U.K Economy Needs to Break Its Dependence on the Finance

(Bloomberg) -- The U.K. isn't doing as badly as many predicted since it decided to exit the European Union in 2016. Employment rates remain high. Exports, which had surged to records in 2016, held up nicely in 2017.

But it's not doing particularly well either. Since the financial crisis a decade ago, output per hour in the U.K. has remained essentially unchanged. Total factor productivity growth has actually been negative, and lagged many other rich countries well before Brexit:

Possibly as a result, real wages in the U.K. have actually fallen since the crisis.

Meanwhile, the economy is beginning to show signs of weakness:

Since inflation is running at a little more than 3 percent, above the official target of 2 percent, it seems unlikely that Britain is experiencing a demand-driven slump like the one in 2008. Instead, the economy is flirting with stagflation, meaning that fiscal and monetary stimulus is unlikely to help.

What's wrong with the U.K.? Is it a blip, or will Britain become the new sick man of Europe (as the continent's laggards are traditionally labeled)?

Part of the problem is Brexit, and the policy risk that goes along with it. In this kind of environment of uncertainty, companies are reluctant to invest. That means less spending on new technology and business-process improvements, which means lower productivity growth down the line. Even if leaving the EU turns out to be a smart move in the long run -- which we won't know for decades -- the immediate impact is negative.

But Britain's economic woes really got started not in 2017, but in 2008. The financial crisis represented a distinct turning point, after which productivity and wages both grew much more slowly. Part of this might have been due to the country's austerity policies, but the persistence of slow growth after full employment was restored points to a deeper malaise.

The roots of that malaise might lie in the country's economic history. In the 1960s and 1970s, the U.K.'s economy lagged those of peers like France, West Germany and Canada:

In the 1980s, libertarian Prime Minister Margaret Thatcher implemented a number of free-market reforms. Those included the so-called big bang financial deregulation of 1986, which many credit with making London one of the world's financial hubs. In the 2000s, finance really took off as a share of Britain's economy, and by the eve of the crisis it was even higher than in the U.S.

Financial services became a key British export -- by 2007, the industry was contributing about $70 billion to the country's net exports. The huge trade surplus in finance helped the U.K. partly offset a big trade deficits in manufactured goods -- essentially, Britain became Europe's banker (and to a lesser extent, the world's).

After Thatcher's reforms, the U.K. economy did very well in the 1990s, making up the ground it had lost to its peers in previous decades. But as in the U.S., the financialization of the British economy set it up for disaster in the 2000s.

Simply put, too much finance may result in wasted activity. British economist John Kay explains the problem in his 2016 book “Other People's Money: The Real Business of Finance.” The financial industry is supposed to help capital flow to its most productive uses, but sometimes it simply shuffles the money around without deploying it, taking fat fees along the way. Tellingly, business investment fell as a percentage of the British economy in the 2000s, even as finance grew.

So the U.K.'s woes may result from too much focus on finance at the expense of other industries. In the future, finance will probably be a smaller percentage of the economies of countries like Britain and the U.S. To get back on track, the U.K. needs to diversify its economy.

Instead of trying to identify and nurture particular industries -- an approach with a poor track record all over the globe -- the U.K. should focus on building the basic infrastructure for a robust technology industry. The country spends too little of its gross domestic product on research:

Much of this spending should be funneled through universities. The U.K. has a number of very prestigious institutions of higher education; with more government funding, the country could be a science powerhouse. That spending shouldn't be concentrated in the capital, but spread to universities throughout the country's regions.

Making the U.K. a tech giant will also involve taking in large numbers of high-skilled immigrants -- the tech industries of the future will need the best brains. Fortunately, the U.K. is one of the world's most appealing destinations for global talent. With the U.S. increasingly shutting out skilled immigrants due to the policies of President Donald Trump, the U.K. has a chance to steal a march on its former colony. To do this, the U.K. needs to lift or (ideally) remove its cap on skilled workers, and dramatically streamline the cumbersome immigration process.

Finally, the U.K. should think about systematically promoting exports other than financial services. After Brexit, the EU won't be nearly as much of a captive market for British exports, so the U.K. needs to consider other ways to get its products out to the world. This is much more important for a small island nation like Britain than for a large continental economy like the U.S. In this case, Japan  might serve as a model.

The U.K. is down, but it's far from out. After the fall of the British Empire and the stagnation of the mid-20th century, the country successfully retooled itself into a financial services powerhouse. Now, with finance fading and Brexit underway, it must reinvent itself once again.

To contact the author of this story: Noah Smith at nsmith150@bloomberg.net.

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net.

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