In Britain’s ‘hedgehog economy’, growth is wild, spiky – and fragile

Putting small nocturnal mammals to one side for a moment, the key issue at hand is productivity. Loosely speaking, that’s the amount of stuff we can produce with an hour’s work. It’s one of the most important determinants of our collective economic prosperity. As the economist Paul Krugman famously once wrote: “Productivity isn’t everything, but in the long run it is almost everything.”

More prosaically, the judgment about the UK’s potential rate of productivity growth is one of the most important inputs into the Office for Budget Responsibility’s (OBR) economic and fiscal forecast, because of its outsized impact on economic growth and tax revenues. That forecast will sit behind the budget this autumn and determine what – if anything – Reeves needs to do to meet her fiscal rules for borrowing and debt.

And here comes the rub. The OBR are known to be undertaking a review of their productivity assumption. It’s highly likely that they’ll decide to downgrade their judgment of the UK’s growth potential this autumn, adding billions to the chancellor’s fiscal headache.

Why is this under consideration? Have a look at the chart above, which displays successive OBR forecasts for growth in UK productivity since 2010, including the forecast from March this year, and the outturn (ie what actually happened). There are three key things to take away.

First, without wanting to overstate the resemblance – any readers with extensive training in zoology may notice some discrepancies – the series of past forecasts for a resurgence in productivity growth look a little bit like the spines rising from a hedgehog’s back. It might help if you squint.

Second, in the years after 2010, the OBR expected a recovery in productivity growth to the rates we enjoyed prior to the 2008 financial crisis. This recovery failed to materialise. In 2017, in light of that disappointing experience – which was by no means UK-specific – the OBR made a chunky downwards revision to their productivity growth assumption. That’s why the hedgehog spines get a bit flatter from that point.

Third, and most significantly, while productivity growth tracked – or even slightly exceeded – expectations for a few years after 2017, productivity performance in the aftermath of the pandemic has been nothing short of disastrous. The OBR’s forecast from March of this year looked optimistic not just with respect to recent experience, but also with respect to other forecasters. This is why their assumptions are under review: we are, unfortunately, probably due another downgrade.

This is bad news for Rachel Reeves, and the chancellor is very much aware of that fact. Formal confirmation of any downgrade won’t have arrived until Friday 3 October, when the OBR fired the starting gun on the official pre-budget to-and-fro by sending the first round of their forecast to be pored over by the Treasury. But the chancellor had alluded to the issue earlier that week in her speech to Labour party conference, warning of “choices to come made all the harder by harsh global headwinds and the long-term damage done to our economy, which is becoming ever clearer”. Elsewhere, she argued that “everyone can see in the last year the world has changed”.

This provides a pretty clear sense of how we can expect any tax rises or spending cuts at the budget to be framed: as the result of global forces and long-term damage caused by the last government. Someone else’s fault, in other words.

Rachel Reeves does deserve some sympathy. A toxic combination of weak growth and high interest rates make it an extremely difficult time to be chancellor. In terms of her inheritance, she wasn’t exactly dealt a hand of aces. The increase in the Nato defence spending commitment (from 2% to 3.5% of GDP by the 2030s) is an additional, unanticipated pressure that makes everything harder. Signing up to this was technically a choice, but one that the government could hardly avoid.

The timing of the OBR productivity downgrade may also leave the chancellor feeling hard done by. It’s largely a recognition of slow-moving structural factors – a belated recognition, perhaps, which could conceivably have come earlier. There’s some degree of bad luck in being the one to get bitten by the productivity hedgehog.

But Reeves can’t entirely escape the blame, for two big reasons. The first is that much of this was foreseeable, and is not simply the result of developments over the past year. Indeed, prior to the election, my colleagues at the Institute for Fiscal Studies (IFS) warned of mounting spending pressures, the possibility of a downgrade in the OBR’s growth forecast, and the risks of tying her hands by ruling out increases in any of the three largest taxes. The decision to present the electorate with a Micawberish conviction that “something will turn up” and magic all of the trade-offs away was the chancellor’s.

Rachel Reeves also bears responsibility for the decision to set out “ironclad”, pass-fail fiscal rules and then aim to meet them by the finest possible margin. This lack of a buffer leaves her entirely exposed to the global headwinds she mentioned in her conference speech. If the forecast moves just a little, she’ll find herself on the wrong side of her fiscal rules, forced to adjust policy in response. Again, I’m reminded of Mr Micawber in David Copperfield: “annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds annual expenditure twenty pounds ought and six, result misery”. Cutting things so fine is risky. If intent on employing a pass-fail rule, the chancellor should have used her first budget to build in a bigger buffer, to leave the government better placed to weather global turbulence and inevitable forecast revisions.

Yet we are where we are. What’s to be done? What levers should the government pull this autumn to boost our productivity prospects? Some humility is important here: if the economics profession had confident, politically popular answers to that question, we’d surely already have given those levers a furious yank. It’s also only fair to point out that by significantly increasing planned public investment, striking trade deals, and pursuing planning reform, the government is taking sensible steps that should pay off in the longer term. And, in the public sector, where the government has (more) direct control, my IFS colleagues have shown that the government is already targeting substantial, ambitious improvements in productivity, particularly in the NHS. So far, so good.

But there is always more that can be done. When it comes to our tax system, for example, the chancellor hasn’t yet shown herself willing to grasp the nettle and enact much-needed reform. The bizarre and damaging way we tax property would be a good place to start. Greater use of road pricing could reduce growth-sapping congestion, and help to fill a growing revenue hole in the process.

We surely haven’t heard the last word on planning rules, especially for infrastructure, nor on our trading relationship with the EU. There is more work to be done to understand and, if possible, undo recent increases in worklessness due to ill-health and disability. And so on. If we’re going to escape the tyranny of the productivity hedgehog, no growth lever should be left unpulled.