Can Britain’s economy grow as fast as it needs to?

A fear looming over British politics in the 1960s was that France and Germany would soon surpass Britain’s economy. Today, worrywarts fret that Britain may be poorer per person than Poland within the decade. Sir Keir Starmer, the Labour Party leader, has voiced this concern repeatedly. Donald Tusk, the Polish prime minister, has made overtaking Britain an explicit goal. If both countries were to stay on the same per-person growth trend as in the past ten years, Poland would slip ahead of Britain in 2031. That is unlikely. But the fact that this scenario no longer looks fanciful is a reflection of Britain’s sorry recent growth record.

Little surprise, then, that pledges to reignite growth feature heavily in the general-election campaign. Rishi Sunak, the prime minister, says the economy is at a turning-point and urges voters to “stick with the plan”. Labour, which is well on track to win a big majority on July 4th, has been more explicit still. It says economic growth will be its first priority if it gets into power. The shadow chancellor of the exchequer, Rachel Reeves, has pledged to lead the most “pro-growth, pro-business Treasury our country has ever seen”.

Growth is crucial: it is the only way to keep living standards rising over the long haul. But British politicians also obsess over growth for a narrower reason: an expanding economy is what keeps their tax-and-spending plans credible. Both main parties have signed up to a fiscal rule that requires government debt to fall as a percentage of GDP between the fourth and fifth year of the forecast period. Current spending plans hit that target only by a vanishingly narrow margin, despite including some improbably hefty future cuts to public services. The budget in March left £8.9bn ($11.3bn, 0.3% of GDP) of annual headroom to meet the rule. Today, that figure is down to £4.5bn after some unfavourable moves in the bond market, according to estimates by Capital Economics, a consultancy. Since 2010 chancellors have on average set aside £25bn or so in headroom.

Even these numbers already rely on rosy assumptions about growth. The Office for Budget Responsibility (OBR), an independent watchdog whose forecasts help determine the size of the fiscal hole, is more optimistic about growth than 85% of forecasters. The OBR expects medium-term growth of around 1.8%; the average forecast is for 1.5% (see chart 1). If the OBR is wrong and the average forecast is right, that difference would punch a roughly £30bn hole in the public finances, The Economist calculates. The shortfall could be bigger still. Growth has averaged a paltry 1.1% since 2008. We estimate that this rate would equate to a roughly £60bn gap.

For now these are just figures on a spreadsheet. Britain’s fiscal rules are loose: the five-year deadline for debt to start falling rolls forward every year. But the longer growth falls below the OBR’s ambitious forecasts, the more Britain’s fiscal sustainability will look like fiction. Both main parties have ruled out big new tax rises if they are elected, and have said they won’t rejig the rules to permit more borrowing. Voters have little appetite for spending cuts to frayed public services. Revving up growth, which delivers the tax revenues to fund public services, is the only way to square the circle. So how much growth is it realistic to expect over the next parliament?

The answer to that question should start with an analysis of what has been suppressing Britain’s growth rate. The economy has endured two big external shocks in recent years: the covid-19 pandemic and the energy crisis brought about by Russia’s war with Ukraine. The country would have to be unlucky to endure similar blows in the next five years.

Troublingly, however, the sources of malaise in British growth run far deeper than these one-off events. Productivity growth—the ability to produce more with the same labour—cratered after the financial crisis and has never recovered. Other rich countries also saw declines, but the drop was especially sharp in Britain. Research by John Van Reenen at the London School of Economics and Xuyi Yang at the University of Cambridge suggests that low capital investment (see chart 2) explains Britain’s unusually poor performance.

Economists blame several culprits for that. One is a broken planning system. Britain has struggled for decades to build enough housing and infrastructure. Built-up land per person in Britain has stagnated since the 1990s, just about the worst record in the rich world (see chart 3). Years of under-building have clogged up the economy: housing shortages push workers out of Britain’s most productive areas and poor infrastructure hinders growth elsewhere.

A lack of business dynamism is another suspect. A hallmark of a productive economy is creative destruction: successful businesses grow, failing ones die. That pushes workers and capital to where they are most productive. But in Britain this motor seems to be stalling. Workers are half as likely to switch industries as they were in the 1990s, according to the Resolution Foundation, a think-tank. Business births and deaths are responsible for a decreasing share of the churn in jobs (see chart 4). Dispersion in firm productivity has widened, dragging the laggards further away from the leaders.

Some blame for that lies with Britain’s illogical tax code. It implicitly subsidises unproductive small businesses, for example, which are exempt from VAT if their revenues are under £90,000. A dearth of competent managers probably doesn’t help, either. Another intriguing suggestion from Benjamin Nabarro of Citigroup is that a more services-heavy economy is to blame. It can be difficult to sell intangible assets like databases or customer registers, or to borrow against them, which means unproductive businesses may simply decide to plough on as they are.

And then, of course, there is Brexit. Most economists reckon that leaving the EU knocked several percentage points off the potential size of the British economy. Goldman Sachs, a bank, estimates a 5% hit; the OBR guesses 4%. Part of the shortfall comes directly from higher trade barriers: goods exports have sunk by 10% since 2019. Another problem has been political instability. The Tories took five messy years to settle on their preferred vision of Brexit. Throughout that period, around half of businesses said in surveys that Brexit uncertainty was a top concern for them. Business investment flatlined immediately after the referendum in 2016 and didn’t pick back up again until 2023.

Some improvement to this poor economic performance is plausible. Falling inflation will let the Bank of England lower interest rates: markets are expecting a first rate cut in August or September. Wholesale energy prices are much of the way back to normal. The immediate shock of the post-Brexit adjustment is largely over (although there will be an enduring drag on productivity growth because British firms are more walled off from EU competition). Some of the more sensible Tory reforms might bear fruit. The OBR thinks that a flagship reform to business investment will boost the capital stock by 0.2% over the next four years.

The policy environment should also get better if the polls are right and Labour wins a sizeable victory. Rates of business investment and surveyed investment intentions have picked up a bit since Mr Sunak picked up the prime-ministerial baton from Liz Truss, but they remain low. Greater political stability would not transform the picture in itself but would be a welcome boost. And Labour has a more constructive position than the Tories on two of the biggest drags on the economy.

The party has rightly said that planning reform is vital: Ms Reeves calls planning the “biggest obstacle to growth and investment” in Britain. There is a lot of low-hanging fruit there: only three onshore wind farms have been built in England over the past decade because of retrograde planning rules. In principle a flurry of building could lift growth quickly. But in practice “shovel-ready” projects can often turn out to be anything but. And Labour’s policy proposals appear thinner than the rhetoric behind them (see next story). Critically, Labour has not said much about whether it will try to shift Britain’s heavily discretionary planning system to a more building-friendly rules-based one.

Labour’s approach to the EU is to seek an incrementally better relationship. Agreements on emissions trading and musical touring would be positive, but marginal. Mutual recognition of qualifications and veterinary and phytosanitary regulation (to ease checks on food trade) would be a little more helpful, but trickier to negotiate. The former is contentious within the EU, the latter would make Britain a legal rule-taker.

The big question for Labour is whether it can lay the political groundwork for a deeper reintegration with Europe in a second term, for instance by re-entering the customs union. That would transform British growth prospects much more than anything else currently proposed. But progress there depends partly on an improbable shift in position on the part of the Tories; the EU is unlikely to negotiate a deal that a future British government would be likely to blow up.

Things can maybe get a bit better

Labour’s other big ideas are unlikely to wrench the needle on growth. Its industrial-strategy plans are still opaque. Bidenomics-style splurging is both unproductive and unlikely—Britain simply doesn’t have the money. The green manufacturing sectors that Labour is most preoccupied with comprise just a sliver of Britain’s economy (total production of cars, machinery, electrical equipment and electricity generation adds up to just 3% of British output). A good year for Britain’s legions of lawyers, accountants and consultants would raise growth by much more than an outstanding one in those more eye-catching green sectors.

Labour also wants to beef up workers’ rights in areas such as unionisation, wrongful dismissal and sick pay. That could make workers a bit more willing to switch jobs, though it could as easily make employers more reluctant to hire. In one big respect, moreover, the labour-market tide is turning against Britain. Throughout the 2010s demographic good fortune masked the full extent of weak productivity growth. More women and immigrants joined the workforce, buttressing overall growth even as productivity flagged. But now a slower-growing labour market will pull 0.5 percentage points off GDP growth by 2028, the OBR estimates. Much of that slowdown reflects Britain’s ageing population (although the country also has a particular issue with workers dropping out of the labour market).

Some optimists, including Mr Sunak, put stock in artificial intelligence to boost productivity. But the history of technological breakthroughs suggests they affect growth slowly: desktop computers were rolled out in the 1980s and didn’t affect the productivity figures until a decade later. AI could also be an economic bear-trap; Britain’s mass of small firms excel neither at retraining workers nor at rolling out robots.

Add all this together and what do you get? Ms Reeves has in the past mentioned as a benchmark the 2%-plus annual growth rate achieved during the last Labour government in 1997-2010. Not even the most bullish forecaster expects that. A more realistic scenario is that productivity improvements largely offset the impact of Britain’s worsening demography. But even that would probably mean an annual growth rate closer to 1.5% rather than the 1.8% rate assumed by the OBR. Britain is likely to grow faster than in the recent past, enough to fend off Poland for a while longer. But it will not grow fast enough to spare the next government a big fiscal shortfall or having to raise taxes. ■

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