It is often said that the UK economy is more flexible than that of continental Europe but its slow productivity momentum is a puzzle.

The following article is by Peter Westaway, chief European economist at Vanguard Asset Management, the giant US investment house. It addresses the issue of how, despite the more flexible economy that the UK is said to have, it is struggling to regain momentum in productivity. Given its fundamental importance in driving sustainable increases in wealth, the issue of productivity deserves close attention by readers of this publication. The views of this author aren’t necessarily endorsed by this publication but the editors are grateful to be able to share this contribution with readers.

The UK is leading the G7 pack in terms of growth. This in itself has a ‘feel-good’ factor, enough that George Osborne, UK finance minister, thought it worth mentioning in his last annual budget speech. But is it anything more than a short-term fillip? What are the real prospects for the UK and the euro-zone in the medium term?

It is worth reminding ourselves that despite the perception that the UK’s economy is structurally sounder than that of the euro area, gross domestic product per head in the UK is actually lower than in the euro-zone as a whole. This divergence is largely driven by lower levels of UK productivity per worker. Of course, there is considerable heterogeneity within Europe, so that while the UK’s productivity is some 10 and 20 per cent below that of France and Germany, it is ahead of most others, in particular most of the periphery countries of southern Europe.

It is a subject beyond the scope of this note to disentangle the underlying causes of these productivity differences across Europe, but some interesting comparators are the number of patent applications per head and the proportion of GDP spent on research and development. Both are plausible indicators of the ability of an economy to invest in the cutting-edge technologies that are likely to be closely correlated with higher productivity. The UK falls behind these metrics relative to France and Germany, though it is ahead of other large European economies.

While the measurement of productivity levels is subject to difficulties, it is worthwhile to compare key elements of the composition of growth, population, productivity and changes in participation (including changes in unemployment).

In the years from 1990 up to the financial crisis, UK growth was around 0.5 per cent higher than the euro-zone, which can mainly be explained by strong productivity growth (defined on a per hour basis) of around 2.5 per cent per annum. Since the crisis, UK growth, while weak, has exceeded that of the euro-zone because of a strong recent contribution from population growth, while productivity has made virtually no contribution. The euro-zone by contrast has had positive productivity growth but has been held back by rising unemployment.

Looking forward, most official estimates suggest that UK growth is likely to be stronger than the euro-zone over the next 5-10 years due to higher population growth and productivity improvements (1.1 per cent per annum in the UK versus 0.8 per cent in the euro-zone). By contrast, euro-zone growth is likely to be boosted over the same period by a gradual recovery in unemployment levels.

Horizons
Any estimate over such a long time horizon is bound to be uncertain. The recent so-called “productivity puzzle” in the UK makes it difficult to be confident about future projections (are we entering a new age of weak performance, as Japan did in the 90s, or are we in for a period of catch-up?). There is also uncertainty around policies geared to curb immigration, which could reduce population growth as a source of expanding activity.

If living standards are lower and recent productivity growth is so poor, why is the UK perceived to have performed so much more strongly than the euro-zone in terms of structural reform? The reason is that the UK economy has made much more progress in terms of structural flexibility - a legacy of painful reforms that took place in the UK during the 1980s, but much more patchily in Europe. Germany is a partial exception, where the process of reunification helped to modernise labour market institutions.

Elsewhere in Europe, the need for structural reform is still apparent. This allows UK product and labour markets to respond more quickly and dynamically to economic shocks. One obvious manifestation of this type of structural flexibility is the natural level of unemployment which remains stubbornly high across much of Europe, but appears to be much lower in the UK, allowing headline unemployment to fall sharply in the last two years.

Overall then, the superior labour market performance in the UK relative to the euro-zone is encouraging but it would be complacent to assume that the structural characteristics of the UK economy are generally superior. There is room for improvement on both sides of the English Channel.