Britain | The economy and productivity

Bargain basement

If Britain cannot get more from its legion of cheap workers, the recovery will stall

GEORGE OSBORNE can be forgiven a bit of global gloating when he delivers his final budget as chancellor of the exchequer on March 18th. Britain did, after all, grow faster than any other G7 country in 2014. Its job market is probably the fizziest in the EU. But Britain is also exceptional in a less desirable way. It has become an island of spectacularly cheap, if not terribly efficient, workers. There are now few better affluent countries in which to hire.

When the coalition government took office in 2010, the big economic problem was weak demand. Workers were unemployed or underemployed and machines sat idle. The output gap—a measure of slack in the economy—was about 3% of GDP, reckons the Office for Budget Responsibility, Britain’s fiscal watchdog. The solution was foot-to-the-floor stimulus. The Bank of England ramped up quantitative easing and clubbed together with the Treasury to provide cheap cash to banks. Mr Osborne allowed borrowing to stay high. In 2013 a new Bank of England governor, Mark Carney, promised low interest rates until things got better.

Demand and growth duly returned. The output gap has shrunk to less than 1% of GDP. That is good news, but it means Britain has a new challenge. Soon the economy will no longer require a heavy foot on the pedal. Instead, its engine must become more efficient.

Productivity slowed almost everywhere after the financial crisis. But the picture is especially dismal in Britain. Output per hour worked is still 2% below its pre-crisis peak; in the rest of the G7 group of rich countries it is 5% higher. The French could take Friday off and still produce more than Britons do in a week. Confounding stereotypes, Italians are 9% more productive.

Britain’s workers are a bargain all the same, because their pay is so pitiful. Of the 15 initial members of the EU, only Greece and Portugal now have lower hourly wages. A British employee produces a fifth less than a French one, but he or she is more than a third cheaper to hire.

For firms, this is wonderful. Unlike real wages, which remain 8% below their 2007 peak, company profits are almost back at their pre-crisis level (and for service companies they have never been higher). The coalition has cut corporation tax, a levy on profits, to boot. In this fruitful environment, it is no surprise that net business creation—the number of startups minus the number of closures—is at its highest for at least 15 years, at 108,000 a year.

When people are cheap, firms would rather hire than invest in machines or technology. So productivity is held down. That tendency is stronger when banks do not lend much—as in the aftermath of the financial crisis—because cash-poor firms struggle to finance new investment. A shift from capital to labour seems to have happened in Britain: growth in the capital stock has fallen along with productivity (see chart).

The ready supply of cheap labour in continental Europe further encourages hiring. In 2012 Britain absorbed eight immigrants per 1,000 inhabitants—more than twice the EU average. Half a million more EU migrants are employed in Britain than in 2010, accounting for roughly a third of the country’s employment boom. Those kept out of work by burdensome regulation on the continent may find a job with ease in a country with weak unions and flexible work rules, perhaps on a zero-hours or part-time contract. Three-quarters of people moving to Britain from recent EU joiners do so to work; 70% of those who succeed end up in low-skilled jobs. Britain draws labour from Western Europe, too: since 2010 net migration from the 15 early members of the EU amounts to more than 200,000 people.

So far low productivity has been tolerable, even welcome. Unlike in America, where firms shed jobs quickly when the financial crisis hit, layoffs were comparatively rare in Britain. Instead the pain of the recession was spread widely, through lower wages. And squeezed workers are finally getting a little relief. Real wages, which fell for years, were 1% higher in the final quarter of 2014 than a year earlier. The Bank of England forecasts 3% growth in 2015. But that has a lot to do with low oil prices dragging down inflation and increased competition for workers. The bank’s forecast for productivity growth is a much more modest 0.75%. With less slack, labour-market tightening alone will only cause domestic inflation. Britain still needs a long-run model for growth.

Productivity is rather mysterious, but the best bet for boosting it is to invest in skills and infrastructure. Overall investment was a paltry 14.5% of GDP at the last count—the lowest in the G20. This is a chronic problem: the country now lags behind Canada, Japan, France and Germany in the quality of its infrastructure, according to the IMF. Money could usefully be spent on better local transport (Britain’s roads are among the most congested in the EU) as well as on fast broadband, housing and energy infrastructure.

Better still would be to harness the strength of Britain’s excellent universities. Research and development spending is most effective at stimulating productivity when it is funnelled through universities, according to research by two academics, Jonathan Haskel and Gavin Wallis. At £2.8 billion a year ($4.2 billion), university research accounts for a tiny proportion of government spending, but it has been cut by 5% in real terms in this parliament. Reversing that would be a good start. It would help, too, if foreign students were encouraged to stay in Britain after graduating. As part of its attempt to cut overall net migration, the government has pursued precisely the opposite policy, insisting that graduates find well-paying jobs quickly if they want to remain.

The country is running up against the limits of what can be achieved simply by boosting employment. With the recovery nearly complete, the next task for the island of cheap workers is to work out how to become an island of rich ones.

This article appeared in the Britain section of the print edition under the headline "Bargain basement"

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