Build or innovate? How to solve the productivity puzzle

How should we tackle our anaemic productivity growth? Two answers have emerged: “Build Something Now”, and “Innovate Faster”. Chris Clothier, fund manager at CG Asset Management, recently put the case for the former when he noted that Britain “ranks... last among the G7 for gross fixed-capital formation, at about 18% of GDP annually. The range for the rest of the G7 is 20%-25%”.

Perhaps the most eloquent exponents of this school of thought are two Americans of the centre-left, Derek Thompson and Ezra Klein. Their book Abundance – very relevant to the UK – posits that the left in the US has championed excessive regulations and administrative burdens, which have severely hampered America’s ability to build essential things society needs, such as affordable housing, modern infrastructure and clean-energy systems.

The result is a system where completing important projects – such as building new homes or advancing green technology – is hampered or blocked entirely by layers of reviews and regulations. They point to Republican states where the balance is right – places such as Texas have built more homes and more jobs.

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Unsurprisingly, this agenda has also attracted interest from Republicans, but the message is clear: America (or the UK) needs to build more infrastructure (and create more jobs) and homes, so that people can enjoy greater abundance. This agenda is being replayed here in the growth caucus of Labour MPs, who are making similar arguments: more homes, more green power infrastructure, more nuclear power, less regulation.

The argument is echoed in another influential book released this year, Breakneck, by technology and China analyst Dan Wang, who previously worked for research firm Gavekal. He compares the US, run by lawyers who often hinder the construction of new things, with China, run by engineers and scientists who focus on building assets such as trains, industry and homes at a rapid pace. His arguments about how long it has taken California to build a high-speed rail system are echoed in the omnishambles surrounding HS2.

How to boost productivity

However, mobilising additional capital to get things built, which in turn helps boost GDP growth (through more construction jobs, for instance), is far from a panacea. Although numerous studies show that additional investment in fixed-capital projects boosts growth (via so-called multiplier effects), these follow-on impacts have declined over the years, perhaps a result of increasingly burdensome regulations.

A rival school of economists and policymakers argues for a different approach. They tend not to disagree with the idea that less regulation is beneficial, and don’t deny that investment is essential. However, they prioritise the importance of what we might call “soft capital”: knowledge and governance. You can see this approach clearly in a recent paper from the UK’s leading economic research organisation, the National Institute of Economic and Social Research (NIESR). In an ambitious collaboration between productivity and growth experts, the NIESR collated a range of views about how to kick-start productivity gains.

The professors and academics suggested more investment in skills training, prioritising vocational and technical training through retraining programmes and flexible learning, supported by the Growth and Skills Levy. They also argued that the UK should support digital transformation of the public sector, ensuring universal access to digital services and mandating digital readiness for all policies.

Low public-sector productivity growth is a crucial problem that every politician likes to talk about, but few offer practical solutions. The academics also focused on what they called fragmented decisionmaking, short-term budgeting and an “overcentralised yet undercoordinated” Whitehall machine, “blocking the very productivity gains on which the government’s economic strategy relies”.

Investment in physical assets, such as roads, and urban transport, such as trams, does get a mention, alongside a commitment to keep public investment at around 4%-5% of GDP (the average since 1987 has been under 3%). But the skew is clear. Building things won’t solve the problem – skills and innovation are crucial. The most explicit exponent of the “Innovate Faster” school is Daniel Susskind, an Oxford economist who published a superb book last year called Growth: A Reckoning.

Like many, he’s sceptical about the view that simply building many things will make much difference. Instead, he suggests that working with the same physical capital, but making that capital work harder, is the key to growth. In policy terms, that might mean significantly increasing spending on research and development (R&D), fostering innovation hubs, and generally improving the workforce’s skills.

If, like Susskind and Co., you favour boosting skills and innovating more, then you need to accept that there are no quick fixes or populist freebies. Improvements in innovation and the skills base require long periods of focused change and investment, and are very far from commanding headlines. At present, the best model for this is China. Its Made in China 2025 technology plan has transformed China into a technology superpower. The downside is that in the process, it’s also almost certainly wasting countless tens of billions backing the wrong projects and plans.

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