Why is the UK's economic growth falling behind?

I spend a lot of time looking through research papers and think-tank notes afflicted with a disease I call “policy lever-itus”. This painful affliction consists of undue regard for big-picture thinking about why economic growth is so poor in the UK (and in much of Europe). Pointy-head types (me included, sometimes) tend to think that there is an endless supply of policy levers that can be yanked up and down to boost growth. Underlying these assumptions are the notions that major changes can affect complex challenges and that governments can make a difference.

Now governments can indeed make a difference; policy changes, especially around planning, can help. I suggest reading an influential report by Sam Bowman, Ben Southwood and Samuel Hughes called “Foundations: Why Britain has stagnated”, which in effect argues that Britain has essentially banned investment in the most important physical infrastructure it needs to grow: housing, electricity pylons, railways, roads, data centres, nuclear reactors, tramways, and more. And when it does build these things, their prices rise to astronomical levels due to the regulatory, legal and administrative costs they face.

However, as HSBC’s senior economics adviser Stephen King recently noted in The Times, “boosting economic growth is not very easy when the underlying trend is heading in entirely the opposite direction”. We also focus too much on big-picture analysis and not enough on the microeconomics of growth: businesses. Many of the most important levers behind growth may be difficult for government to influence because they rely on firms and their management, and, crucially, what they spend their money on. In this area of business change and innovation, several new ideas and discussions have emerged in recent months that are worth digging into. Take AI. This whole niche within technology tends to prompt breathless statements. Typical of this is a recent article from the US by Brian Albrecht, chief economist at the International Centre for Law & Economics.

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He argues that “we are on the verge of an AI-driven boom… the data suggest we could get back to the kind of productivity growth we saw during the IT boom of the late 1990s and early 2000s”. He reckons we may be underestimating productivity growth by as much as 0.5% of GDP because of mismeasured AI investments alone.

Is the AI bubble going to burst?

Yet could the AI boom be strangled at birth? A recent report by Reuters notes that the available data for training large language models (LLM), whereby machines learn to process language, may have run out. Researchers have known since at least 2022 that the amount of high-quality human writing in the world would only allow scaling (the process of spreading AI through businesses) to continue for a few more years, and copyright reduces the available amount even further. As the economist Noah Smith notes, “it’s also likely that the current crop of AI models has some problems that scaling just can’t solve. The main problem is hallucinations – ie, lies”.

Not that any of that will stop companies here in the UK and, more obviously, the US from investing hundreds of billions in new research and development (R&D). There is a tacit assumption that spending money on R&D, especially in AI and the life sciences, will improve growth rates. But a recent paper by the International Monetary Fund came to a radically different conclusion. It observes that in the 1980s, total US R&D investment represented 2.2% of GDP. Today, that figure is 3.4%, according to the National Science Foundation. Private R&D spending by businesses more than doubled, to 2.5% of GDP from 1.1%.

“Based on conventional economic models, that kind of increase in R&D spending should have led to accelerated economic growth rather than the slowdown that actually occurred,” says Ufuk Akcigit, the Arnold Harberger professor of Economics at the University of Chicago, and a research associate with the National Bureau of Economic Research.

“At the beginning of this century, roughly 48% of American inventors worked for these large incumbent companies – those that are more than 20 years old and employ more than 1,000 workers. By 2015, that figure had surged to 58%.” The evidence “suggests that while the US is investing more in R&D, the concentration of resources among large businesses has led to diminishing returns in terms of productivity growth”.

One possible explanation? Bad management. It wasn’t just stroppy unions that laid the UK low in the 1970s. Dreadful managers were also to blame, especially in much of the long-lost industrial sectors, such as British Leyland.

Economist and strategist Joachim Klement at investment bank Panmure Liberum closely monitors research relating to economic productivity and management. He has identified a problem, namely with the structure of ownership and management of many UK businesses: “companies with poor management practices were particularly prevalent among companies with dominant family ownership”.

“If a company is owned by the founder or the founder’s family, it isn’t a bad sign. We know from other studies that family-owned and founder-run firms tend to have better long-term performance because they are less beholden to short-term earnings management. But the problem starts when the family exerts too much control over a company, for example if a member of the family is also the CEO.”

Improving productivity in UK businesses

Worryingly, this problem was especially prevalent in the UK and France, the two countries with particularly poor productivity and relatively large resource misallocation. So maybe, Klement suggests, “we could improve productivity in the UK by improving governance among unlisted, family-owned businesses. But of course that would require controlling families to admit that their first-born sons aren’t necessarily the best person to run the business”.

Another area where we Brits could be inflicting pain on our businesses is our relentless application of questionable accounting practices. The former Bank of England chief economist Andy Haldane recently suggested that modern accounting treatments, eagerly lapped up by our financial regulators, might be a problem in deterring investment, which would boost productivity and thus growth.

Accounting rules regarding how you value assets are based either on historic cost or on “market value”, also known as “fair value”. The International Financial Reporting Standards (IFRS) have encouraged a bias towards fair value, widely adopted in Europe and especially the UK, whereas US accounting conventions have maintained a historic cost bias. Investment is higher in the US.

Fair-value rules may well encourage managers to make short-term decisions, says Haldane. “In particular, they may cause companies to prioritise shareholder payouts, inflated by asset-price inflation, over reinvesting... the switch to IFRS accounting rules is found to have [dampened] business investment by between a third and a quarter.” Also, guess which country has most eagerly embraced these IFRS rules, especially for public companies? The UK.

Note too that Britain is comparatively good at launching companies, but bad at keeping them alive, and even worse at scaling them up. We also tend to let family businesses stay in the wrong bits of the family for too long. We eagerly embrace accounting rules that appear to inhibit growth. And we put too much faith in businesses investing in whizzy new technologies, such as AI, to dig us out of the growth and productivity hole.

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