What explains the problems the Labour government faces?

  

The Labour government is clearly in deep trouble. In this blog I want to argue that the problems are ones that have a long history but can be solved. The basic problem is that since the 1970s there has not been enough investment in the economy. While the low levels of investment have often been given as a problem facing the economy I want to argue it is the problem. How this problem has affected almost every aspect of what the labour government wants so achieve will be the focus of this blog.

The labour government came to office promising growth. The reason for the promise was obvious. Without growth the rise in public sector spending, which the economy obviously required, would need higher taxes. Having promised that it will not increase national insurance, the basic, higher or additional rates of income tax, or VAT (the three biggest revenue-generating taxes) the government was stuck. Initially Rachel Reeves raised national insurance on firms finessing the manifesto promise on national insurance by refocusing the commitment as not taxing working people. By the middle of 2025 it was widely assumed that further tax rises would be required and how the promised growth was to be achieved was not explained.

To increase the size of an economy requires both more labour and more capital. The ONS has produced data that enables us to measure the total increase of labour and capital to the market sector of the economy. (A note on this data is at the end of this blog). In Figure 1 I show the annual percentage changes of labour and capital services from 1970 to 2024. The red line in the charts is the trend of the growth rate. We see dramatic differences. While there is a modest upward trend in the growth rate of labour services there is a much more pronounced downwards trend in the growth rate of capital services. In the figure I also show average growth rates, for the whole period from 1970 to 2024 and before and after the financial crisis of 2008 and 2009.

Again, the ONS data enables us to measure both these aspect of the determinants of growth per person and we show how their growth rate has varied since the 1970s in Figure 2 and before and after the financial crisis. The left-hand part of Figure 2 shows the growth rates of the capital labour ratio. As we would anticipate from Figure 1 with a rising growth rate of labour and a falling growth rate for capital the result is a rapid decline in the growth rate of the capital labour ratio. There is also a decline in the rate of growth of total factor productivity. Notice that when we get to 2024, ie the year Labour was elected, the growth rate both of the capital labour ratio and total factor productivity is negative.

We can now show how the growth of capital and labour has changed output (the left-hand part of Figure 3) and how output per person has changed (the right-hand part of Figure 3). As we can see from the right-hand side of Figure 3 the long run decline in the growth rate of output per person has given us a negative growth rate by 2024.    

 

It is important not to conclude from these figures that the red line tells us that there has been a steady decline in the rate of growth of output per person. It is probable that the financial crisis of 2008 to 2009 was followed by a step down in the growth for output per person, and the factors determining it shown in Figure 2.

 Finally, we look out at how closely linked are capital labour ratios and total factor productivity to the growth of output per person in Figure 4.

Any view as to how economies grow in the long term must focus on both the extent of investment which ensures rises in the capital stock and factors that determine TFP. The latter are complex and in large part unknown. So, the focus of policy needs to be on how investment can be increased. While the rhetoric of government may focus on growth it is less clear that the means to attain it are understood.

A note on the data

The data used in this blog are ONS data to measure capital deepening and TFP by market sector. They are described as ‘Official Statistics in development’. The ONS notes say that the dataset used contains experimental estimates of growth accounting statistics for the UK market sector. Data for the market sector which is used in this blog ‘includes all industries whose products have an economically significant price. This excludes central and local government, non-profit institutions serving households, and imputed rental. The latter is an estimate of the housing services consumed by households who are not actually renting their residence. Its inclusion in the National Accounts ensures the valuation of housing services is calculated on a consistent basis over time and between countries.’