Without economics, the world appears as ‘a mere chaos of proliferating and unintelligible detail, reasonable and orderly only in the small.”
Tyler Cowen, quoting GLS Shackle
Effective economic policy needs two ingredients: a set of basic principles, and a diagnosis of what is going on.
The principles are the easy bit. Tories on the whole believe that markets and free enterprise do a good job in helping people lead more prosperous lives, that institutions (both public and private) matter, and that the government’s job is to create the conditions for those competitive markets and strong institutions — always remembering that not infrequently government can help best by getting out of the way. We don’t propose to challenge any of this.
The more difficult and controversial part of building an economic policy is forming a view of what is going on in the economy, scoping out the opportunities for improvement, and developing a strategy for achieving them.
What follows is our attempt to sketch out a relatively small number of important factors and trends that could form the basis for a coherent economic policy agenda.
1. Productivity growth has slowed down dramatically.
The foundational fact in today’s British economy is our slow productivity growth (the amount of output we produce per hour worked), and low productivity levels compared to other large, developed economies like France, Japan, Germany and the United States.
From 1980 to 2007, the UK’s productivity grew at 2.3% per year, but from 2008 to 2018 the annual rate fell to a meagre 0.4%. If the UK had kept up with its pre-crisis trend growth, we would be 25 percent richer today — richer per capita than Germany.
Productivity growth over this period has been sluggish in all rich countries, but the UK has had worse performance than any other G7 country except for Italy. And recent research suggests Britain’s downturn has particular characteristics: most of the decline in the last decade has been due to Britain’s most productive firms and sectors doing less well. Productivity has grown at roughly the same rate across the country, but starting from a much lower point outside of London — gross value added per hour worked, a measure of productivity, is 85% of the UK average in Wales, Yorkshire and the Humber and the East Midlands, compared to 108% in the South East and 133% of the UK average in London.
Slow productivity growth is not just economically toxic but politically destructive. It leads to a sense of malaise and a widespread belief that the system is not working for ordinary people. Conversely, strong productivity growth cures all sorts of problems. Faster productivity growth would lead to higher wages, better returns for savers and pensioners, lower taxes, and lower deficits with higher public investment. And, perhaps, more confidence in the liberal economic model.
2. Cities and towns can drive growth — if we let them.
Everyone knows that some parts of the UK are doing better than others. What’s less well understood is why.
The UK has two particular problems with regional growth that better government policy could help solve. The first is that many of our most prosperous places can’t grow in size, which means fewer jobs in prosperous places and less economic growth in the places with the most potential. The second problem is that most of our largest cities are nothing like as rich as they could be.
The first is a problem of what economists call “agglomeration effects”. In most rich countries, big cities are richer and more productive than smaller places, thanks to “Adam Smith” effects like specialisation, knowledge spillovers, deep labour markets and better matching to jobs.
These effects mean that workers who move from small to large cities gain a wage premium when they do so and accumulate better experience as time goes by — experience which persists even if they leave. In the United States, productivity per worker rises by 11% with each doubling of city size, “whether from 10 to 20 thousand or from 1 to 2 million”.
But in Britain, while the productivity-size link holds true for London, it does not hold for most of our other big cities. The dotted line in the chart below ought to slope upwards, but in fact it slopes downwards. This means that places like Birmingham, Liverpool and Bristol are much poorer than cities of an equivalent size in other countries, perhaps because of England’s unusually centralized political processes and the investment bias this causes.
The second issue is that many of our smaller but richer cities and towns, places like Oxford or Milton Keynes, find it hard to grow by (for example) building more densely on urban land — mainly because of the UK’s unusually restrictive planning laws. The same is true of our biggest city — London — too. If it is hard to build new housing or office space, it will be hard for businesses to expand, and hard for workers to move to these places to take up good jobs.
Fixing these two problems would make a big difference to British prosperity. What’s more, fixing them would be politically advantageous to any party of the Right that put the solutions in place, offering a way to rekindle the fortunes of the Tory party in northern cities. Keeping cities dense would help stop marginal suburban seats from turning red because of educated, Labour-voting workers being priced out of places like London and moving to them. Lowering the cost of homes would allow people to form families earlier on, getting us more of the kind of voters that are solidly Conservative-voting.
This of course leaves the question of what happens to so-called ‘left behind’ towns, which once upon a time could have been supported by local manufacturing businesses. But the UK is fortunate in that most such towns are close enough to major cities to share in their economic growth if the right infrastructure is put in place. This is not the case in bigger, more spread-out countries like the US or France. Better housing and transport policy could make a virtue of England’s high population density, which is closer to that of Israel and the Netherlands than Germany or France.
3. An intangible economy means winners do better.
For the last few decades, the nature of investment across the developed world has been going through a steady but profound change. In the developed world, businesses now invest more in assets you cannot touch or feel, like R&D, software and design (so-called intangible assets) than on tangible assets like factories, buildings and machines. This is partly the result of digital technologies — companies like Uber and Facebook invest in lots of intangibles — but the effect plays out in every sector of the economy.
This has some big implications. Because intangibles have spillovers, the rewards to businesses located in dynamic cities and towns increases. This is bad news for less prosperous areas that do not have a base of intangible industry to build on, or for countries whose laws and rules prevent thriving places from growing. There are big synergies between intangibles and highly skilled workers, which is bad news for places that cannot educate people well or attract talented people from elsewhere. Because the benefits of intangibles like R&D can’t always be captured by the businesses that make them, they also tend to require more public support.
This is why there is a strong case for governments to co-fund scientific research. And because intangibles are highly scalable, particularly intangibles based on software, big intangible-rich companies like Google or Amazon can acquire dominant market positions.
High house prices also means that this effect increases regional inequality. When the cost of moving to productive areas with high spillovers is high, only the most productive people can do it — leaving behind less productive people who cannot benefit. A quarter of the United States’s regional wage inequality may be down to this effect, and the effect may be even stronger in the UK.
Understanding the importance of intangible assets helps us understand how a government that wishes to improve rates of innovation should do so, and what a government that wants to allow as many people as possible to take advantage of the spillovers from those breakthroughs should do.
4. The UK under-invests.
For a very long time, Britain and its businesses have invested less in tangible capital than other rich countries (when compared to the US and Germany, this gap is at least 150 years old). Britain also invests less in R&D, an intangible type of investment (1.7% of GDP compared to an OECD average of 2.4%).
The UK invests a lot relative to other countries in intangibles like design and marketing, but the growth of intangible investment has slowed considerably since 2008. There is some evidence that intangible investment requires different institutions and support than traditional tangible capital — for example, intangible-intensive companies tend to need equity finance rather than bank loans to grow.
So when it comes to investment in tangible capital, the UK is well behind countries it used to lead. And when it comes to investment in intangible capital, the UK only leads in some respects, and lags countries like South Korea, despite the UK’s long history of scientific excellence and inventiveness.
This leads to particularly acute problems in places like the North of England that have traditionally prospered from tangible capital-based industries. Places where land is relatively cheap and where agglomeration effects have not led to booming cities should be the parts of the country where manufacturing can prosper — but because we invest relatively little in heavy industry, it is far behind some of our neighbours both in size and in sophistication. Much of this underinvestment is due to distortions in the tax code that penalise investment in tangible capital relative to intangible capital, which can be corrected to level the playing field.
Improving the UK’s investment rate would bring big benefits: about half the shortfall in productivity growth since the financial crisis can be attributed to underinvestment in (tangible) capital, while some of the rest is likely to be due to the shortfall in intangible investments like R&D.
Each of these factors is politically challenging in its own way. It is hard to talk about the productivity slowdown without inviting criticism for why part of the period of slow productivity growth coincided with Conservative and Conservative-led governments. A model of growth centred on cities and on expansion will be rejected by those who believe that focusing public investment directly on left-behind towns is the answer. While we share the same aims of people who want to drive more growth in the poorest parts of Britain, we believe the way to do that is to better integrate these places into the areas that are growing strongly already, allow people to move more freely, and eliminate the geographical and other biases created by existing public policy.
Next: Policy constraints