Tag: agglomeration economics

Global long-term economic growth has slowed dramatically since the financial crisis of 2007–8. This can be illustrated by comparing the two 20-year periods 1988 to 2007 and 2009 to 2028 (where IMF forecasts are used for 2024 to 2028: see WEO Database under the Data link below). Over the two periods, average annual world growth fell from 3.8% to 3.1%. In advanced countries it fell from 2.9% to 1.6% and in developing countries from 4.8% to 4.3%. In the UK it fell from 2.4% to 1.2%, in the USA from 3.1% to 1.8% and in Japan from 1.9% to 0.5%.

In the UK, labour productivity growth in the production industries was 6.85% per annum from 1998 to 2006. If this growth rate had been maintained, productivity would have been 204% higher by the end of 2023 than it actually was. This is shown in the chart (click here for a PowerPoint).

The key driver of long-term economic growth is labour productivity, which can best be measured by real GDP per hour worked. This depends on three things: the amount of capital per worker, the productivity of this capital and the efficiency of workers themselves – the latter two giving total factor productivity (TFP). Productivity growth has slowed, and with it the long-term rate of economic growth.

If we are measuring growth in output per head of the population, as opposed to simple growth in output, then another important factor is the proportion of the population that works. With ageing populations, many countries are facing an increase in the proportion of people not working. In most countries, these demographic pressures are likely to increase.

A major determinant of long-term economic growth and productivity is investment. Investment has been badly affected by crises, such as the financial crisis and COVID, and by geopolitical tensions, such as the war in Ukraine and tensions between the USA and China and potential trade wars. It has also been adversely affected by government attempts to deal with rising debt caused by interventions following the financial crisis and COVID. The fiscal squeeze and, more recently higher interest rates, have dampened short-term growth and discouraged investment, thereby dampening long-term growth.

Another factor adversely affecting productivity has been a lower growth of allocative efficiency. Competition in many industries has declined as the rate of new firms entering and exiting markets has slowed. The result has been an increase in concentration and a growth in supernormal profits.

In the UK’s case, growth prospects have also been damaged by Brexit. According to Bank of England and OBR estimates, Brexit has reduced productivity by around 4% (see the blog: The costs of Brexit: a clearer picture). For many companies in the UK, Brexit has hugely increased the administrative burdens of trading with the EU. It has also reduced investment and led to a slower growth in the capital stock.

The UK’s poor productivity growth over many yeas is examined in the blog The UK’s poor productivity record.

Boosting productivity

So, how could productivity be increased and what policies could help the process?

Artificial intelligence. One important driver of productivity growth is technological advance. The rapid advance in AI and its adoption across much of industry is likely to have a dramatic effect on working practices and output. Estimates by the IMF suggest that some 40% of jobs globally and 60% in advanced countries could be affected – some replaced and others complemented and enhanced by AI. The opportunities for raising incomes are huge, but so too are the dangers of displacing workers and deepening inequality, as some higher-paid jobs are enhanced by AI, while many lower paid jobs are little affected and other jobs disappear.

AI is also likely to increase returns to capital. This may help to drive investment and further boost economic growth. However, the increased returns to capital are also likely to exacerbate inequality.

To guard against the growth of market power and its abuse, competition policies may need strengthening to ensure that the benefits of AI are widely spread and that new entrants are encouraged. Also training and retraining opportunities to allow workers to embrace AI and increase their mobility will need to be provided.

Training. And it is not just training in the use of AI that is important. Training generally is a key ingredient in encouraging productivity growth. In the UK, there has been a decline in investment in adult education and training, with a 70% reduction since the early 2000s in the number of adults undertaking publicly-funded training, and with average spending on training by employers decreasing by 27% per trainee since 2011. The Institute for Fiscal Studies identifies five main policy levers to address this: “public funding of qualifications and skills programmes, loans to learners, training subsidies, taxation of training and the regulation of training” (see link in articles below).

Competition. Another factor likely to enhance productivity is competition, both internationally and within countries. Removing trade restrictions could boost productivity growth; erecting barriers to protect inefficient domestic industry would reduce it.

Investment. Policies to encourage investment are also key to productivity growth. Private-sector investment can be encouraged by tax incentives. For example, in the UK the Annual Investment Allowance allows businesses to claim 100% of the cost of plant and machinery up to £1m in the year it is incurred. However, for tax relief to produce significant effects on investment, companies need to believe that the policy will stay and not be changed as economic circumstances or governments change.

Public-sector investment is also key. Good road and rail infrastructure and public transport are vital in encouraging private investment and labour mobility. And investment in health, education and training are a key part in encouraging the development of human capital. Many countries, the UK included, cut back on public-sector capital investment after the financial crisis and this has had a dampening effect on economic growth.

Regional policy. External economies of scale could be encouraged by setting up development areas in various regions. Particular industries could be attracted to specific areas, where local skilled workers, managerial expertise and shared infrastructure can benefit all the firms in the industry. These ‘agglomeration economies’ have been very limited in the UK compared with many other countries with much stronger regional economies.

Changing the aims and governance of firms. A change in corporate structure and governance could also help to drive investment and productivity. According to research by the think tank, Demos (see the B Lab UK article and the second report below), if legislation required companies to consider the social, economic and environmental impact of their business alongside profitability, this could have a dramatic effect on productivity. If businesses were required to be ‘purpose-led’, considering the interests of all their stakeholders, this supply-side reform could dramatically increase growth and well-being.

Such stakeholder-governed businesses currently outperform their peers with higher levels of investment, innovation, product development and output. They also have higher levels of staff engagement and satisfaction.

Articles

• World Must Prioritize Productivity Reforms to Revive Medium-Term Growth

IMF Blog, Nan Li and Diaa Noureldin (10/4/24)

• Why has productivity slowed down?

Oxford Martin School News, Ian Goldin, Pantelis Koutroumpis, François Lafond and Julian Winkler (18/3/24)

• How can the UK revive its ailing productivity?

Economics Observatory, Michelle Kilfoyle (14/3/24)

• With the UK creeping out of recession, here’s an economist’s brief guide to improving productivity

The Conversation, Nigel Driffield (13/3/24)

• UK economy nearly a third smaller thanks to ‘catastrophically bad’ productivity slowdown

City A.M., Chris Dorrell (12/3/24)

• Can AI help solve the UK’s public sector productivity puzzle?

City A.M., Chris Dorrell (11/3/24)

• AI Will Transform the Global Economy. Let’s Make Sure it Benefits Humanity

IMF Blog, Kristalina Georgieva (14/1/24)

• Productivity and Investment: Time to Manage the Project of Renewal

NIESR, Paul Fisher (12/3/24)

• Productivity trends using key national accounts indicators

Eurostat (15/3/24)

• New report says change to company law could add £149bn to the UK economy

B Lab UK (28/11/23)

• Investment in training and skills: Green Budget Chapter 9

Institute for Fiscal Studies, Imran Tahir (12/10/23)

Reports

• The Productivity Agenda

The Productivity Institute, Diane Coyle and Bart van Ark (eds) (29/11/23)

• The Purpose Dividend

Demos, Andrew O’Brien (November 2023)

Data

• World Economic Outlook Databases

IMF

Questions