One positive legacy from the brief premiership of Liz Truss is that politicians are finally talking about the importance of economic growth. Unfortunately, there is little agreement on how to turn this talk into action.
My manifesto would be based on four priorities: rebooting productivity; removing blockages that add to the cost of living; improving the quality of public services; and encouraging more people back into work. All will require fundamental changes in mindsets.
But first, it is essential to appreciate the scale of the problems.
Liz Truss put growth back at the top of the agenda by setting an ambitious target of 2.5 per cent for the annual increase in Gross Domestic Product (GDP). This growth rate would have been unremarkable in the 1980s, 1990s and most of the 2000s. But since the Global Financial Crisis (GFC) of 2008, the UK economy has grown by an average of barely one per cent a year.
Perhaps mindful of this, Rishi Sunak watered the target down to a promise merely to “grow the economy”. However, even this low bar is not being cleared. UK GDP was flat in the second quarter of last year and contracted marginally in the third quarter. The latest monthly data suggest it was still falling in October.
This did not quite meet the standard definition of ‘recession’, which is two successive quarters of falling GDP. The latest business surveys also suggest that the economy picked up a little in the final months of last year.
Nonetheless, if the data are adjusted to allow for growth in the population, GDP per head has now declined for two quarters in a row. On this basis, the UK is already in recession.
At least ‘Brexit Britain’ is no longer an outlier. Before the 2016 referendum it was popular to blame almost any problem in the UK (real or imagined) on our membership of the EU. Now it seems that Brexit is the scapegoat for every ill.
In fact, most European economies are also stagnating, including Germany, France and the euro area as a whole. Indeed, the US is just about the only major economy that did not stall in 2023. But this is, of course, no comfort to those struggling here.
So, what needs to happen for GDP to start motoring again?
There are good reasons to think that the UK economy will at least move up a gear this year. In particular, tumbling inflation could be a game changer.
Tne Bank of England will be able to take the foot off the brakes as inflation continues to fall more quickly than it predicted. Bond and equity markets – and mortgage rates – have already started to price this in.
Looser fiscal policy should help too. Lower inflation and lower interest rates could save as much as £20 billion on the annual cost of government debt. Jeremy Hunt will therefore have more firepower for pre-election tax cuts and spending sweeteners in the Spring Budget.
My guess (no more) is that he will cut the basic rate of income tax. This may only hand back some of the Treasury’s windfall from the freeze on personal allowances. But it would be on top of the cuts in National Insurance contributions announced in the Autumn Statement, which take effect from 6 January.
However, this will not be enough to shift the economy into the fast lane – and keep it there. Growth needs to be ‘sustainable’, rather than just a ‘sugar rush’. This is reflected in the Labour Party’s version of Liz Truss’s growth target, which is to “secure the highest sustained growth in the G7”. But how to achieve this?
This is where my four priorities come in.
The first of these is the need to reboot productivity. The Nobel Prize winning economist Paul Krugman once famously said that ‘productivity isn’t everything, but in the long run it is almost everything’. He was surely right.
In economic terms, ‘productivity’ is a ratio of outputs to inputs, such as output per hour worked (a measure of labour productivity).
In more practical terms, if workers are more productive, they are worth more to their employer and so can command higher wages or work fewer hours for the same pay.
Productivity gains allow economies to grow without using more resources. It may often be possible to do more with less. This raises living standards, increases tax revenues, and can deliver better public services, while still protecting the planet.
Alas, the UK’s record on productivity since the GFC has been even worse than that on growth. If output per hour worked had continued to grow at its pre-crisis trend, it would now be around 25 per cent higher. Translate that shortfall into real incomes, or living standards, and the scale of the problem becomes even clearer.
True to form, economists disagree on the solutions to this ‘productivity puzzle’. Some think we may just have to accept that growth has shifted to a slower path, whether due to diminishing gains from IT and globalisation, or the increasing constraints of climate change and an ageing populations.
A few have gone further and argued that advanced economies should give up on growth altogether. They argue in favour of simply redistributing the wealth we already have, as part of a ‘de-growth’ agenda. This seems even more defeatist.
If there is a consensus, it is on the need for more investment to raise the quality of UK infrastructure, technology, skills and training. Some of this may need to be done by government. This may require more flexible ‘fiscal rules’ that distinguish properly between capital projects and day-to-day spending.
There is also still some role for ‘industrial policy’. The UK should not try to compete with the US or the EU in a subsidy race. If overseas governments want to lower the prices of products that we can then import, then why not leave them to it? Nor should the government be in the business of picking winners.
However, Kemi Badenoch seems to have found a sensible middle ground at the Department of Business and Trade – focusing on lowering costs rather than increasing subsidies, but still willing to spend a little public money in areas where there this could leverage much larger amounts of private investment.
Indeed, most of the new investment can and should be done by the private sector. The UK government has a pretty dreadful track record on big projects (just think HS2). Instead, the emphasis should be on creating the conditions under which private businesses are willing to take on more risks.
These conditions include business taxes which are low, simple, and predictable. Making ‘full expensing’ tax break for some types of investment permanent was an important step forward here. But mostly the UK has been going backwards. This is typified by the six-point jump in the main rate of corporation tax and arbitrary ‘windfall’ taxes on ‘excess’ profits.
Much more should also be done to reduce the punitive marginal rates of income tax that many people face as their earnings increase.
The second priority is to remove the blockages which are keeping the cost of living high. The overall level of inflation is mainly determined by monetary factors. But many individual prices are much higher than they need to be because of poor government policies.
An obvious example is planning restrictions which hold back housebuilding, driving up both prices and rents. Another is the design of ‘Net Zero’ policies which actually make energy supply less secure, and obvious flaws in the ways that electricity prices are set. Many ‘sin taxes’ are also well above levels that could be justified by any costs imposed on others.
The third priority is improving the quality of public services. The Institute for Government publishes a regular ‘Performance Tracker’ for the NHS, schools and police, among others, which is grim reading.
Some might say this is just about funding, or the lack of it, and blame ‘austerity’. But the bigger picture again comes back to productivity.
Output per hour worked has at least continued to increase in the private sector, but it has lagged far behind in public services. The NHS in particular is now treating fewer patients than it was before the pandemic, despite a huge injection of cash and many more doctors and nurses.
There are many factors at play here. One is a lack of competition. It is no coincidence that sectors where market pressures are strongest also tend to be those where productivity gains are greater.
Another is the reliance on the Treasury for much needed capital spending. We can debate the appropriate amount of public investment in new hospitals, or schools. But any business model that depends on political choices will always be vulnerable to under-funding – or wasteful spending.
High rates of trade union membership (and more militant unions) are surely a factor too. This is reflected in the increased number of strikes in the public sector, and greater resistance to change, even though higher productivity is the best way to justify bigger pay rises.
And all these factors probably contribute to the slower adoption of new technology. The scope for AI to transform the provision of public services must be huge.
Jeremy Hunt is at least on the case here. Labour’s Wes Streeting also appears ready to grasp the nettle on NHS reform. But there is awful lot of catching up to be done.
My fourth priority is to encourage more people back to work. A key factor holding back the UK economy is that rates of participation in the labour market have failed to cover from Covid, with a notable increase in the number of people on long-term sickness benefits.
Delivering on the first three priorities will go a long way here. For example, higher productivity and lower taxes will help make work pay. More housing will make it easier for people to move to where the jobs are. A better NHS will help those with health problems to return to work too.
But it is also important that labour markets remain flexible. A good example here is the campaign against so-called ‘zero-hours contracts’, which are simply a flexible form of working that creates more opportunities for people who might otherwise not work at all.
Most of this may sound obvious. There also seem to be an encouraging amount of cross-party consensus on many of these issues. For instance, the Conservative and Labour parties are not far apart on the need for planning reform and more housebuilding.
But this brings me to my final point – the need for fundamental changes in mindsets. The first instinct almost always seems to be to find a policy lever to pull that involves more state intervention, rather than less. In many cases, policymaking is actively anti-growth (echoes of Liz Truss again).
Examples include repeated subsidies to first-time buyers rather than actually building more houses, perennial calls to ‘save the traditional High Street’ rather than letting consumers vote with their wallets, or the growing tendency to over-regulate anything that might be new or risky, or ban it outright.
It may be wishful thinking to hope this will change much before the general election. Indeed, policies are even more likely to be based on how they play with focus groups, rather than their real merits. But in the meantime, lower inflation should at least buy a little breathing space for growth to recover.
This article was first published in MoneyWeek on 5 January 2024
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