It’s time to get serious about our productivity gap

By Mark Dominik

When the economic recovery is more fully under way, we will need to turn our attention to reducing the UK’s £178 billion budget deficit.

At the top of the list of things we should consider doing to reduce the deficit is to address the UK’s persistent productivity gap once and for all. The productivity gap is a problem that successive governments have tried to tackle since World War Two, with mixed results. But every year that we allow it to persist, we lose hundreds of billions of pounds in output.

In 2008, the UK’s GDP per hour worked was about 8% below G7 average, 11% below Germany’s, 16% below France’s, and 19% below the US’s. If we were as productive as Germany, the UK’s 2008 GDP would have been £178 billion higher; if we were as productive as France, it would have been £274 billion higher; and if we were as productive as the US, it would have been £338 billion higher.

Why are we so much less productive than our G7 peers? And what can we do to close this gap in labour productivity?

There are three key components of labour productivity: physical capital, human capital, and innovation and technological progress. We lag behind our peers in each of these categories, to different extents and for different reasons.

Since World War Two, Britain has chronically underinvested in its physical capital. Between 1970 and 2007, which is the most recent year for which data is available, Britain invested an average of 18.2% of its GDP per year in fixed assets. The United States invested an average of 18.7% per year, France 20.8% per year, and Germany 22%, according to OECD data. A gap of one or two percentage points may not sound like much – but the UK would need to up annual investment by about £50 billion if it wanted to close its gap with Germany in 2007 alone. £50 billion of additional annual investment in infrastructure adds up over four decades.

Physical capital formation is not only influenced by how much is invested, but also by how effectively it is invested. The UK, sadly, has a history of delivering large infrastructure projects late and over budget. For example, the 108 km high-speed rail link from London to the Channel Tunnel, which was beset with chronic delays and budget overruns, ended up costing £5.2 billion; France, in contrast, is in the process of completing a 406 km TGV line that will cost only €4 billion. Indeed, an independent report by the Commission for Integrated Transport found that the Channel Tunnel Rail Link was “much more expensive than any other high speed line that has been constructed anywhere in the world”. Sadly, the experience of the Channel Tunnel Rail Link is all too familiar: The Jubilee Line, the Millennium Dome, Wembley, and the Olympic Park have all suffered from major delays, cost overruns, or both. When the crippling effect of these inefficiencies in infrastructure investment is added up, it is no wonder we lack France’s high-speed rail network or Germany’s autobahns.

Our economy takes a material hit due to the combined impact of underinvestment and inefficient investment. A 2004 study by the Confederation of British Industry found that UK rails are less reliable than most of our competitors, roads are the most packed in Europe, and road congestion alone cost the economy about £20 billion a year.

The second major factor that contributes to our productivity gap is a workforce that lacks the skills needed for our modern economy. Last year, the Commission for Employment and Skills published “Ambition 2020: World Class Skills and Jobs for the UK“. The report paints a sobering picture of the state of the UK’s workforce.

Data show that the UK ranks 12th among OECD countries for the proportion of the workforce with high skill levels. For intermediate skills, the UK comes even lower, at 18th place. A much higher proportion of the UK workforce than our peers has only a low skill level – 31% compared to Germany’s 17% or the US’s 12%.

Perhaps even more worrying is that our skills gap is widening. While older British workers (45-54 year olds) rank 12th in the OECD for high skills, their younger counterparts rank 15th; older British workers rank 15th for intermediate skills, while younger ones rank 21st. Our eroding competitive position does not bode well for closing the productivity gap.

The third major factor that contributes to our productivity gap is innovation and technological progress. Britain does better in this area than in physical or human capital, but there are still significant gaps to be addressed.

Between 1999 and 2005, French inventors registered nearly 50% more patents with all three major global patent offices than British inventors; German inventors, nearly 4 times as many; and US inventors, more than 11 times as many, according to OECD data.

More encouragingly, the UK does attract a large share of venture capital investment – which is critical to commercialising new technologies. In 2008, it attracted over 10% of all venture capital investments in the OECD area. Despite the successes attracting venture capital, the Department for Innovation, Universities and Skills identified a low rate of business start-up and growth in small and medium enterprises as a key weakness in its 2008 report “Innovation Nation”.

Shortcomings in innovation and technological progress, in all likelihood, contribute less to the productivity gap than problems with our physical and human capital. The Government has worked hard to boost innovation and technological progress by increasing public R&D funding – and this should pay off in the years ahead.

What is clear is that we have a great deal of work to do across the board if we want to bring our labour productivity up to French, German, or American levels.

First, we should increase investment – both public and private – into infrastructure, equipment, and other capital goods by at least 2% of GDP per year.

In the public sector, we should improve our roads, rails, electric power grid, and IT interconnections. We should undertake a series of mega-projects, such as a high-speed rail link between London, Birmingham, Manchester, Glasgow and eventually Edinburgh. And we need to modernise Heathrow. Few of its peers operate with only 2 runways – indeed, Frankfurt has 3, and is planning to add a 4th; Paris Charles de Gaulle has 4; Amsterdam Schipol has 6; and Chicago O’Hare has 7, and is in the midst of a billion modernisation and expansion programme. Adding a 3rd – and a 4th – runway to Heathrow would bring our international hub into line with its peers around the world, cutting the time inbound planes spend circling over London in holding patterns, which costs the economy untold billions a year in wasted time and fuel. Adding just one new runway at Heathrow would generate benefits of about £30 billion, according to conservative estimates in the British Chambers of Commerce report “Economic Impacts of Hub Airports“.

In the private sector, we will need to shift spending away from consumption and to investment. We need to buy fewer plasma TVs, Porsches, and Prada bags, and invest more in buildings, bulldozers, and broadband. Scaling up investment in electricity generation – especially in low-carbon power – is an urgent priority. The government will need to shift incentives to facilitate the transition from private consumption to investment.

Second, we must upskill our workforce. We should continue to encourage students to go to university, but need to give more consideration to the courses they are taking. More places should be created in the sciences, and we should reinvigorate our traditional centres of excellence in engineering. At the university level, we must insist on a high standard of technical instruction, so that we produce large numbers of the most skilled scientists and engineers of the future.

This does not mean that we should ignore the arts – far from it. The creativity of our workforce is a core asset, and one that should be cultivated. But we must ensure that, as in the sciences, courses in the arts meet the highest standards. We cannot afford to tolerate courses like the one in Social Work at Swansea University, which last year received the lowest rating in the National Students Survey of more than 200,000 students. Allowing courses like this one to continue wastes precious taxpayer money and is unfair to students, who are left with far fewer skills than they should have at the end of their 3-year degree.

And finally, we need to reinvigorate apprenticeships and technical training at the highest levels. We have been moving in the right direction on this front recently, with Lord Mandelson’s decision last year to double the number of apprenticeships. But other European countries, particularly Germany, have a much better track record of training highly skilled technicians and craftsmen. We should continue to look to them for guidance as we seek to create a modern class of technicians.

To be sure, all of this will initially be costly, and will require our government to get better at managing complex projects and developing and deploying training schemes that are fit for purpose. But the costs of allowing our productivity gap to persist are far higher than those associated with tackling it today.

The prize of increased productivity is clear – a reduced deficit, and higher quality of life for people across Britain. If we hope to achieve this goal, we must rebuild our infrastructure and upskill our workforce. It’s time to get started in earnest. The costs of failing to do so are far too high.