15 June 2022

Britain is once again the sick man of Europe

The UK is predicted to record the worst economic growth of any major country except Russia next year. What has gone wrong?

By Duncan Weldon

Illustration by Anthony Gerace

Until very recently, Boris Johnson liked to boast that Britain was “the fastest-growing economy in the G7”. This was never worth taking especially seriously. If you torture numbers enough they will tell you anything. In this case the method used was to focus on the limited time period after the first national lockdown in 2020. Britain’s economic growth fell further in the first wave of the pandemic than that of many international peers and so bounced back quicker. Nowadays, not even our boosterish Prime Minister can find much to shout about.

Britain’s economy is shrinking. In April, GDP fell 0.3 per cent, following a 0.1 per cent contraction in March. For the first time since the national lockdown of January 2021, all three of the UK’s main sectors – services, industrial production and construction – registered falls in the latest data. The consensus view of economists is that 2022 will be a tough year for the British economy but that it should just about avoid a recession. Sadly, the track record of economists when it comes to spotting British downturns is terrible. In the case of both the 2008 crash and the early-1990s recession, forecasters failed to predict the falls in output, only spotting the downward trends months after they started. Measures of consumer confidence have proved a more reliable guide to the outlook over the last few decades. The longest-running survey, from the public research firm GfK, in May recorded the lowest reading since the series began in the mid-1970s.

Whether the UK falls into an outright recession or not, 2022 is likely to see the biggest drop in living standards on record and a tough trading environment for firms. But beyond the immediate outlook, even the bigger picture is failing to provide much cause for cheer. The OECD expects Britain’s economy to perform worse next year (zero per cent GDP growth) than that of any other developed country except for sanctions-hit Russia. In its view, high inflation will continue to squeeze household incomes while the government raises taxes and the Bank of England hikes interest rates. The result is a dismal economic climate. Domestic spending is weighed down by falling real incomes, the export environment is tough and business investment is drying up as firms are ever more cautious about the outlook.

The lingering impact of the Covid-19 pandemic, disrupted global supply chains and the commodity price shock emanating from the war in Ukraine are causing problems for economies around the world. Global factors are the primary determinants of the high inflation that is driving the cost-of-living crisis. But the UK is being hit harder than many of its peers.

As the 2020s progress, Britain increasingly appears an outlier. Inflation is forecast to be higher in the UK than in much of Europe, and growth weaker. It has been a long time since Britain was last dubbed “the sick man of Europe” (a label first applied by Russia’s Tsar Nicholas I to the Ottoman empire in 1853). In the 1970s the UK was western Europe’s laggard. It was a country beset by toxic industrial relations, stubbornly high inflation and a volatile business cycle that veered between periods of overheating and contraction. “Britain is a tragedy,” observed the then US secretary of state, Henry Kissinger, in 1975. “It has sunk to begging, borrowing and stealing until North Sea oil comes in.”

The reason the sick man label is recurring is that the UK’s troubled start to the 2020s followed a poor previous decade. Real wages, adjusted to take account of inflation, are expected to be no higher in 2025 than they were in 2008. Workers are facing almost two lost decades of growth.

In the decade before the 2007-09 financial crisis, the British economy grew at an average annual rate of 2.7 per cent. In the following decade – before the pandemic – it grew by just 1.7 per cent. The financial crisis was a jarring experience for many countries. Few emerged unscathed. But almost no major country suffered as great a blow as the UK. Before 2007, Britain enjoyed the second fastest growth rate among the G7 group of countries, behind only the US. Since then, it has recorded the second lowest, ahead of only Italy.

Italy is the cautionary tale for students of economic decline. As recently as the early 1990s it was as rich as Germany when measured by GDP, or national income, per head. A decade later in the early 2000s, it had fallen behind Germany but was still ahead of Britain. Nowadays Italy’s income per head is closer to that of Spain. The fear is that Britain is embarking on a similar path. Not a sudden economic shock that grabs the attention of the public and politicians but a slow process that plays out over years and decades; relative economic decline with a whimper rather than a bang.

Most economists would agree that the long-term driver of economic growth and higher living standards is productivity growth, the ability to get more output from any given level of inputs. While global productivity growth slowed sharply after 2008, Britain’s crashed. Output per hour worked in the UK economy grew at 1.9 per cent a year between 1997 and 2007 but only 0.7 per cent between 2009 and 2019. It is that slower productivity that has led the economy as a whole to fall further behind the US and Germany over the last 15 years.

The causes of this sharp slowdown in productivity growth are not straightforward; they are many and varied. Nor are they universally agreed upon: for much of the decade economists spoke of a “productivity puzzle”. Weak business investment, a damaged banking system after 2008, poor quality-management, skills gaps and a host of idiosyncratic problems in different sectors all contributed. Weak economic demand, as David Cameron’s government pressed ahead with austerity and prioritised deficit reduction over economic growth, played a role. Whatever the ultimate causes, there is little doubt the financial crisis acted as a catalyst. Britain’s old growth model was damaged, perhaps fatally, by the events of 2007-09.

The real danger with anaemic productivity growth is that it is not the kind of indicator that grabs attention. High inflation and rising unemployment are the sort of economic problems that bother voters and hence politicians. A slow-burning crisis of weak productivity growth is much tougher to mobilise a political coalition around.

Indeed, weak productivity growth is an economic cloud, but one that comes with a short-term silver lining. If productivity is the ability to get more output from any given level of inputs and it is growing slowly, then more inputs are required. To put it in straightforward terms, poor productivity growth means that even a relatively weak economy can generate a lot of jobs.

That is the story of Britain’s 2010s. Economic growth, by any objective measure, was low in both absolute and relative terms. And yet, despite weak economic growth, unemployment continued to fall and employment to rise. Unemployment declined from almost 8.5 per cent in 2011 to just 3.9 per cent on the eve of the pandemic in 2020. Cameron’s government used to boast of its “jobs miracle” as joblessness fell far faster than most analysts expected. This fast jobs growth was the flipside of weaker-than-expected productivity. In the short term, as long as there were idle economic resources that could be put to use, poor productivity growth was almost a nice problem to have, or at least a politically convenient one. But as time moved on, the silver lining became smaller and the cloud more apparent. By the end of the 2010s, Britain was running out of spare economic resources to put to work in driving growth.

The productivity and growth problem of the 2010s has been compounded by Brexit. Indeed, for half of the first lost decade, political attention was more focused on the fallout from the Leave vote than the underlying growth problem. If the financial crash left Britain’s growth model in crisis, Brexit may have killed it.

Membership of the European Economic Community, and then the European Union, was a core component of the British economic model that developed over the 1980s and 1990s. Access to a larger market helped exporters to grow, and even domestic firms were subject to greater competitive pressure as imports from Europe flowed easily into Britain. Firms could harness wider supply chains and hire across the continent. London, whose population had declined from 8.2 million in 1951 to 6.8 million in 1981, became Europe’s financial powerhouse. All of this was a factor in the UK’s relatively fast growth during the 1990s.

But EU membership meant more to Britain’s growth model than simply increased dynamism and productivity growth. Membership of the EU’s customs union and single market served as an anchor for the policymaking elite across the major political parties and the civil service. It deterred some of the economic interventions previously favoured by the left (through strict rules on state aid and procurement) and much of the deregulatory agenda of the right (through social and environmental legislation).

Dismantling a major pillar of Britain’s growth model was always going to cause problems. The standard workhorse model of international trade, the so-called gravity model, predicts that trade volumes will usually be determined by the size of the economies involved and their physical distance from each other. Countries tend to trade with their neighbours. Defying gravity, by making trade with Britain’s largest and closest peers more difficult, was always going to create an economic gap that had to be filled.

Many Brexiteers thought they had an answer. Freed from the shackles of EU membership, “Global Britain” would be a buccaneering, free-trading nation. Yes, trade with the EU would be harder, but Britain would sign up to free-trade agreements with faster-growing emerging economies. There would be deregulation too, as European rules were scaled back, unleashing the dynamism of British firms. There was even talk of “Singapore-on-Thames”.

[See also: What is the Northern Ireland protocol?]

Six years on from the Brexit vote, that agenda has foundered. Rather than Brexit generating a new economic model, the government has been left scrabbling to find “Brexit dividends” to show that the economic pain has been worth it. Daniel Hannan, one of the godfathers of Brexit, recently conceded it might have been better if Britain had stayed in the European single market for longer.

The plan failed on two grounds, one economic and one in the realms of political economy. In straightforward economic terms, the plan to revive British capitalism with a dose of Thatcherite deregulation failed to engage with just how “British” contemporary British capitalism actually is. The muscle memory of the 1980s might be strong in the Conservative Party, but British business has changed. It is more globalised, more integrated into international supply chains and much less nationally focused. To the chagrin of Brexiteer ministers, many larger British firms – from car-making to finance – are not especially keen on diverging from European standards. They would rather cling on to whatever market access they can retain than enjoy the fruits of deregulation.

Then there is the politics. If Brexit was, as many of its advocates proclaim, a revolt of “left-behind” areas against an out-of-touch policy elite, then it is difficult to believe that what they were calling for was more deregulation and exposure to competition with emerging economies.

With neither the voting public nor the business elite keen on the wholesale regulatory change that “Global Britain” promised, the country finds itself stuck. It has incurred the upfront costs of Brexit in terms of postponed and cancelled business investment, a fall in the value of the pound and new trade barriers with the EU, but it is unable to even attempt to take advantage of the supposed economic benefits.

The old British growth model was damaged by the financial crisis and then wrecked by Brexit. The result is an economy stumbling forward from crisis to crisis, and economic shock to economic shock, with the government lacking any coherent idea of how to respond. The pandemic and the inflationary surge following Russia’s invasion of Ukraine are simply the latest episodes. The productivity crisis of the 2010s was allowed to fester. Whatever the short-term upsides, it was always going to be a problem in the long run. The long run is now our present, and, despite John Maynard Keynes’s famous dictum, we are not dead. But Britain is sick. And we have to live with the consequences: a persistent and slow period of relative economic decline. Without a new growth model, the UK’s future looks distinctly Italian – but without the pleasant weather.