Special Report - Are we better off as laggards?

The Chancellor is obsessed with the productivity gap between Britain and other leading industrial na

As a sales pitch to woo those all-important inward investors to our shores, it was not one of Gordon Brown's best efforts. More Cassandra than Del Boy, he proclaimed: "Productivity levels in the US are 40 per cent higher than in Britain, and 20 per cent higher in Germany than here".

Worse, he didn't exactly keep quiet about this claim. Instead, alongside his Calvinist zeal for the "work ethic", Brown made the need for higher productivity into a mantra late last year. In November he launched a series of "productivity roadshows" and hosted confessional seminars at the Department of Trade and Industry and the Treasury to spread the unhappy message. Rectifying Britain's laggardly performance will be a core theme of the March Budget.

But does Britain really need to pull its socks up as much as Brown says? Is there really still a huge productivity gap between us and our competitors, even after Thatcher's self-proclaimed "productivity miracle"?

Not everyone thinks so. Since Brown made this a big theme in his pre-Budget report last year - devoting 30 pages to it - a number of people have stepped forward to question his gloomy analysis. In a recent research paper, Lies, Damned Lies and Productivity Statistics, Graeme Leach, senior economist at the Institute of Directors, wrote: "Statistical deficiencies do not preclude the possibility that UK productivity levels are second only to the US. This seems unlikely, but is this caution merely the product of decades of doing Britain down in the media?"

Leach is not alone in questioning Brown's figures. The Institute for Fiscal Studies (IFS), the Trades Union Congress (TUC) and the Institute for Public Policy Research (IPPR) have all produced papers doing so. The TUC report, Productivity and Partnership, for example, points out that the most recent studies of the productivity gap with the US offer estimates of between 7 and 40 per cent.

The basic squabble is over what kind of definition should be used. This may sound an arcane topic, suitable only for economic pointy-heads. But it matters because, as Leach says, "if the gap is more of a mirage, then the opportunity for a productivity miracle is undermined".

What exactly do we mean by productivity? Statistical definitions are a bit like balloon animals. You've either got your basic, crude shape - not very sophisticated. Or, with a bit of imagination and sleight of hand, you can turn your material into a far more impressive puppy.

And so it goes with productivity figures. The standard definition of productivity is output per worker. This is the figure the government uses. What this ignores, however, is exactly how many hours the worker was beavering away to produce those widgets. If, for example, it took one worker ten hours to produce a car, and another one five hours, the output would be the same, but it is easy to see that one worker was more productive than the other. Tweak the equation by sprinkling "hours worked" into it and the gap with the US magically shrinks from 40 to 20 per cent, because the average American worker puts in longer hours.

And with a bit more clever tweaking, such as that employed by Rachel Griffith and Helen Simpson of the IFS in their paper Productivity and the Role of Government, the gap shrinks to nearly zero. This is because they also factor in both the age of Britain's physical capital and its dodgy quality. Workers, it seems, can sometimes legitimately blame their tools for their poor productivity levels.

Why then does Brown persist in putting the worst possible spin on British performance? There are good and bad reasons for his doing so. Poor productivity offers a handy scapegoat for the recession now hitting manufacturing. Ministers were particularly keen last year to blame poor productivity rather than the high pound for the problems at Rover's Longbridge factory. Far better, too, to talk, as Peter Mandelson did, about linking potential government subsidy to assist the ailing factory to "productivity improvements", rather than convey the impression that the government was engaged in old-style bailouts to prop up inefficient industries.

Making an issue of poor productivity shows Brown in a macho light for focusing on a tough long-term agenda. "To caricature Brown, you could say, 'In my first Budget I solved the unemployment problem, in my second I dealt with work incentives and now, in my third, I will lick the productivity problem'," observes Peter Robinson, senior economist at the IPPR.

Highlighting a productivity problem helps to get the issue higher up the political agenda. Indeed, the Treasury itself implicitly acknowledges that the figure it cites is inflated. "We know and you know there are a number of ways of looking at this," said John Kingman, head of the Treasury's productivity panel, at an IFS conference last year. He added that the high figure acts as "a way of focusing minds on the need for further supply-side reform which seems to us to be desirable". The seminars and the roadshows all helped to "build a public perception that this was an important priority".

And so it should be. Although it is possible to explain away why Britain has worse levels of productivity (shorter average hours, or ageing equipment and so on) this does not mean that we should ignore Britain's relative decline. Higher productivity does matter because, as Brown puts it, it is the "key to the stronger economy - to higher growth, more jobs and opportunities, and better living standards for us all".

How do we get to this economic utopia? There are lots of different routes. Margaret Thatcher thought she had found one and talked boldly of a "productivity miracle" in the 1980s. And although Peter Mandelson has claimed that "productivity relative to our main competitors did not improve during the Tory years", there is a body of evidence that contradicts him. Britain did see a marked reduction in the productivity gap, particularly in manufacturing, after a time of slow productivity growth, and even some decline, during the 1970s.

"It is hard to say Britain didn't improve," says Nicholas Crafts, professor of economics at the London School of Economics. However, some of that improvement came at a price. "The revival in manufacturing productivity growth stemmed mostly from reductions in employment; output rose at only 1.2 per cent per year during 1979-89," wrote Crafts in Britain's Relative Economic Decline 1850-1995,published by the Social Market Foundation.

Despite these improvements, Britain's relative economic decline was stalled, not reversed. Worse, official estimates of manufacturing productivity growth suggest that since 1994 even this progress has stopped, with spartan growth since then. Adair Turner, the director general of the Confederation of British Industry, argues: "The process of liberalising the economy in key ways, the productivity improvements in the privatised industries, labour market reforms and the relegitimisation of enterprise and business as key social values were all beneficial. So this government has to preserve them." But, he adds, "Thatcher's changes were probably a necessary but not sufficient condition for us to close the gap".

So what is still missing? For Turner there are two important elements. "Between 1979 and 1993 there were dramatic booms and busts. These are relevant to the productivity debate because in a more volatile macroeconomic environment it is more rational for businesses to focus on the short term."

The first way for Brown to help improve productivity, then, is to ensure that there is fiscal and monetary stability. "The more you strip out financial noise," argues Turner, "the more you can concentrate on the fundamentals." He suggests, however, that this stability may not be enough. "Does the pursuit of macroeconomic stability also require going into the euro? On balance I would say yes."

The second factor that Turner thinks significant is "the failure to grip the education system. We have a less skilled workforce compared with our major competitors. Therefore we need to focus on an education and skills agenda."

This kind of view, however, is dismissed by the McKinsey Global Institute, whose paper on British productivity helped jump-start the debate last year. It sees "low capital investment, poor skills and sub-scale operations" as merely secondary effects. Instead, McKinsey touts a neo-liberal agenda of ever more deregulation, arguing that the productivity gap is "the effect of regulations governing product markets and land use on competitive behaviour, investment and pricing".

Although this conclusion has been embraced by the Institute of Directors, there are not many others who subscribe to it. The Treasury's John Kingman says: "It [the McKinsey paper] was not something the government had commissioned and they have their own views. They are better on individual sectors than on the economy as a whole. They are more convincing at explaining the gap with the US instead of continental Europe."

The TUC has also duffed up McKinsey's findings. It points out that it is bizarre to say we are less productive than France and Germany because we are over-regulated. Those two economies, after all, are far more snarled up in red tape. The TUC argues that the real causes of poor performance are "under-investment, skill shortages and poor workplace relationships". While Britain was better at cost-cutting in the 1980s, Germany's higher labour productivity comes from a history of higher investments in human and physical capital.

The TUC is right to emphasise the need for higher levels of investment. However, its focus is still very much on improving manufacturing industry. Increasingly, experts recognise the crucial role of productivity in the service sector, which matters more than manufacturing, since the latter makes up only around a fifth of the overall economy.

Nicholas Crafts agrees that "we focus far too much on manufacturing. The lever for improving it is not necessarily the same as for services. It requires a different sort of human capital."

Mary O'Mahony, an economist at the National Institute of Economic and Social Research, is one of the few people who has attempted to quantify rigorously how Britain compares in this area. It's not all doom and gloom. Based on her data she found that, in sectors such as mining, utilities and construction, British labour is more productive than its French, German, American and Japanese counterparts. Overall, however, she concludes that "Britain does not generally enjoy a comparative labour productivity advantage in service sectors".

Figuring out ways to measure, or even boost, productivity in services is tough because what you mean by "output" is tricky. School class sizes are a good example of this. You could argue that the government's commitment to smaller classes, made in its five pre-election pledges, is a commitment to lower productivity in education because there will be more teachers ("input") to each child ("output"). But shouldn't "output" in education be measured by results? And, if so, which results: more exam passes, higher literacy levels, lower delinquency rates?

Or take retailing, in which France is far more productive than Britain. This is partly because there is more land available to build whopping big hypermarkets on the edges of towns. And they offer poorer service levels than British stores. There are no bag packers or people in unfashionable garb offering to show you where to find muesli. The French may be more productive in retailing, but are they really "better"?

A similar dilemma faces the hotel industry. Is a hotel "better" because guests have to make their own coffee and carry their own luggage? And again it is easier for a hotel to be more productive on a greenfield site than on an older one simply because you can design it so that, say, the kitchen is near to the dining room. Both France (which has the same population as Britain but twice the land) and America have a highly productive hotel sector, partly because they have the room for new edge-of-town development. One survey found that, for new hotels in Britain, the break-even occupancy rate was 80 per cent, compared with just 50 per cent in America.

Should we then rip up our planning laws as part of an effort to squeeze more productivity out of hotels? Most people would say not. But different issues are raised by efforts to forge industrial clusters, such as a mini-Silicon Valley in Cambridge. In this case, people like Adair Turner would argue that it may be worth compromising social welfare and allowing development to proceed in order to boost hi-tech productivity. What matters, Turner explains, is whether the industry is one which could have "a cumulative dynamic effect" on the rest of the economy.

The existence of these potential trade-offs suggests that the government needs to be careful about over-hyping the importance of higher productivity. A big part of the political problem is that long-run productivity performance can have nasty side-effects in the short term. There are often good reasons to prefer lower productivity. As Nicholas Crafts sees it, "productivity is a benchmark for performance, instead of an objective in itself ".

The additional danger is that, as Britain faces an economic downturn, efforts to get short-term productivity improvements are more likely to involve job losses or tougher conditions for workers - as they did at Rover's Longbridge plant - than expansionary investment to sustain economic development.

Speaking at the launch of the CBI's Fit for the Future campaign, Turner acknowledged this prognosis when he said "we need to improve more than productivity. If we simply improve productivity we will create a high unemployment economy."

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