Productivity and innovation: not such a simple story

The discourse around innovation and growth is simple, and goes as follows: Britain had been mired in a productivity rut since the financial crisis; innovation is the way out of it. But the years leading up to the pandemic saw concerns grow that it was becoming ever more difficult to create and exploit new ideas. Therefore, the government needs to redouble its efforts at innovation and research and development (R&D) if the country is to become prosperous again.  

Only, it is not such a simple story.

The pandemic has highlighted the virtues of innovation

In the wake of the pandemic, which has magnified the value of science and the UK’s confidence that it can ‘do it well’, the government is eager to seize the moment. The prime minister himself (unjustly) accuses the UK of a dismal recent record in innovation, and vows to pour state money into solving the problem, largely through R&D spending. He will steer the direction too, with a newly announced National Science and Technology Council (NSTC), led by Sir Patrick Vallance, urged to follow national priorities such as climate change and tackling dementia.

In fact, the government’s obsession with science, technology and innovation long predates the pandemic. For Dominic Cummings, so long this its leading thinker, the ability to seize science policy was alone enough to justify the risks of Brexit. But while pursuing specific national priorities may be sensible – it was endorsed in my 2020 report on industrial strategy and pioneered by Theresa May and Greg Clark in 2017 – a failure to ‘do innovation right’ is a poor explanation for the UK’s productivity problems.

Picking or promoting the ‘wrong’ sectors plays little part in the productivity crisis

In my latest report, Productivity: Firing on all cylinders, I look for sectoral culprits behind the UK productivity growth slump. Caution should always be applied to any sectoral breakdown of economic performance – the 20 sector divisions are a misleading portrayal of the complex, interactive and dynamic ferment that is a modern economy. However, sectoral analysis can yield useful insights, and among these is that the UK didn’t flounder simply because it pushed workers and other resources into the ‘wrong’ sectors. The shift into ‘lower value’ industries (in essence to services, from manufacturing) is an inevitable, global trend and was not substantial enough to explain the shuddering stop in productivity growth. Other countries like Germany or Italy that kept a relatively high share of production in manufacturing also saw a slowdown.

Another is that while a few sectors did contribute significantly to the slowdown, this sits uneasily with any explanation centred around a failure of industrial policy or innovation. Financial services, IT, management and consultancy, and law may all have failed to match their pre-financial crisis pace, but that is much more convincingly explained by the long-lasting effects of the crisis on global spending growth than inherent problems with those sectors taken individually. Furthermore, they continue to be sources of competitive advantage for the UK economy as a whole.

Innovation – on its own – is not the answer

A problem with over-reliance on R&D as a tool of policy is that industries can be extremely innovative and yet could either shrink or grow in terms of their economic footprint. It all depends on the innovation. Look at the music industry: this generates vastly more music-consumption in the age of streaming, but is nothing like as weighty in economic terms as previously. Or energy, which through new forms of renewable generation is clearly ‘innovating hard’, but where the effect cannot be seen in terms of output per head.

Even where an industry grows because it innovates, any thoughtful economist ought to question how much it benefits the whole economy for that industry’s ‘gross value-added’ to be larger. What one sector produces, others need to consume. A truly competitive, innovative industry should hit a limit on what it can charge everyone else. Take telecommunications – a sector that clearly transforms the whole economy through innovation: it should surely be seen as a good thing that its revenues are not on an ever-upward march.

The belief that innovation is the key to all growth is neat and simple, but as writer H.L. Mencken once wrote, “there is always a well-known solution to every human problem—neat, plausible, and wrong”. The government’s recent innovation strategy, UK Innovation Strategy: Leading the future by creating it, cannot be accused of simplicity – it is more than 100 pages long, covering R&D funding and science bureaucracy to immigration, and seven “technology families” the UK aims to prioritise.

But it does make that too-simple link between innovation and productivity, hinting in the early pages that the slowdown might have something to do with the R&D budget. Productivity is not a problem solved in the laboratory; the high-R&D sectors account for less than a tenth of workers.

The government should be open-minded in its search for productivity gains

Most of the good productivity gains are to be found in the parts of the economy that use technology, which today can mean any of them. Hence the Strategy’s decision to highlight ideas like the Help to Grow management scheme, which is aimed at businesses right across the economy, is a welcome one. Administration, social care, retail, transport, construction, restaurants – all of these do innovate, but they do not necessarily invent or carry out R&D to do so. Britain’s economic performance provides plenty of evidence for how they could be doing much better, too.  They are, moreover, where the bulk of people work.