The House of Lords will debate the following motion on 29 June 2023:

Lord Eatwell (Labour) to move that this House takes note of the low rate of growth of the United Kingdom’s economy, and the rate of core inflation and its differential effects; and of the necessity of increasing productivity.

1. What are the potential benefits of growth?

Economic growth is assumed to be important and desirable due to the role it plays in providing jobs and improving living standards. As explained by the International Monetary Fund, strong economic growth means that “employment is likely to be increasing as companies hire more workers […] and people have more money in their pockets”. The Organisation for Economic Co-operation and Development (OECD) adds that “while it cannot buy happiness”, money is “an important means to achieving higher living standards”.

Former chief economist at the Bank of England Andy Haldane has argued along similar lines. Mr Haldane notes that gross domestic product (GDP)—a measure of the value of goods and services produced in an economy over a certain time period—does not measure “a whole raft of things that improve our wellbeing”. However, growth does still matter, according to Haldane, because “sustained rises in GDP have been shown, over the course of history, to improve our health, our wealth and our happiness”.

A key mechanism through which economic growth is understood to lead to higher living standards is productivity growth. Economic growth can also be the result of increased employment or investment, but these processes do not necessarily lead to rising wages or incomes. Productivity growth, however, means that businesses can produce more output per given labour input, which effectively increases the value of labour in the production process, allowing for higher wages. This insight provides the basis for the commonly cited remark by economist Paul Krugman:

Productivity isn’t everything, but, in the long run, it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.

This understanding of economic growth and its benefits is not universally accepted. For example, in terms of the mechanism, OECD research suggests that productivity growth no longer feeds through to increased wages in the way it used to. More fundamentally, the correlation between GDP and happiness has been questioned, with some research suggesting that growth in GDP per capita in already rich countries does not tend to improve life satisfaction. Separately, the extent to which economic growth is compatible with environmental sustainability has also been a subject of debate.

Nevertheless, economic growth remains a political priority, albeit with emphasis increasingly placed on ensuring that future growth is “sustainable”. For example, the G20 committed to supporting “strong, sustainable, balanced and inclusive growth” at the November 2022 leader’s summit in Bali.

At the national level, Prime Minister Rishi Sunak has made growing the UK economy one of his top five priorities for government. Similarly, Leader of the Opposition Keir Starmer has made “securing the highest sustained growth in the G7” one of the five “national missions” which would “drive” a future Labour government. When making their commitments, both political leaders highlighted the role of economic growth in creating more and better paid jobs.

2. What are the prospects for the UK economy?

2.1 Growth and productivity

In historical terms, UK economic growth has been weak since the 2007–08 financial crisis, with low productivity growth underlying the weakness. Office for National Statistics (ONS) data, illustrated in the chart below, shows that productivity has deviated sharply from its pre-financial crisis trend rate of around 2% from 2008 onwards. Productivity would have been around 26% higher in 2022 had the pre-2008 trend continued.

Graph 1: UK productivity from 1971 to 2022

Graph 1 shows UK annual output per hour worked, from 1971 to 2022, using chained volume measure (2019 = 100). Productivity growth has slowed since 2008.
Graph 1: UK annual output per hour worked, from 1971 to 2022, using chained volume measure (2019 = 100). Source: ONS, ‘Output per hour worked, UK’, 26 April 2023.

At an aggregate level, UK economic growth since 2008 has, therefore, largely been driven by increasing hours worked rather than increasing output per hour (productivity). Low productivity growth underpins the Office for Budget Responsibility (OBR)’s assessment that the economy has “weak underlying momentum”, with high energy prices, stagnating business investment, and the recent rise in labour market inactivity also contributing factors. The latest OBR forecast, published in March 2023, suggested that GDP would contract this year but recover to grow at 1.9% per year by the end of the forecast period. However, this was premised on trend productivity growth recovering to 1.1%. This would be much lower than the pre-financial crisis trend rate but would represent an approximate doubling of the rate experienced during the 2010s.

2.2 Inflation and living standards

As well as inhibiting growth, the series of economic shocks highlighted by the OBR are contributing to a sustained rise in inflation well above the Bank of England’s 2% target. Consumer price index (CPI) inflation rose sharply over the course of 2021 and early 2022, peaking at 11.1% in October 2022. By April 2023, it had fallen to 8.7%. However, in the wake of these figures, Governor of the Bank of England Andrew Bailey noted that inflation was taking a “lot longer” to come down than the Bank had expected. May’s inflation figures, released on 21 June 2023, also failed to decline as expected. Annual CPI inflation remained at 8.7%, despite forecasters’ expectations that it would fall to 8.4%.

In response to these releases, financial markets started to bet on interest rates peaking at a higher level than previously expected, perceiving that higher rates will be necessary to bring inflation sustainably back down to target. Before April’s inflation figures, swap markets were pricing in the Bank of England raising interest rates to a peak of 5%, but in light of May’s figures they are now betting they will rise to at least 6%. On 22 June 2023, the Bank raised its base interest rate by 0.5 percentage points to 5%, citing “recent upside surprises” in official estimates of inflation as a motivating factor. Most economists had previously expected only a 0.25 percentage rise, according to a Financial Times report.

Underlying concern with the recent inflation data has been the rise in ‘core inflation’, which increased from 6.2% in March to 6.8% in April, rising further to 7.1% in May. As explained by the ONS, core inflation is “a complementary measure of consumer price inflation, which looks specifically at the underlying rate of inflation in an economy that puts lower weight on items subject to erratic and seasonal price movements”. Therefore, the current elevated rate of inflation is, according to the ONS’s definition, increasingly becoming a persistent, rather than transient, phenomenon and cannot now be attributed primarily to sharp rises in the price of food and energy.

A continually high rate of inflation puts pressure on living standards, as household incomes struggle to keep pace with risings costs.

The impact of this real-income squeeze varies across households. Firstly, different income groups have different consumption patterns. For example, as reported by the ONS, poorer households typically spend a higher proportion of their income on energy and food, and have thus experienced a comparatively higher rate of inflation as energy and food prices have surged. Secondly, the extent to which wage growth can compensate workers for rising costs varies significantly by sector. For example, ONS data shows that average regular pay growth between February and April 2023 was 5.6% in the public sector, compared with 7.6% in the private sector. In addition, there are discrepancies across jobs within each sector; so, for example, average growth in the private sector was 9.2% in ‘finance and business services’, but only 5.1% in ‘wholesaling, retailing, hotels and restaurants’.

In anticipation of these challenges, the OBR has forecast that “living standards are set for the largest fall on record”. In March 2023, it forecast for real (inflation adjusted) household disposable income per person to decline by 3.2% in 2023. This follows a fall of 3.1% in 2022. As a result of this decline, the OBR expects that real household disposable income will still be below pre-pandemic levels in 2027/28.

3. What are the causes of and solutions to the productivity slowdown?

There is no consensus on the causes of the slowdown in productivity growth that underlies weak economic growth. As such, it has often been referred to as the ‘productivity puzzle’. Various large-scale research projects have been set up to try and understand it.

In 2021, the ‘UK Productivity Commission’ was established by the National Institute of Economic and Social Research (NIESR) and the Economic and Social Research Council-funded Productivity Institute to examine the UK’s poor productivity performance and provide policy solutions to address the shortfall. In its first evidence review the commission noted, among other things, the slowdown in productivity growth globally and the uneven nature of productivity performance within the UK, both across regions and across and within sectors. In its publication ‘Priorities for 2023’ the commission said it would focus on attempting to understand the role of investment, both public and private, in supporting productivity growth.

Separately, in 2021 the Resolution Foundation and the Centre for Economic Performance at the London School of Economics set up ‘The economy 2030 inquiry’, which is attempting to understand the strengths and weaknesses of the UK economy and what a successful economic strategy for the 2020s might look like. Its interim report, ‘Stagnation nation’, highlighted the UK’s weak investment record compared with other advanced economies (such as the US, France and Germany) which have higher productivity. For example, it suggested that “persistent low investment means virtually all of the productivity gap with France is explained by French workers having more capital to work with”. More generally, the report noted that “the importance of an area’s workforce size, skill levels, and stocks of capital (including intangibles) in determining its productivity has grown during the 21st century”.

In terms of policy action to improve productivity growth, a 2020 poll by the Centre for Macroeconomics highlighted ‘investment in human capital’, such as education and job retraining, as a favoured option among leading economists. ‘Infrastructure investment’ and ‘regulatory and competition policies’ were among the next most popular options. The survey suggested that the same set of economists believed ‘low demand (including due to the financial crisis, austerity policies or Brexit)’ to be the most likely cause of the productivity slowdown in the 2010s. However, improved ‘aggregate demand management through fiscal and/or monetary policy’ was not a favoured option for trying to improve productivity growth going forwards.

Chancellor of the Exchequer Jeremy Hunt outlined his framework for understanding and tackling the UK’s low productivity growth in a speech at Bloomberg on 27 January 2023. He set out four pillars of “economic growth and prosperity” which will be used to guide UK economic policy, summarised below:

  • Enterprise. Improve access to capital and reward for risk for the UK’s most productive growth industries.
  • Education. Improve skills training.
  • Employment. Reduce barriers to work to ensure that everyone who can participate in the economy does.
  • Everywhere. Ensure the benefits of economic development are across the whole of the UK.

However, Mr Hunt also noted that “sound money” was an “essential foundation on which long term prosperity depends” and that bringing down inflation would be prioritised before tax cuts or public spending increases in pursuit of the above objectives.

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Cover image by jcomp on Freepik.