Change is happening in the UK… but let’s try and make it positive: how the UK can boost it's productivity

The UK currently faces two seismic events – Brexit and COVID-19. Whatever your views are on how successive governments have handled these events, it is apparent that both have had, and will continue to have, a profound impact on the structure of the UK economy.

by Michael Bray

Research Analyst

Thankfully, this appears to have been recognised across the political spectrum and there now feels like a real openness to improving upon the economic paradigm which led the UK economy out of the global financial crisis in 2008/09. The government’s ‘levelling up’ agenda, although undeveloped at this stage, is an attestation to that. More focus is likely to be placed on driving economic growth rather than the cost cutting of austerity, and more emphasis is likely to be placed on making sure that this growth is sustainable and inclusive – regionally and by income attainment.

Improving productivity remains the key mechanism through which to bring about this positive change.

Productivity drives real wage growth 

Productivity is one of the most important determinants of long-term economic growth and is the most important determinant of real wage growth (see chart 1). Driving its growth should therefore not only be viewed through an economic lens, but also a social one.

UK productivity, real wages and GDP per head

There are a number of ways to measure productivity, but we will focus our attention on labour productivity. It can be defined as a measure of output that a labour force is capable of producing given its existing resources. This output can be enhanced by improving the skillset of the labour force and by increasing investment. Investment includes both private and public sector, and in physical assets (e.g. machinery and infrastructure) and intangible assets (e.g. research & development and patents).

Improving labour skills and increasing investment sounds simple enough but the evidence suggests otherwise.  UK productivity has flat-lined for more than a decade and has chronically underperformed international peers (see chart 2). 

Level of productivity

Indeed, when looking at investment levels versus 27 EU nations, only Greece spends less on investment as a percentage of GDP.

These factors suggest that some deep seated structural forces are at play.

Innovative but not productive

The UK’s relative productivity performance is puzzling, given our status as a global innovation hub. The UK has consistently ranked within the top 5 of the global innovation index, ahead of the similar sized economies of France and Germany. It also scores highly on research and development (R&D) and start-ups. Five of the world’s top 20 universities are from the UK, it ranks first globally in categories such as citable scientific publications, and leads in many e-commerce and Information and Communications Technology (ICT) markets. Moreover, it remains the largest market for tech talent within Europe.

Digging deeper, the UK’s productivity issues are more apparent when looking at the dispersion of productivity across the best performing and worst performing businesses. 

According to the Bank of England’s (BoE) 2018 report on the UK’s productivity problem, the UK has a small set of world leading businesses which have an excellent track record of delivering productivity growth but a long tail of stagnant businesses which are acting as a drag on overall productivity growth.

Another way of viewing this divergence is through R&D expenditure. Three-quarters of the UK’s private R&D spending - which at 1.7% of GDP is already more than one percentage point below our main competitors - is concentrated in only 400 companies, less than 0.01% of the UK’s business population.

Productivity is one of the most important determinants of long-term economic growth and is the most important determinant of real wage growth.

Knowledge diffusion is key

So, what explains why the UK is poor at disseminating the innovation, which it has a strong track record in producing, throughout its economy? The heart of the problem comes down to weak knowledge diffusion. A useful way to analyse the UK’s knowledge diffusion is through the technology diffusion framework created by economists Diego Comin and Marti Mestieri. They highlight four structural factors:

External openness

This represents the openness to cross-border flows of goods and services, capital, people and information. The UK scores highly on all external openness metrics so this isn’t the issue. 

Technology transfer

The rate of technology transfer is dictated by 1) adoption - the time it takes new technology to first reach a country or company and 2) penetration – the extent to which this technology then reshapes processes and products. Both these aspects contribute to the long tail of unproductive companies in the UK.

On adoption, although somewhat a dated statistic, the BoE estimated that by 2015 fewer than 10% of UK companies were using four or more technologies: of 1) mobile access to email, 2) documents and software, 3) websites with online ordering, 4) fast broadband access and 5) electronic interchange sales. On technology penetration it’s a similar story. In 2015, the BoE estimated only 20% of UK businesses had 50% or more of their employees using a portable device with internet access.

Recent McKinsey research found that three-year revenue growth for the most proactive digital movers was over twelve percent, nearly twice that of companies playing it safe. A lack of awareness of new technologies and how best to use them is a key issue for many UK small and medium enterprises (SMEs).

Institutional infrastructure

Countries with high-quality institutions typically grow more rapidly and have higher levels of productivity and living standards.

The UK fares well internationally in regards to rule of law and property rights, which support investment and innovation, but fares poorly on its diffusion and financial infrastructure. The BoE’s 2018 comparison of UK and German institutional infrastructure reveals why. 

Germany has a long-established support infrastructure to diffuse knowledge and technical know-how to its companies. Its Fraunhofer institutes were established in 1948 to rebuild the German corporate sector and now cover all sectors and regions. 

Comparison of UK and German institutional infrastructure

Secondly, Germany’s Steinbeis system, established in 1971, provides a network of 6,000 technical professionals whose skills and experience can be drawn upon. 

Thirdly, Germany has multiple layers of financing, which operate at local and national levels, and serve both small and large businesses. 

Turning to the UK’s equivalent institutional infrastructure, we either have such institutions but they lack scale and scope, or we are missing them entirely. The UK’s Catapult Centres, established in 2011 are modelled on Germany’s Fraunhofer institutes, but lack their presence. Furthermore, the UK has nothing like the Steinbeis system for disseminating technical expertise and know-how between companies. 

On financing infrastructure, although big corporates are served well by the UK’s large and liquid corporate bond market, smaller UK businesses have to seek financing from banks where options are more limited; lending to the corporate sector by UK banks represents just 6% of their assets compared to 18% for German banks.

Human Capital

People are unsurprisingly a key mechanism through which ideas and innovations are diffused. As workers transition between companies, their expertise and experience is transferred with them.

Historically, UK firms have performed worse on measures of good business practices, such as lean operations, performance monitoring, and aspects of talent management, versus firms in competitor nations such as Germany and the United States.

Again, the UK also exhibits a greater degree of dispersion of management skills when compared to competitor countries. Mckinsey estimate that when comparing UK businesses in the top decile of management performance scores versus those in the bottom decile, they are nearly three times more productive, grow revenue c.25% faster per annum, and invest ten times more in R&D. Moreover, poor management practices make it less likely that a firm will invest in and adopt ICT and digital technology effectively.

This has been amplified by around a 20% reduction in employment churn compared to before the 2008/2009 financial crisis and by the fact that the most skilled workers are increasingly staying within the top performing productivity companies, limiting knowledge and technological trickle-down.

What can be done?

With the bad news out of the way, let’s focus on what is being done and what more can be done to improve the UK’s diffusion structure.

Supply chains, universities and financing

Large, global companies are already playing a crucial role. These businesses are typically more productive than smaller, locally focused firms and are helping to drive adoption of productivity boosting technologies and industry practices within their supply chains. These supply chains are typically made up of thousands of large and small businesses and provide a natural diffusion structure which can be harnessed. 

A national set of structured projects are currently underway, co-ordinated by the Government established ‘Be the Business’ advisory body, which aim to use supply chain infrastructure to disseminate knowledge and best practices across companies. The UK needs to double down on such efforts. 

Outside of supply chains, more hands-on guidance is required to implement new technology. The UK’s catapult network are already doing this, but as discussed, the scale and scope lack that of Germany’s Fraunhofer system and other international peers. A relatively quick way to boost such capabilities could be through the UK’s world class university network. The UK’s top-ranked universities are already playing a crucial role in establishing the UK as an international innovation hub through their business parks. They are an important reason why the UK ranks so highly on innovation and start-ups. Many UK universities do not however have such close interactions with local businesses. Building these links out could help diffuse innovation more broadly across sectors and regions.

Many SMEs also need enhanced incentives and access to finance to adopt what may seem risky new assets and technologies. For example, the German government’s Digitisation and Innovation Loan provides businesses, even those with weak credit ratings, with funding to invest in new technologies. There is no reason the UK couldn’t do the same.

Disseminating and Investing in skills

A way to solve the UK’s diffusion of human capital is through mentoring or twinning between firms of different levels of skills and experience. 

‘Be the Business’ is already engaged in a sequence of pilot mentoring schemes between companies. They have also created programmes to develop management and technical skills with “mini-MBAs” and provide online tools for businesses to benchmark their practices against and receive actionable advice. 

However, the most proven methods for enhancing managerial practices tend to involve relatively intense, on-the-job support, which combines classroom based instruction with experiential learning. The same is true for increasing management’s capacity to adopt and implement new technologies. This suggests a more formal national network for knowledge-exchange, along the lines of the German Steinbeis system, is worth considering.

Aside from improving management skills, more needs to be done at scale to improve foundational skills for workers; Denmark’s flexicurity model provides a guide. It brings together trade unions, the government, and businesses to maintain a flexible labour market while also supporting workers in finding new employment opportunities. The model incentivises continuous learning and retraining, and provides a generous social welfare programme that helps unemployed workers retrain whilst looking for a new role. It is estimated that Denmark spends 1.5% of its GDP on offering job guidance or education to the unemployed, compared to just 0.2% of GDP spent in the UK on Jobseeker’s Allowance on average between 2010–11 and 2015–16.

Establishing national skills training for both managers and workers would go some way in helping alleviate the productivity gap between firms, but crucially regions as well. Worthy of deeper analysis in its own right, the productivity by region mirrors that by company – the UK is overly reliant on London and the South East to drive productivity. 

The OECD estimate that c.60% of the variation in productivity across UK cities are driven by age, education or experience. A lack of skills thus perpetuates this regional divide.  Devolving more power over adult skills budgets to regional administrations could help fit workers to available jobs better; the current patchwork of government grants targeted at skills training often fits awkwardly with local skills gaps. This is highlighted by Manchester’s Working Well programme, which has a better record than national schemes at getting people working after long periods of unemployment. 

Promoting investment in infrastructure 

A more obvious way to boost the diffusion structure of the UK is to improve its transportation infrastructure. UK infrastructure investment has lagged for some time, and overall public and private infrastructure investment as a share of GDP only rose above pre-crisis levels in 2017.

Large and dense cities are best suited to support knowledge diffusion due to the concentration of workers and firms. Improving inter and intra connectivity between large cities, and their suburbs, can thus help with knowledge diffusion.

Again, UK regional disparities can be seen with London and the South East having relatively good transportation infrastructure compared to cities in the North, which do not offer the same density networks.  The “Northern Powerhouse” project which was touted by George Osborne during his tenure as Chancellor of the Exchequer aimed to better connect six Northern cities and their combined 15 million population. For example, lowering travel times from Leeds to Manchester and Sheffield to 30 minutes is estimated to lift productivity in the city by more than 10 percent.

Graph 04

Administration change in Westminster has meant the Northern Powerhouse proposals have not garnered steam. The current government’s ‘levelling up’ agenda looks to do a similar thing, but lacks detail at this stage. Again, devolution of powers and finances could help by bringing a longer-term focus to regional infrastructure planning.

Why has change not been forthcoming?

There is no mystery around what is required to boost UK productivity. History tells us that improving productivity is the surest way to drive sustainable and inclusive real wage growth. However, what has been absent is consistent enthusiasm from central government, across the political divide, to implement the necessary policies because they are slow to take effect. I am hopeful that the economic shocks of Brexit and the COVID-19 pandemic – which has already forced many businesses to hasten digitisation - will provide renewed impetus for a sustained commitment by government and business to accelerate efforts to increase productivity, and help the UK realise its full potential. 

Illustration by Adam Mallett 

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