John Mills

Why is UK productivity so low?

Why is productivity growth in the UK so low? The answer is nothing like as mysterious as it is often cracked up to be. It is both because we invest far too little and because the return on what investment we do undertake is far lower than it could and should be.

The world average percentage of national income which is spent on investment rather than consumption is 26%, and about 45% in China. In the UK, it is barely 16%. The world average overall rate of return on all investment has recently been about 14%. In China, however, it has recently been 25%. In Japan, it was 35% for the whole of the1950s and 1960s. Between 2005 and 2016 it was only 8% in the UK – but just in case you think the UK always lags behind, look at what happened to us as we geared up for World War II. Between 1934 and 1941, we chalked up a return of 37%, better than almost anywhere else, as our manufacturing base was hugely strengthened. This is why we staved off defeat in 1940.

Why is the UK’s return now so low? The reason is that lots of investment – not just in the UK but everywhere else too – produces an overall return of little more than the rate of interest. This is true of almost all public-sector investment – in road, rail, schools, hospitals, housing and public buildings but also in a large proportion of private sector investment too – in office blocks, shopping malls, new restaurants, and IT support.

It is only a narrow range of other types of investment – in mechanisation, technology and power – which produce much higher overall returns. Think of a bulldozer instead of a shovel, a combine harvester in place of a sickle, a 44-tonne truck instead of a wheel barrow, or replacing an old machine with a new computer controlled one which produces far higher output from the same inputs. It was machines, technology and power which created the Industrial Revolution.

The problem is that UK expenditure under these headings is desperately low – at around 2.7% of GDP compared to 15% in China – and when depreciation is deducted, virtually nothing is left in the UK. This, in a nutshell, is why we have such an acute productivity problem.

What can we do about this situation? Plenty, if we are prepared to understand why things have gone so badly wrong.

The reason why the type of high-powered investment we need is largely absent in the UK is that most of it tends to take place in the private sector, much of this, in turn, in internationally tradable activities, particularly in manufacturing. Expenditure on investment in these circumstances depends on it having a reasonable chance of being profitable.

The problem in the UK is that exchange rate if much too high for this condition to be met. This is why we have deindustrialised. Only exceptional companies can make manufacturing in the UK pay, and there aren’t enough of them. As late as 1970, almost one third of our GDP came from manufacturing. Now it is less than 10% and still drifting down.

This has been disastrous in four separate ways. It has left large areas of the UK with far too little to sell to the rest of the world to enable them to pay their way. It has deprived our workforce of far too many highly paid satisfying jobs. It has meant that we have foregone the productivity improvements which are much easier to secure in manufacturing than they are in services. And it has left the UK as a country with chronic balance of payments problems, as we import far more manufactured goods than we sell abroad.

Why is the exchange rate so important? It is because this is what determines the rate at which we charge out all the overhead costs involved in manufacturing in the UK to the rest of the world. About one third of manufacturing costs, on average, consists of machinery, raw materials and components, for which there are world prices. All the rest, paid for in sterling, depends on how strong the pound is. The higher the exchange rate, the less competitive our export prices are, the more profitable importing becomes, and the bigger the foreign payment deficit we suffer, as we run up larger and larger debts to pay for a standard of living which we have not earned.

So what is the solution? The answer is that we need a much weaker pound to make investments – especially in mechanisation, technology and power – much more profitable than they are now. Until we do this, unfortunately we will continue you to suffer from inadequate expenditure on our future, poor returns, stagnant productivity and low growth. Not a great way to run the country.