted that the growth rates achieved then were not sustainable. Private demand was artificially inflated by excessive personal borrowing and public demand by continuing annual budget deficits.

The economy is now still well below its previous peak in output although employment is almost back to its peak. (In GDP terms, this recovery has been much worse than that of the 1980s and 1990s but it has been much better in employment terms.) That would suggest there has been a sharp fall in output per person, in productivity. There probably has been some decline simply because much of the rise in employment has been in part-time work. But maybe these employees were not producing so much as was thought when the economy was at its peak.

All this leads into a debate about the real level of productivity and the output gap – the amount by which the economy is below its productive potential. Can the ground that we have lost as a result of recession be recovered, or is that wealth that has been lost for ever?

If you look at all this in cyclical terms, my guess is that the economy was running somewhat above its long-term sustainable level between 2003 and 2007, and is now running quite a bit below. So we can expect to recover some of the losses. This could take a very long time but things do eventually revert to a mean.

But what about the structural issue: has something radical changed? The argument is that it has proved easier to increase productivity in manufacturing than in services, but, for a number of reasons, the former is likely to employ fewer people – compare a highly automated car factory with the complex staffing needs of a large general hospital. So the key, in the future, will be to find ways of getting much higher productivity in service industries.

It is too big an issue to do more than sketch it, but I think that while there will be some services where you really cannot do much about productivity – care for the elderly, for example – there are many others that we have only begun to think about increasing and improving output and using fewer people to do so, including public administration. That will be the key to maintaining the underlying growth rate.

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We need skills, not just funds

What is really holding back investment in the UK? Money or confidence? The background to the new Vince Cable business bank is that there is a funding gap for small and medium-sized businesses. So £1bn of new government money is to be put behind this – which sounds a lot until you consider that the Government itself is borrowing that amount every two-and-a-half days.

This plan does, however, come on top of the existing Funding for Lending scheme set up in August, whereby the Bank of England will supply up to £60bn in cheap money to banks for them to lend to consumers and companies.

The difficulty is knowing to what extent the lack of investment is the result of a shortage of access to loans. The company sector is sitting on £750bn of cash. So what is happening? GE Capital – the financial arm of General Electric – has identified some gaps in access to funding, because mid-sized companies did not have the same access to capital markets as the giants. There was also a lack of confidence. But its biggest worry was people: how could companies find and retain skilled workers? If we have skill shortages at this stage of the cycle, what happens when eventually the economy does begin to hum?

h.mcrae@independent.co.uk

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