UK: Weak finance, soft productivity – another piece of the puzzle

• The big slowdown: While UK productivity grew at an average of 2.2% YoY between 1998 and 2007, it has since slowed to a mere 0.4%. This deceleration has badly weakened real GDP momentum. Various factors have been proposed to explain this 'productivity puzzle,’ but insufficient attention has been given to the role of financial services, in our view.

• Sending signals: Financial services play a pivotal role in supporting productivity by improving capital allocation and fostering innovation. The sector acts as the economy's nervous system, disseminating information, enhancing price discovery, managing risk, and providing credit for long-term investments. Although UK financial services remain world-class in many respects, mismanagement of domestic-oriented activities has impaired the growth prospects of home-grown companies.

• Helping home-grown winners: The UK remains a world leader in many areas of finance, showing that policymakers and regulators have the know-how to build successful markets. However, neglected parts of the domestic market deserve serious policy attention, especially as they may play a critical role in fixing economy-wide productivity weakness.

“Productivity isn't everything, but, in the long run, it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.”

—Paul Krugman (winner of the 2008 Nobel Memorial Prize in Economic Sciences)

Productivity: the essential ingredient

While almost all advanced economies have struggled to grow their productivity since the 2008 Global Financial Crisis (GFC), the UK’s experience has been especially dire.

UK output per hour growth was a healthy 2.2% YoY, on average, between 1998 and 2007 – almost topping the league for major advanced economies. Since 2008, however, UK productivity growth has decelerated to a meagre 0.4% YoY average. The slowdown has contributed to weakness in headline and per capita real GDP growth and profits.

As one single factor can easily explain the deterioration, it is often referred to as the ‘productivity puzzle’. Economists have proposed a host of possible causes:

1. A normal slowdown in technological progress after the rapid 1980-2010 internet and personal computer boom;
2. A higher share of income going towards saving and credit repayment and away from investment following the GFC to rebuild balance sheets;
3. The rise of inefficient ‘zombie firms’ in the 2009-2021 era of ultra-low interest rates and massive asset purchase programmes by global central banks;
4. Outdated statistical methods for measuring output in modern economies – especially in high value-add services;
5. A succession of external supply shocks, including the 2020-21 Covid-19 pandemic dislocations to global shipping and production and the European gas shock following the Russian invasion of Ukraine in 2022;
6. Rising barriers to global trade and the higher costs of UK-EU trade due to Brexit; and
7. Chronic underinvestment, especially public, in transport and energy infrastructure.

What about financial services?

What remains striking across this broad discussion about the causes of productivity weakness is how little attention is given to a simple observation – that the softness seems to have started at roughly the same time that financial services activity begins to struggle on the eve of the GFC. Figure 1 (cover page) highlights the visible correlation between productivity measured in output per hour (for the whole economy) terms and real output for financial services (finance and insurance). Figures 2 and 3 (page 3) expand this analysis to include the US, the Eurozone, Canada, and Australia.

Two points stand out:

1. The UK had the second-largest growth in financial services between 1997 and 2007, as well as the second-largest gain in productivity; and
2. Since Q4 2007, the UK has suffered the worst performance in both financial services and productivity. The Eurozone comes a close second on both counts.

Major differences between these economies make a true like-for-like comparison difficult. The UK is tiny compared to the US and the Eurozone and is resource-poor relative to Canada and Australia. But these supply-side challenges are probably reasons why the financial services sector may play an even greater role in enhancing UK productivity.

How financial services lift productivity

In 2017, the OECD produced a detailed literature review of research highlighting the importance of financial services for productivity growth and the mechanisms through which it can improve capital allocation and innovation. 

In Figures 4 and 5, we briefly summarise the various indirect and direct channels.

Fixing the nervous system

Even though repeated efforts have often fallen short, UK policymakers have long recognised the importance of building more housing and physical infrastructure to accommodate the UK’s growing population and economy. The same principle applies to financial services, especially domestic-oriented activities such as equities, insurance and pensions.

As economies grow and become more advanced and complex, financial services play an increasingly important role in disseminating information, enhancing price discovery, managing risk and providing credit for the long-term investments that boost innovation. The financial sector serves as a nervous system, helping to efficiently coordinate the whole economic body. When the financial system stops growing, it acts like a straitjacket on the broader economy.

Although the contribution of UK financial services to GDP remains is well off the 2008 peak, UK finance remains world-class in many respects. According to HM Treasury’s 2023 annual review of financial services 2023, the UK has the world’s:

•       second largest asset management centre;

•       biggest market for international debt issuance;

•       highest financial services trade surplus;

•       largest centre for OTC derivatives trading; and

•       Europe’s leading centre for IPOs.

However, for the kinds of activities which are most focused on enhancing domestic productivity, the situation looks much less favourable. Most notably, the UK equity market has struggled badly in recent years. An overly precautionary approach to regulation, persistent outflows and a falling share of domestic ownership by pensions and insurers have impaired the growth prospects of home-grown companies.

That the UK remains a world leader in many areas of finance shows that policymakers and regulators have the know-how to build successful markets. But this neglected part of the domestic market deserves serious policy attention, especially as it may play a critical role in solving productivity weakness.

For a detailed analysis of the challenges facing the UK equity market, as well as potential solutions, please see the following analysis from Charles Hall (Peel Hunt Head of Research):

• AIMing for success – 18 September
• AIMing higher – 17 September
• Selling down the UK – 2 May 2024
• Turning the page (to a better future for the UK) – 1 May 2024
• Revitalising the UK market – pension reform – 4 March 2024