Few British budgets have mattered as much as the one that Philip Hammond will deliver to the House of Commons on Nov. 22.
The chancellor of the exchequer must shore up Theresa May’s perilously shaky government ahead of a vital Brexit summit of European leaders in mid-December. At the same time Hammond has to keep a grip on the public finances.
But the gravest challenge he faces is economic: Britain’s persistent productivity blight.
Productivity – output per hour worked – is the mainspring of economic growth.
In the decade before the financial crisis of 2007-08 productivity was increasing in Britain by just over 2 percent a year, outpacing the average for the other economies of the G7. But since the crisis British performance has been dismal. Although productivity jumped in the third quarter of 2017, prolonged weakness means that it is barely higher than its pre-crisis peak a decade ago. The recovery in GDP has been driven overwhelmingly by more labor input, a source of growth that is running dry – not least since the vote to leave the European Union delivered a message to curb immigration.
Other advanced economies have also experienced setbacks to productivity growth following the financial crisis. Where Britain stands out is in the severity of its reverse. The shortfall in productivity is the main reason real wages are now 4 percent lower than 10 years ago, a potent reason why the leave campaign prevailed in the Brexit referendum.
Productivity is so central to prosperity and to macroeconomic management – by determining how fast the economy can sustainably grow – that a gaggle of economic researchers have been busy in their labs trying to diagnose the now decade-long disease. Early detective work highlighted the impact of the financial crisis itself, which was especially severe in Britain. This held back productivity by throttling bank credit to new potentially fast-growing ventures and by jamming up the usual way in which capital moves from declining to advancing sectors.
But as the crisis has receded and British banks have become better capitalized this explanation is less convincing. Longer-term forces appear to be in play in Britain and elsewhere. Firms at the technological frontier continue to forge ahead in raising productivity. However, the diffusion of their best practices within economies has slowed. An aging workforce is now acting as a drag. And the contribution to productivity from improved educational attainment is falling.
One reason the productivity setback has been particularly severe in Britain is that its apparently robust performance before the crisis was overstated and unsustainable. Banking activities ballooned on the basis of what turned out to be economically and socially harmful practices such as risky securitizations. Despite making up less than a tenth of the economy, the financial sector has been responsible for nearly a third of the productivity slowdown. Longstanding weaknesses in qualifications and skills have also become more damaging as business becomes more knowledge-based. Over a quarter of British working-age adults perform poorly in numeracy or literacy or both.
Investment is inadequate, too. Although firms have stepped up their capital spending after it collapsed during the recession, they have done much less so than in previous recoveries. Business investment is only 5 percent above its pre-crisis high a decade ago. At a similar stage in the recoveries following recessions at the start of 1980s and of the 1990s it was 63 percent and 30 percent higher than the respective previous peaks.
The reluctance to invest in turn is rooted in a financial and business culture that is especially and perniciously short-termist in Britain. Firms under pressure from the markets are reluctant to make the strategic investments needed to keep productivity moving ahead. And too many British managers are simply not good enough.
Although a definitive diagnosis of the British productivity disease remains elusive there is a surprising degree of consensus about the treatment needed to resuscitate the patient. The chancellor’s to-do list should include steps to tackle congested roads and overcrowded trains, to support the sciences, to foster R&D in the private sector, and to upgrade Britain’s poor skills. Since competition spurs higher productivity as new and smarter firms drive out older and less productive businesses, Hammond needs Britain to be as open an economy as possible.
The remedies make good sense but they will not rescue the chancellor, who has in any case already announced more spending on infrastructure. First, they will take time to be effective. Second, finding more money for austerity-hit public services such as policing and health will add to the pressures on the public finances. And third, Brexit is now contributing to the productivity malaise as businesses respond to corrosive uncertainties by curbing their investment plans and as Britain becomes less open to trade by leaving the EU. Raising taxes is always an option for a cash-strapped chancellor, but it would be highly unpopular − not least in the bitterly divided Conservative party.
When he presents his budget, Hammond can be expected to put a brave face on things. He will point to the fall in the budget deficit from a peak of almost 10 percent of GDP after the financial crisis to 2.3 percent of GDP in the financial year ending in March 2017. But what matters now is the future path of the public finances. Britain’s poor productivity prospects will box the chancellor in because GDP is the tax base and future revenues will be smaller to the extent that output per hour worked continues to stall.
The harsh reality is that Brexit will blight the public finances by hurting productivity. While Prime Minister May might see Britain’s overriding priority as ensuring that next month’s summit enables the Brexit talks to move on to trade, she’ll have to broaden her focus if she hopes to stay in office long enough to secure a deal that minimizes the damage Brexit is inflicting on the economy.