06 December 2024 Economics & Growth | Politics & Geopolitics | UK

Fixing the UK Economy

By Bilal Hafeez

Speech given to members of a leading UK political party in London on 5 December 2024.

The UK’s Fundamental Problem: Productivity

Rather than talking about the recent UK budget or other such announcements, I would rather discuss the broader context of what hampers the UK economy. From there, we can then understand which are the right policies to implement.

At its heart, the fundamental problem is that the UK is not productive enough. In the long run, productivity growth is what generates the bulk of economic growth, especially when the working-age population is growing more slowly (as it currently is). Higher productivity leads to broader prosperity for all.

In the UK, however, productivity growth has been declining since the 1970s. This is true across the advanced economies from the US to Germany. So, to some extent, the decline is the natural phenomenon of maturing economies. But the UK stands out for its anaemic productivity growth since 2008. The UK has lagged the US and comparable European countries like France and Germany.

Why is this? Numerous explanations have been put forward, but I will focus on three: the UK’s chronic underinvestment, the long tail of low productivity firms, and the over-centralisation of government.

Investment

Starting with investment, the statistics are stark. The UK has the third-lowest investment rate in the OECD – only Portugal and Greece are lower. Others like the US, France, Germany and even Estonia and Czech Republic are higher. The UK suffers from both low private and public investment.

On the private side, poor tax incentives hold back investment and R&D, but also the labour market. While the UK has a very flexible labour force, it also has low competition between firms, which results in a low-wage and precarious labour force. Firms are then inclined to get cheap labour rather than invest in capital. Put another way, if your workers are low wage and easy to fire, why invest in making them more productive.

Firms in continental Europe, meanwhile, have higher-wage workers, and firms are forced to invest to make them more productive to justify the wage expense. The US has a labour market more like the UK’s, but firms are more competitive, forcing them retain and invest in talent.

Then on the public side, investment has been low in the UK – whether in infrastructure, health or education. Better public investment can lead to more private investment, especially if it is in areas where the private sector would not normally invest. This would naturally include health and education, but infrastructure such as internet/wifi access and transport also matter. Imagine if every part of the country had fantastic wifi access!

On transport, while tempting to focus on high-profile projects like HS2, which connect the North to London, research suggests that transport links within cities and towns are more important to productivity. So rather than connecting Birmingham to London, it is better to improve local transport within Birmingham, Leeds and so on. This would then allow workers to move more easily within cities to the best work opportunities.

UK government policy could fix the underinvestment problem with better tax incentives, higher minimum wages and job protection (e.g., ditch zero-hour contracts), improved competition policy, and more public investment in the right kinds of infrastructure.

Long-Tail Problem

Does the UK lack innovation? After all, it has some of the world’s top universities and it has a thriving start-up scene compared with Europe. Or is the problem that the innovation fails to spread through the economy?

We find it is the latter – and the data backs us up. Outside finance and the arts, all UK sectors have lower productivity than France and Germany. But when we look within each sector, we find that the top UK firms are very productive and as good as, if not better than, other countries. The trouble is that the rest of each sector is filled with a long tail of low-productivity firms. This suggests there is a low diffusion of skills and innovation from frontier firms to the rest.

How do we solve this? For one, it is important to recognize the problem. Too often government policy focuses on the frontier firms and the innovators, but that is not where the problem lies – the UK has cutting-edge innovators. The problem is that ideas are failing to spread.

To fix this, one option is using the UK’s impressive network of universities. Almost every city has at least one university. These could become hubs to connect frontier firms to the long tail. Ecosystems could be created to channel R&D from the universities to a broader set of firms.

Another approach could be to twin frontier firms with a long-tail firm. The incentives would need to be right, but perhaps the frontier firms could get tax rebates if they have a twin.

In any case, we need to recognize that the UK is very innovative, but it needs to spread its innovation more broadly.

The Curse of Over-Centralisation

The UK has a remarkably centralised government dominated by London. This has its origins in its Empire days when Britain ruled its colonies in a centralized manner. Ironically, it has kept those habits even as the Empire has ended, with London ruling the rest of the UK in a similar style!

The problem with centralised policymaking is that it makes policy very fragile to shocks. Take the 2008 financial crisis or COVID. There were numerous possible policy responses all with reasonable chances of success. Ideally, you would want to run policy experiments across the country, see which works, then run with those.

In a country like the US, this happens naturally with the interplay between federal and state-level policies. California tries one thing, while Texas another. You can see which policies fares better, and other states can copy. In this way, you avoid making a big bet on one policy that, if it goes wrong, leaves the country with years of pain.

The UK meanwhile has a highly centralised policymaking with little actual power decentralized down to regions, cities and local authorities. And the trend if anything has been moving towards more centralisation. This has likely contributed to alarming economic disparities across regions in the UK.

What does not help is the first-past-the-post electoral system that pushes the UK into the direction of ‘elective dictatorship’. Countries like Germany or Switzerland, which have proportional representation (PR), also have more decentralized power. The PR system naturally forces more power sharing between competing blocs. In the case of the UK, this would help break the deadlock of centralisation and open the way to decentralisation.

But even if PR is not adopted, the UK has in the past devolved power to Scotland and Wales, so there have been bouts of decentralisation. These could be re-invigorated by shifting more decisions and power down to sub-national units whether regions, counties, cities or local authorities. This would necessarily mean the ability to tax, control spending and regulation.

UK 2.0

In the end, while there is productivity problem in the UK, it is not terminal. Rather, with some clear-sighted thinking and an eye to the long-term, the UK could end up becoming one of the most productive countries in the Western world.