Britain's Growth Problem Isn't What You Think

Five ways to really get the economy growing

Growth, Growth, Growth. We (politicians) love to talk about it. In the long run, it’s sort of everything. But what actually leads to growth? What policies should we pursue to make the economy grow?

Everyone has their own pet theory of growth, and it usually ends up with “whatever I really care about, is what is good for growth”. The right wing thinks it’s all about tax cuts for the rich, the YIMBYs think it’s all about building, the anti-poverty charities think solving poverty will do it, and so on and so forth.

Here’s the thing, all of these people (except the tax cuts for rich stuff) are right about what’s good for growth. But that isn’t the point. We need to know how to maximise growth. The question is what will have the most impact on growth, when it will raise growth, and what we should focus on right now. Both attention and capital are limited, and we need to prioritise.

There is a way to figure this out. Enter Rodrik and Hausmann, and their ‘growth diagnostics’. The major point of the framework is this - figure out what policy change will have the biggest impact on growth, and then do it. There’s a whole decision tree and framework for figuring out what is binding on growth (which interested nerds can read - the maths is particularly helpful).

In order to find what factor is constraining growth, we need to assess both price and quantity signals. The price signal indicates how expensive the factor is, and the quantity signal is evidence on scarcity of that factor.

Let’s use a concrete example of STEM graduates. If there is a large wage premium for STEM as opposed to other graduates, it indicates a relative demand for this factor (price), and if there is a shortage of these graduates it indicates we need more of them (quantity). It turns out there is a large wage premium for STEM graduates as shown and, despite the increase in the number being produced, a large number of unfilled vacancies too. Therefore, we know that increasing STEM graduates will have a large impact on growth.

Notice what doesn’t work in this framework. People (rightly) point to fact that UK investment is very low. But we need to know why investment is so low. A lot of that is due to returns being too low, and that’s what I cover below.

The top five ways to get growth (in order)

1. Low Demand = Low Spending aka the Negative Output Gap

The most important current determinant of growth is that there is low demand aka low spending. During austerity, low spending meant lower growth. The Iran crisis, which will reduce domestic spending even further (high fuel prices mean we spend more on imports from abroad and less at home), also means lower growth. And, in an economy with too little spending, it’s very hard to grow.

We can estimate the shortfall in spending using a quantity measure (the output gap) and a price measure (the natural rate of interest - r*). The output gap measures the difference between actual growth and potential growth (i.e. it is the quantity shortfall in spending). When this is negative, it means that more spending is needed to generate growth. The natural rate of interest (r*) measures the underlying, structural return of investment. It falls when investment and spending are structurally lower.

As you can see in the graph below, the output gap is negative and r* has been low ever since the financial crisis.

Price and Quantity give clear signals that spending is too low

Source: The End of the Road, Alan Taylor, July 2025

We know what happens when we increase spending and the powerful effects it can have on growth, because of the post-COVID stimulus in the United States and their phenomenal growth performance since. A lot has been written about why the US has grown so much more than other nations. But far too little attention has been paid to the simple fact that the US government increased spending through fiscal policy. It spent much more and this led to far more growth.

US GDP was higher than the Congressional forecasts, which undercounted the growth benefits of extra spending

For the UK, we also have a specific regional spending problem. In short, demand and spending are far too low outside the Greater South East and other major cities. Postindustrial areas, in particular, have had far too little spending ever since deindustrialisation. This shows up in these areas as higher vacancy rates, and higher unemployment.

The easiest way to increase spending is through fiscal policy (spending more) or monetary policy (interest rate cuts). In the UK, both are tricky at the moment due to the Iran crisis. Inflation is high while spending is too low. Borrowing more is not advisable because the Bank is worried about inflation (which is more likely to increase rates if we borrow more).

To get around this problem, we have pursued wealth tax-funded cuts in energy bills that mechanically reduce inflation. In the last Budget, we raised tax on dividends and second homes, to pay for a direct cut in energy bills, which got inflation down and gilt rates down too.

This also means a redistribution from the wealthy (who spend a lower share of their money) to the less wealthy (who spend a higher share of their money), which boosts spending overall. This means more spending, less inflation, and more room for the Bank to cut rates.

2. Energy Costs

The second most important constraint holding back UK growth are energy costs, which are the highest amongst high-income nations. This raises costs for every business - from your local pub to the steel mills in Scunthorpe. This especially hits businesses who produce tradable products, because they have to compete on price with companies overseas. This leads them to cut investment to stay competitive or, if energy prices stay high for a while, go out of business altogether. The big problem here: exporting businesses are a third more productive than non-exporters.

As you can see below, electricity is very expensive here (the price signal) with much less energy consumed here per person as well as higher imports of energy intensive products e.g., steel from abroad (a quantity signal).

Industrial energy prices (including taxes) - pre-British Industrial Competitiveness Scheme

Our energy costs are so high because we are dependent on natural gas, which sets our electricity price far more than in other nations. Natural gas was more than 50% more expensive than wind and solar, and is now even more expensive as the cost of natural gas has risen post-Iran. The good news is that the build out of the renewables means that natural gas is setting the price of our electricity far less today. Natural gas was setting our electricity price 90% of the time in 2021 - it now sets our electricity price around 60% of the time.

Solar is now cheaper to build than fossil fuels even not including the fact that the sun is free

Source: Ember

3. Transport Infrastructure

The UK has higher transport costs than elsewhere, and it’s holding us back by reducing connections between people.

Transport increases the effective size of a place by reducing travel times. Before the Elizabeth Line, it took an hour to get from deep East London to Paddington. Once it was built, it took 30 minutes, and you could now commute to central London much more easily. Suddenly, you could apply for many more jobs, making it easier to find one that you’re a better fit for and in which you can be more productive. It also means there are more people within an easy commute, with whom you can share ideas and innovate. This means higher wages for you today, higher wages for you in the future, and higher productivity for us all.

But, as anyone who has used a train outside of London will know, not everywhere has a new £19bn rail network. Bad transport holds us back, and we see this in commuting times (which we can take as the price of transport) and the fact that much less area is accessible from British cities within 30 minutes than European cities (the quantity signal).

Source: Stansbury, Turner, and (Ed) Balls

Source: Rodrigues and Breach (2021)

Building more infrastructure is a matter of cash (obviously) but less obvious is the need for devolution and control of transport policy away from London. It’s not a coincidence that areas with more devolution (read: London and Manchester) also have far better transport infrastructure. We all know about TfL and we’re all learning a lot about the Bee network at the moment.

4. Diffusion of Innovation AKA non-frontier company policy. Getting finance and improvements away from the frontier.

The UK has world-leading research and some of the most productive companies in the world. Our problem, however, is away from the leading edge of these companies, other firms are falling further behind. The ground-breaking and other innovation we are making simply is not diffusing away from the leading edge.

Source: van Ark and O’Mahony

We see this in both the growing productivity gap between leading companies and others (the price signal as a premium on innovation) and a long tail of low productivity companies unable to catch up (the quantity signal). The UK’s SMEs are also poor on other measures like digital adoption as well.

As my colleague Liam Byrne has noted in his excellent piece here and work elsewhere, we don’t have institutions (like Fraunhofer, which supports adoption amongst SMEs in Germany) to diffuse innovation throughout the economy. These SMEs sometimes fail to get access to long-term ‘patient capital’ investment, which is available from policy banks in Germany. The UK also has, as John Van Reenen has pointed to, managers who appear to innovate less than their overseas counterparts.

5. STEM and Technical Skills

As Ed Balls and others have shown, and as I covered above, STEM graduates both get a large premium in what they’re paid (a price signal) and there is a well reported shortage of them (a quantity signal).

Source: Stansbury, Turner, and (Ed) Balls

But there is also another huge skills issue in the UK - technical skills, like construction workers, are in short supply. We simply do not have the plumbers, builders, and engineers we need. These workers are seeing their wages rise faster than elsewhere (price signal) and there are large shortages as shown in vacancy data (quantity signal).

The answer here is obvious. Invest more in STEM degrees and train more technical workers. This is both needed at university (more training of STEM graduates) and in sixth-form colleges, where we are not training enough technical workers.

What is not holding back growth

A brief note on what is not holding back growth. Firstly, high taxes on the wealthy are not costing us in terms of growth. Taxes on wealth are less distortionary than taxes on work, and we have taxed work over wealth. Having more billionaires than peer nations hasn’t led to more investment here. Secondly, Employment Rights. Trade union membership fell over the 2010s, but this categorically didn’t boost growth. Historically, peer nations in Europe tend to have stronger workers’ rights than we do, but this doesn’t seem to give us a growth advantage.

Conclusion

Growth isn’t a mystery. We know what’s holding Britain back. It’s low demand, energy, transport, diffusion, and skills, in that order. Fix the binding constraints and growth follows. This is what a serious growth agenda looks like.