Forging Ahead, Falling Behind and Fighting Back

by Nicholas Crafts

  Comparisons of levels of productivity or real GDP per person between countries rely on estimates of the purchasing power parity exchange rate. Inevitably, there are significant index-number problems in any such calculations which are, of course, central to the notion of relative economic decline which is the focal point of this book. They are, however, an essential ingredient of an evaluation of economic growth in the United Kingdom and the development of a database of purchasing-power-parity adjusted estimates of GDP per person for OECD countries by Angus Maddison has had a profound effect. This is especially clear in the context of the Golden Age of the 1950s through the early 1970s. Apologists for United Kingdom growth performance in this period used to point to a higher growth rate than in any other period and dismiss faster growth elsewhere in Europe as simply a reflection of an initial productivity shortfall and greater scope for catch-up. This loses all credibility, however, once it is recognized that the United Kingdom had been overtaken by much of its European peer group and had a lower real income level than they did by the end of the Golden Age.

  In understanding the reasons for success and failure in economic growth, it is essential to examine incentive structures which result from institutions and government policies and which impact on investment and innovation. It has become widely agreed among both economic historians and economists that institutions matter for economic growth. This is, of course, substantiated by United Kingdom experience. The Industrial Revolution itself was predicated on an adequate set of institutions which were already in place including a strong state which could provide essential public goods and underpin a functioning market economy but was not above the law.

  A key aspect of British economic history is that its long-run institutional trajectory was to arrive at a Liberal Market Economy (LME) rather than a Co-ordinated Market Economy (CME) destination in the second half of the twentieth century. In general, this meant a somewhat lower volume of investment and less patient capital than would be expected in a CME although perhaps having a compensating advantage in allowing flexible responses to shocks. The United Kingdom was disadvantaged during the Golden Age, which was the heyday of the CME as a configuration well suited to exploiting the opportunity for rapid catch-up growth from a starting point well behind the United States. On the other hand, when the ICT revolution came along, the United Kingdom was favoured by having the flexibility of an LME.

  Economic historians often stress that institutions are persistent and this means that ‘history matters’. Institutional reform is often difficult even when existing arrangements have plainly become dysfunctional – switching costs are high and the resistance of supporters of the status quo is hard to overcome. The longevity of the ‘British system of industrial relations’ during the twentieth century is a prime example. An implication of persistence is that growth performance can be affected by institutional legacies. At the same time, it is important to recognize that history also matters through its legacy of constraints on the policy choices of vote-seeking politicians.

  Sometimes constraints have been the result of the arithmetic of winners and losers from a proposed policy change. An obvious example of this is the opposition to tariff reform in the early twentieth century where the structural changes linked to precocious industrialization worked against the protectionists and the United Kingdom was something of an outlier in its sustained commitment to free trade. In other cases, the legacy effect works through ‘rules’ which have been put in place intentionally to take away political discretion – for example, the commitment to balanced budgets in peacetime prior to the Second World War. The strongest constraints can, however, arise simply from ‘inescapable’ historical experience which promotes a policy paradigm. Thus, in the Golden Age, the ‘post-war consensus’ (or set of feasible policy choices) was anchored by the political imperative of no return to the perceived failures of the 1930s.

  An important lesson from the history of economic growth is that supply-side policy can make a significant difference, as new growth economics suggests. The most obvious manifestation of this was during the Golden Age when many unfortunate policies were implemented and growth was undermined. Inter alia, there were big problems with industrial policy, control of nationalized industries, design of taxation and policy towards European economic integration. Perhaps, however, the biggest lesson to take from this experience is that competition policy (broadly defined) really matters for productivity performance in an LME. These were errors from inappropriate intervention but there have also been failures to intervene, with a persistent problem being lack of support for civil R & D.

  An unfortunate implication of this discussion is that ‘government failure’ has been a serious problem. There are many reasons for this some of which have already been explained. At bottom, the key point is that, generally speaking, there are few votes to be gained from effective long-termist policies to promote productivity. The silver lining to this cloud is that, provided we don’t forget, at least we know a lot about ‘what doesn’t work’.

  The period of most acute relative economic decline was the 1950s, 1960s and 1970s. This was a period of rapid economic growth during which the United Kingdom failed fully to exploit the opportunity and was overtaken by many European economies including France and West Germany. The main thrust of my argument, simply put, is that growth in the United Kingdom was undermined to a significant extent by institutional legacies which can be traced back to the early start and which interacted with weak competition in product markets to impair productivity performance.

  In earlier chapters, I have outlined the evolution from the Industrial Revolution to the Golden Age of key institutions, namely, the systems of industrial relations and corporate governance, with a distinctive British flavour. These institutions developed along trajectories from which it turned out that it was difficult to escape. Their disadvantages became clear in the context of a malfunctioning LME after the Second World War.

  The British system of industrial relations stemmed from the craft unionism of the nineteenth century. It was characterized by strong but decentralized collective bargaining in which union bargaining power was underpinned by legal immunities. Workers engaged in rent sharing which paid a wage premium and/or accepted low effort bargains. The switching costs of reforming industrial relations were seen as too high both by employers and politicians. The corporate governance of publicly quoted companies was characterized by an unusually high degree of separation of ownership and control with diffuse shareholding, that is, outside rather than inside control and equity rather than bank finance. This pattern was already visible in embryonic fashion in the nineteenth century but was intensified by the transition from personal to institutional shareholding. Short-termism consolidated outside control.

  These institutional arrangements had a potential downside for productivity outcomes. In a world of asymmetric information, the separation of ownership and control implied that managers had considerable scope to underperform or to pursue objectives other than profit maximization, especially if competition was weak. Strong competition is an antidote to these principal-agent problems because it reduces the scope for managerial discretion and also makes it easier for shareholders to detect and act upon underperformance. Multi-unionism encouraged short-termism by workers and exacerbated the hold-up problems entailed in sunk-costs investment. When bargaining power of unions is strong, bolstered by legal privileges and tight labour markets, it might be expected that a significant share of profits are diverted to workers including through the acceptance of restrictive working practices. Competition addresses these problems by reducing the surplus that is available for unions to extract.

  The early post-war decades were a period when competition in much of the economy was weaker than ever before in the context of protectionism, delayed entry into the EEC, regulation, nationalization and a largely ineffective competition policy. This configuration meant that the potential adverse effects on productivity of the institutional legacies of the e
arly start materialized to a much greater extent.

  A further implication of these institutions is that they were incompatible with the so-called ‘Eichengreen cooperative equilibrium’ with wage restraint in return for high investment. In general, this is more likely to be sustained in a CME. The key to maintaining the bargain is that both sides apply a low discount rate to future payoffs. The short-termism endemic in the United Kingdom’s distinctive institutions was not conducive to patience. This accelerated relative economic decline given that other European countries did achieve rapid catch-up growth in the Golden Age through a corporatist approach.

  Finally, it should be remembered that the Golden Age can be seen as the high point of the restricted set of policy choices consistent with the ‘post-war consensus’. This was profoundly affected by the experience of persistent high unemployment in the interwar period and the structure of industrial relations. In particular, the political imperative after the Second World War was to maintain a very low level of unemployment. Strong but decentralized collective bargaining potentially made this problematic, as subsequent experience confirmed only too well. Accordingly, supply-side policy was designed with a view to making it acceptable to trade union leaders in the hope that this would be reciprocated by wage restraint and, in effect, the NAIRU would be held down. This precluded important reforms including, of course, to industrial relations.

  The discussion of this chapter, and indeed the whole book, relies fundamentally on the ideas and techniques of modern economics and the evidence base that has developed based on these foundations. This seems appropriate for an interpretation of the United Kingdom experience of economic growth over the past 250 years. Even so, the learning process between economic history and economics should be a two-way street. In this respect, economic historians have to describe the contours of growth and communicate them to economists. More than that, however, they have to explain how and why ‘history matters’ in the sense that in various ways the past constrains growth performance. My narrative has tried to achieve both these objectives and thus to show the value of a long-run historical perspective in thinking about economic growth.

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