Driving productivity and growth in the UK economy

Management Services, Feb 1999

Driving Productivity and Growth in the UK Economy is the latest in a series of in-depth studies carried out by the McKinsey Global Institute (MGI) on the performance of national economies. It suggests that increased productivity in key sectors of the UK economy could lead to higher incomes, lower prices and greater employment opportunities.

Extracts from the McKinsey Report

The United Kingdom has an opportunity unique among OECD nations to increase its rate of economic growth. By tackling the enduring problem of low labour productivity that so handicaps the UK economy, the United Kingdom could realise the untapped growth potential in many key industries. The prize could be a trend growth rate, over the next ten years, well ahead of the G7 average. In the process, it could catch up and even pass the economic performance of other leading European countries.

In the first part of this article, published in the January edition of this Journal, we looked at the findings of the McKinsey study showing that the United Kingdom currently lies bottom of the G7 league table in terms of output per capita. The study revealed that labour productivity was the main cause and examined the reasons behind this productivity shortfall

This month we look at McKinsey's recommendations to improve UK productivity.

In the report McKinsey diagnosed the United Kingdom's productivity problem in terms that may seem unfamiliar and perhaps even contrary to many engaged in productivity improvement, . For instance, thr report emphasised the effect of product market and land use regulation despite the fact that the United Kingdom is in many respects a highly deregulated economy. Similarly, the report identified barriers to high competitive intensity in sectors such as food retailing, even though the battle for leadership in this sector is evidently a fierce one.

Conventional wisdom would tell a different story about the reasons for the United Kingdom's under performance. It would talk of the apparent reluctance or inability of UK companies and investors to put their money into productivity-enhancing capital; of the low educational attainment and technical skills of the worlforce' and of the scale penalty of operating in a relatively small market.

All of these things - low capital investment, poor skills and sub-scale operations - are undoubtedly factors in the performance of the UK economy. McKinsey's sector studies suggest, however, that in most cases they are consequential or secondary effects rather than root causes. The report suggests that if we successfully address the real root causes, then we will be taking major steps towards addressing these secondary effects.

Extracts from The Report

Capital investment

It is clear that the United Kingdom does have relatively low capital investment and that this contributes to the labour productivity problem, though it does not account for the majority of it. If the country could close its capital investment gap with the United States without changing the level of its total factor productivity, around one-fifth of the labour productivity gap would be eliminated (igure 2).

Conventional wisdom suggests that short term management thinking leads UK companies and investors to demand an unusually high return on the capital they do invest. We find the evidence for this inconclusive. Our studies reveal a more compelling reason for low capital investment in the UK economy; a failure to adopt operational best practices. Only if the barriers to their adoption are removed will UK companies and investors find sufficient opportunities to invest in productivity enhancement. Consider these examples from our product market studies:

Food processing: If EU constraints on milk supply were removed, dairy manufacturers could invest in more plants to produce a wider range of dairy products.

Food retailing: If leading food retailers could obtain the sites they want for large modern stores, they would almost certainly invest substantially more and raise both the capital intensity and the labour productivity of the entire sector.

Hotels: If the cost of hotel construction and refurbishment were lower, hotel operators would be encouraged to invest in well-designed new chains that allow the implementation of efficient operating practices.

Software: If there were higher levels of leadingedge demand for IT products and fewer restrictions on cluster development, there would most likely be greater investment in software development

So there is a strong case for the UK economy to invest more in its capital base. But unless the root causes of its productivity problem are addressed, the impact of increased investment on labour productivity - and thus on economic output - is likely to be limited. If no other changes were made, increasing the level of investment would have a diminishing impact on labour productivity and actually result in a decline in capital productivity, thus generating unattractive returns for investors and savers.

On the other hand, the removal of the barriers to best practice would naturally encourage a surge of investment that would both generate good returns and make a strong marginal impact on productivity. The attractiveness of the investment and its returns would pull in more savings and foreign direct investment, reducing or eliminating the need for government subsidy.