Balancing UK Productivity and AgilityBusiness Beyond Boundaries

Author: James Sproule

IoD Policy Report

Business Beyond Boundaries

• Views on productivity have to be seen in the context of a rapidly changing economy and likely future

demands and developments; UK productivity may have languished since 2007, but the critical question is:

are we prepared for the future?

• The productivity challenge is acute. Incremental productivity gains, while desirable, are unlikely to give

the UK economy the boost that demographics suggest it needs.

• Institutional agility is vital. Firms need to be open to new products and processes; an active employment

market can encourage new approaches to work and more rapid acceptance of innovation, resulting in

greater productivity gains.

• New industries and methods of working are altering the productivity challenges that businesses face;

economic success will ultimately be more about mastering entrepreneurism than excelling at

mature processes.

• Investment can be critical to improving productivity, but effectiveness is largely determined by three

critical elements: volume of investment, how capital is directed into new investment, and the agility within

the broader economy to be able to capitalise on any investment.

In all the debate on UK productivity, there are two things that should be remembered. Productivity

is not something that businesses tend to target. Instead businesses look to measure profitability, or

margins, or some form of return on capital. Of course productivity and returns are related, but they

are not the same, nor are they thought of in the same way. A business could produce good profits, but

underinvest, meaning not only would productivity suffer, but that the business itself may ultimately prove

unsustainable. Alternatively a business could invest heavily, enjoying good productivity, but fail to meet

expected returns on capital, which again calls into question the sustainability of any business model.

Ultimately a successful economy needs agility in outlook and willingness to question assumptions across

the entire business spectrum to identify the best route to ensuring prosperity and business sustainability.

3

Measuring the economy is always fraught with difficulty, and appreciating the difference between economic growth generally (usually expressed as growth in Gross Domestic Product or GDP) which is focused on output versus productivity (which measures output per unit of input) can be tricky.

No man or woman should ever be thought of as a machine and, thankfully, no-one lives simply to increase productivity or GDP. However, a rise in economic activity generally allows for rising incomes and any increases in standards of living that are not underpinned by raised economic output are, ultimately, unsustainable.

That productivity rises over time is at least in part a natural outcome of people getting better at their jobs and helped by technology, that has led to a long run of steady productivity gains. Yet for the UK there are two concerns: British productivity lags that of a good number of other industrialised nations and, even within the UK, productivity gains have stalled over the last few years.

Turning first to the comparative position of productivity in the UK versus other industrialised countries: while there has been a considerable degree of academic investigation and debate, there remains a considerable number of explanations as to why the UK is faring poorly in comparison to a number of other countries. Some of the most persuasive include:

• The high dependence on service sector firms in the UK economy; historically productivity gains have been far easier to achieve (and measure) in manufacturing than in services 1.

• There are over one million small companies in the United Kingdom, and these companies often tend to be less productive.

• Financial services have been critical to the UK, constituting 8.0% of the economy 2. There is evidence that productivity in financial services has declined, a natural result of a significant increase in regulation after the 2008 credit crisis.

• Science, Technology, Engineering and Maths (STEM) skills underpin many of the potential high-growth industries but STEM skills remain in short supply 3.

As this graph shows, the problem for the UK is not GDP per capita, where the country comfortably ranks in the middle of the highly industrialised nations. The concern is GDP per hour or worker, commonly called productivity, where the UK’s position is relatively poor. The conclusion has to be that the UK uses more inputs to achieve a set amount of output, that is more people are needed to produce the same product or service when compared to most of the rest of the European Union. This makes clear the trade-off between higher productivity and the general rate of employment.

Productivity

1 Service sector productivity has been particularly prone to the Baumol effect, where a range of outputs have been difficult, if not impossible, to make more efficient.

2 Down from 9.3% of GVA in 2009, House of Commons Briefing Note; Financial Services: contribution to the UK economy; 26 Feb 2015.

3 According to UK Commission for Employment and Skills (UKCES) report (July 2015), five million people are employed in high level STEM roles. But 43% of STEM vacancies are hard to fill, due to skills shortages, compared to a UK average of 24% for other difficult to fill roles.

4

4 Dolphin, Tony and Hatfield, Izzy; “The missing pieces: solving Britain’s productivity puzzle”; IPPR, August 2015.

5 Ibid.

5

Table 1

Comparative GDP (2014)

Looking at the UK in isolation, from 1960 to 2007 the trend was for productivity to rise by 2.5% per annum; this trend came to a halt in 2007 and since then productivity has languished. A number of commentators have cited changes to the underlying structure for at least in part being responsible for this languishing in productivity 4. However this explanation has to be questioned as there were considerable changes to the underlying structures of the UK economy from 1960-1997, all the while productivity continued to grow along a steady trend.

There are credible conclusions 5 that the initial stages of the slowdown in productivity were due to reactions of employers and employees. If the UK has had a surprising economic success story in the last five or so years, it has been the manner in which employment has been sustained through what was the worst recession since the Second World War. Unemployment peaked at 8.4% in late 2011, well below any figure which could have been expected given the severity of the economic slowdown. Much of this has been attributed to the approach of both employers and employees: the former resisting the urge to slash jobs in light of the slowdown, the latter resisting making unreasonable demands, particularly wage demands on businesses which they could see were struggling.

0

10

20

30

40

50

60

70

80

Source: IMF, IoD Policy Unit

US

US

Netherlands

Australia

Sweden

G7

Canada

Germ

anyBelgium

UK

OEC

D

France

New

Zealand

Japan

EU Italy

Korea

Spain

GDP/Cap ($000)

GDP/Hr ($)

This development has undoubtedly been a long-term boon to both employers and employees, with employees retaining skills and of course income, while employers benefited from retention of a skilled workforce. The cost, however, has been a languishing of productivity.

How might this stalled productivity trend be revived?

• Skills – There has been a significant focus on skills shortages in the UK and the impact they have had on productivity. While there is no doubt that shortages in Science, Technology, Engineering and Maths exist, the STEM shortage predates the plateauing of productivity. Thus while better skills offer a potential solution, it is not the cause of the problem. Encouraging employers to invest in their people can be difficult to mandate. How big a boost to productivity might come about remains difficult to gauge. We note that the French economy enjoys good levels of productivity, some 10% higher than the UK, but at least in part this can be attributed to a workforce some 8% smaller than that of the UK. Without doubt the vast majority of the structurally unemployed in France will have few skills, and thus were the UK to shift low skilled people out of the labour market, overall average productivity rates would rise, but at a high cost to the low skilled and wider society.

Table 2

UK Productivity

0

20

40

60

80

100

120

19601965

19701975

19801985

19901995

10002005

2010

CAGR–2.5%CAGR–3.6%

Whole Economy

Manufacturing

Services

Source: ONS, IoD Policy Unit

6

• Capacity – In theory the fact that the economy is still operating at some way below full capacity, as deduced by the long run trend established before the 2007/08 credit crisis, offers the UK the potential for a rapid catch-up economic activity. We are sceptical that such a catch-up is possible. The longer that any theoretical spare capacity languishes, the more unlikely it can be readily utilised. The pace of technological change means that such spare capacity rapidly becomes redundant and thus catching up to any previous productivity trends becomes nearly impossible without further investment.

• Finance – One of the draw-backs of ultra-low interest rates has been the survival of many businesses whose long term viability has to be questioned. Not only are businesses which need ultra-low interest rates to survive invariably amongst the least productive, they are effectively tying up capital that could be better employed elsewhere in the economy. A Schumpeter-esque bonfire of the least productive firms could eventually lead to better productivity outcomes. Such an outcome is not what lies behind the IoD’s calls since the autumn of 2014 for monetary policy to be tightened; our view is, and remains, that UK interest rates should be set on a path of normalisation because we wish to see monetary policy have the scope to return to being an effective tool for central bankers. But we do recognise that a side effect of normalising monetary policy would be to encourage reallocation of capital to more productive firms.

7

Productivity is always going to be important for future economic growth, but there is an added concern that is going to make it absolutely critical. Given that any rise in GDP is at its most basic a combination of increasing number of people in work, together with the productivity of those workers, it quickly becomes apparent that any change to either of these factors is critical to the economic health and, ultimately, to the prosperity of society.

Demographics are one of the most, if not the most, predictable statistics in all of macro-economics. The number of workers or retirees in a decade, barring very significant degrees of unexpected immigration or emigration, is quite easy to determine. We are certain in our knowledge that the UK baby boomers, born between 1955 and 1965, are now beginning to retire in significant numbers. The result is the working age populace of the UK is, depending on the scenario, set to remain flat or fall very slightly over the next two decades. For the UK, as for the rest of Europe, the retiring of the baby boomers means that the working age populace is set to decline by approximately 0.6% per annum through to 2040. Given that as recently as 2000-2010 the workforce was expanding by 0.6% per annum, this represents a significant reversal of underlying growth drivers and trends 6.

The impact of this demographic trend on economic growth is significant. There are ongoing questions and mitigations; in the past there was a correlation between the age of workers and their productivity, this has faded as the demands of work have changed 7. Therefore we have assumed that long-run productivity growth rates resume, but even this means the trend rate of GDP growth will in coming years drop from 2.5% p.a. to 0.8% p.a. Even if the narrow economic definition says this is not a recession, it will feel like one, with all the attendant challenges to consumer and business confidence.

Demographics

6 All figures from UN Population database.

7 OECD; “Maintaining Prosperity in an Ageing Society: the OECD study on the policy implications of ageing”; Working Paper AWP 4.1; p136.

Adjusting to a lower trend rate of growth, if it comes to pass, would be a significant political and economic challenge because it implies a number of things. Firstly, where economic growth is stagnant, productivity can perversely increase as business seeks efficiencies and undertakes redundancies, and there is a widespread focus on meeting immediate goals and customer requirements. Such a focusing on business needs can be necessary, but how long such an approach can be maintained, and how it affects the broader economy and employment, are open to question.

If the demographic trend does result in the long term implications outlined, merely looking for incremental productivity improvements in existing businesses is likely to be an inadequate.

Table 3

UK GDP Growth, Demographics and Productivity

100

150

200

250

300

350

400

450

500

550

600

1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 2060

GDP

Population + Production FCST

Population + Production

Source: ONS, UN Population Database, IoD Policy Unit

8

CAGR–0.8%

CAGR–2.5%

Table 4

Employment tenure: Percentage of employees with over ten years with same employer

9

Much of the productivity debate centres on measures that government or businesses might take to improve skills. What is less commented upon is the way in which new practices and new technologies are brought into and disseminated within companies. Our view is that one of the best ways to have companies consider new approaches is to have new employees joining firms at a variety of levels, to advocate fresh approaches and ideas throughout the firm. For much of Europe, labour markets are particularly rigid, which leads to a low degree of labour market churn and stifles the facilitation of new ideas brought in by energetic new employees. This employment sclerosis has resulted in far more than high degrees of structural employment. Where a labour market is rigid, those people who do become unemployed often find it difficult to find new jobs of equal stature, something which makes people naturally reluctant to shift between employers. The challenges inherent with rigid labour markets are generally well understood, but because for many European countries levels of productivity are relatively good, the negative effects of employment rigidities on productivity have been effectively masked.

The degree of employment rigidity in continental European is remarkable: over 50% of Italians and 47% of French workers having worked for the same employer for more than a decade. By contrast the figure for the UK is 35% and 33% for the OECD as a whole. Now there is undoubtedly a tremendous amount of value that long-term employees bring to any firm, but equally there is a point at which an organisation needs newer employees with their differing experiences and approaches to bring fresh approaches and to challenge the status quo.

Key measures to improve productivity

20

25

30

35

40

45

50

55

2000 2002 2004 2006 2008 2010 2012

Brazil

CanadaOECD

UK

Sweden

Spain

Germany

France

Italy

Source: OECD, IoD Policy Unit

The OECD has found that the capacity of firms to learn from the best in terms of improving productivity has diminished since 2008 8. That said, the diffusion of productivity gains from frontier firms (those who have the highest rates of productivity in their industries) to the rest of other firms seems to vary, with many manufacturing firms seeing relatively rapid diffusion and many service based companies seeing relatively low and slow levels of best practice transfer 9. This is however changing, with for example, London based, primarily service-focused firms enjoying a 40% productivity advantage over the majority of the rest of the country, an advantage that rises to 60% when comparing London to Wales.

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In one of those all too rare moments of economist humour, Prof Robert Solow noted in 1987: “I can see computers everywhere except the productivity statistics”. But times have moved on and many a traditional business, not to mention those in the new economy, now depend completely on information technology and, without a doubt, removal of that IT would be a catastrophe that ranged well beyond a collapse of productivity.

Most productivity gains are of course the accumulation of minor adjustments to the way work is processed or completed. High degrees of productivity can often be achieved through intense specialisation, but this degree of specialisation often tends to mitigate against agility. The IoD’s view is that while productivity is good, great even, agility is going to be the crucial differentiating factor in securing future success. How quickly ideas are adopted is dependent upon a number of factors: the already discussed institutional agility, competitive pressure (both national and international), and the adoption rate of technology. The adoption rate itself is a key factor in further understanding and absorbing technological knowledge, which itself is a key component in raising productivity.

Just how dynamic the business environment has become can be difficult to fully conceptualise. The technological revolution has affected businesses old and new, and presented a series of challenges and opportunities unprecedented since the industrial revolution. To take just one element of the change: twenty years ago just over 5% of Europeans were engaged in an entrepreneurial start up, today the European levels of entrepreneurism have risen to 7.5% 10. This is a reasonable degree of growth, but it pales when compared to what the rest of the world is experiencing. There has been an explosion in entrepreneurial activity with unforced entrepreneurialism levels often exceeding 15% 11. For European economies, levels of entrepreneurial activity which were respectable in 2002 had, by 2014, become inadequate.

The link between entrepreneurism and productivity is one that warrants investigation. There are two countervailing pressures here: the need for dynamic adoption of new technologies and techniques where smaller firms can excel, versus the poor productivity and latent inefficiencies that beset many smaller firms, particularly when it comes to coping with increasing levels of bureaucracy and regulation.

Innovation

8 The Future of Productivity” OECD, 2015, p35.

9 The Future of Productivity” OECD, 2015, p43.

10 Well below the roughly 20% of humans who carry the DRD4-7R gene which has been suggested is tied to traits running from exploration to entrepreneurship.

11 Forced entrepreneurialism is undertaken when there are no, or few, other viable employment options ; Global Entrepreneurship Monitor 2014 data: www.gemconsortium.org.

Table 5

Global early stage entrepreneurship

11

First on regulation: for policy makers, there is a challenge. Government initiatives, however well-meaning, have a tendency to increase the burden on businesses. From employee tax credits, to auto-enrolment of pensions, to filing of real-time accounts, there is an ever shifting burden that smaller businesses in particular find onerous. Earlier in 2015, the IoD polled its members on the subject of regulation 13; the results were that half of respondents felt compliance costs were high, versus 15% who felt they were low, while 62% felt regulations were complex against 9% who felt they were not. The top concerns were about the amount of management time that compliance entails, as well as the feeling that the regulatory risks are not addressing what executives feel are the real risks within the business. Issues such as regulatory fees, over-zealous enforcement and value for money, were seen by business men and women as secondary concerns.

Fostering an entrepreneurial environment is possibly even more critical for long-term success. For economies which do manage to embrace entrepreneurism, the situation becomes self-reinforcing and where there is a profusion of new companies, there is invariably the infrastructure to help entrepreneurs. This can range from firms which might be willing to provide services to new ventures on a success fee basis 14, financiers who are familiar with the risks and rewards of small and start-up businesses, or even availability of short-term, flexible-term office space.

The UK has had great success in recent years in increasing entrepreneurship with 586,000 businesses founded in 2014 alone, encouragingly survival rates amongst businesses is also improving 15. The Global Entrepreneurship and Development Institute has increased the UKs global ranking from 14th in 2012 to 4th in 2014. If the UK is to challenge the top three nations, America, Canada and Australia, it will need to address its various productivity and agility challenges outlined in this paper.

0

5

10

15

20

25

30

35

40

Source: OECD, IoD Policy Unit

12 Percentage of 18-64 population who are either a nascent entrepreneur or owner-manager of a new business.

13 IoD Policy Voice Survey, March 2015.

14 For instance finding firms who agree to provide legal services, which pay out at an enhanced rate if a project goes ahead, but at a reduced rate if it does not. Such approaches can be critical to controlling early-stage costs.

15 IoD Policy Report, ‘Opening the equity economy’, by Jimmy McLoughlin

12

Wo

rkin

g P

op

ula

tio

n in E

ntr

ep

ren

eu

r A

cti

vit

y (

%)

2014

2002

EU 2014

EU 2001

USA

UK

UK

USA

12

The idea that in aggregate a country can invest its way to better productivity outcomes is a beguiling one. Certainly there are examples of countries, most notably Germany, where a high degree of corporate investment has been one of the crucial factors driving historically impressive rates of productivity. However, a degree of circumspection is needed. Just as it is possible to invest productively, there is also no question that it is possible to not only invest so badly as to lose money, but less acknowledged to “over-invest”, that is make investments where even if the end result is positive, the capital invested fails to make an adequate or appropriate return. The trigger for over-investment is often where there is undue encouragement of that investment through a combination of investment tax breaks and renewing capital stock too rapidly as companies seek to avoid a high rate of corporation tax. The trick, as in so much of business, is to figure out where value is being added and what enhances the long-term value of a business and wealth of an economy.

Turning to business investment undertaken in the UK; the most common way of gauging business investment is “Gross Fixed Capital Formation” (GFCF). Here the evidence is that British companies have been doing relatively well since at least 2000. Overall only in countries with an extensive natural resources sector, like Canada, has there been more rapid growth of fixed capital formation.

There needs to be an appreciation that while internal business investment matters, simply looking at the capital being deployed within existing companies gives only a partial picture of economic health. Our preferred measure to gauge long-term potential productivity gains is to look at the capital being deployed in both investment as well as in new ventures, and the returns on that capital. One finding this approach does show is that long-term wealth generation is not simply dependent on the level of business investment, but the level of immediate, compared to deferred, consumption.

Effective use of capital

Table 6

Investment Gross Fixed Capital Formation (2000=100)

Source: OECD, IoD Policy Unit

80

90

100

110

120

130

140

150

160

170

Canada

France

Germany

Italy

Japan

UK

US

2000 2004 2008 2012

13

As part of this debate, there have been questions as to why British companies emphasise dividend payments, rather than undertaking investment which could raise productivity. In the IoD’s view this misconstrues a critical point; at a time of great technological change what matters as much as individual business investment is how effectively capital can be reallocated across the economy. Given that most UK company shares are owned by one form or another of collective investment funds, dividend payments are not consumed, but are reallocated by fund managers to new investments. This is one effective, and welcome, method of reallocating capital from cash generative companies to those who can justify to investors their need for fresh capital.

Looking forward, the IoD believes the most important policy is to ensure that capital can be readily reallocated. For capital to be reallocated it first must be saved and this does mean there is a need to ensure that the Government does not seek to achieve a balanced budget through permanently lowering the aggregate capital stock of the country. In plain English it would be a mistake to raise taxes and in so doing move money away from being invested towards immediate consumption. In particular this means avoiding further rises in taxes on the wealthy who save and invest a disproportionate amount of their income.

14

Does Goodhart’s law trump Krugman’s claim? Professor Charles Goodhart has said that dependence on any single variable by the very nature of that dependence makes the variable unreliable. Professor Paul Krugman has stated that: “Productivity is not everything, but in the long run it is almost everything”. Professor Goodhart was referring to monetary policy indicators, not to productivity, but the questions do need to be asked: does too close a focus on productivity pose a greater long-term risk to the economy and prosperity? Is the cure worse than the disease?

We believe that undue focus on any indicator is likely to lead to poor policy outcomes. In pursuing the nirvana of steadily-rising productivity, one has to bear in mind how our economy is changing technologically and how people choose to work, as well as how success might be funded.

• Demographic changes point to the need for flexible working practices, particularly longer working lives and life-long learning.

• Measures that even inadvertently restrict labour market flexibility are likely to have detrimental effects on employment churn and thus on adoption of new techniques and procedures and, ultimately, productivity.

• Speed in adoption of new technologies, as much as enhancing existing mature processes, will help to determine future productivity levels.

• Effective capital reallocation is crucial. Encouraging consumers to defer spending and save, or governments to diminish their expenditure, can enhance business investment and hence long-term productivity.

Conclusions

The Institute of Directors

The IoD has been supporting businesses and the people who run them since 1903. As the UK’s longest running and leading business organisation, the IoD is dedicated to supporting its members, encouraging entrepreneurial activity, and promoting responsible business practice for the benefit of the business community and society as a whole. www.iod.com

Institute of DirectorsFor further information on this report, please contact:

James SprouleChief Economist and Director of Policy020 7451 3113james.sproule@iod.com

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