Dear Chancellor, forget the big infrastructure projects. Boosting the productivity of SMEs is the key to growth, writes Paul Ormerod
The Chancellor, Rachel Reeves, has reportedly asked Cabinet colleagues to come up with ideas to boost economic growth. We might reasonably wonder why this exercise was not carried out during Labour’s long period of opposition. Still, something useful may come of it, which is more than can be said of the letter sent at the very end of last year by the Prime Minister.
Keir Starmer asked regulators such as Ofgem and Ofwat to come up with suggestions to stimulate growth. My first reaction on reading this was that it was a brilliant spoof that someone had managed to plant in the media.
Much policy discussion around growth centres on investment. This can be investment in either infrastructure or in what economists call “human capital” – in other words, increasing the educational standards and skills of the labour force.
An overlooked source of growth
The approach has a sound basis in economics. Increases in both the stock of physical capital and the labour force are the foundations of the modern theory of economic growth, first formalised in 1956 by the MIT academic Robert Solow.
The policies of the current Chancellor are essentially based on the standard Solow model of economic growth. Rachel Reeves, in particular, is emphasising the role of investment in infrastructure.
But there is one source of potential growth which is barely being addressed by current policies. Although it is not an entirely new area of inquiry, much more attention has been paid in recent years to the spread of productivity levels – output per worker – across firms in the same industry.
The importance of this wide spread of performance is shown by the fact that the United States Bureau of Labor Statistics and Census Bureau announced a new data product in 2020, Dispersion Statistics on Productivity, to measure and track it over time.
The issue has been investigated here in the UK by the Office of National Statistics (ONS). Their work confirms the statement made by Andy Haldane when he was at the Bank of England: “A long and lengthening tail of [poor performing] companies explains why the UK has a one third productivity gap with its international competitors”.
The productivity gap
The differences in productivity within companies in the same industry is quite striking. Looking at firms at the very top and those at the bottom, the former can easily be four or five times more productive. And these are companies within the same industry, usually defined very narrowly by the researchers.
The American work cited above compares not these extremes, but more typical firms in a wide range of manufacturing industries. For example, the productivity of the company which is more efficient than 75 per cent of all companies and less efficient than the top 25 per cent with the one which is simply more efficient than the worst performing 25 per cent. On average the former is 2.4 times more productive than the latter.
Increasing the productivity of less efficient companies, almost all of which are SMEs, would provide a big boost to growth. There is, in principle, a policy support network already in place, but it is very confusing. Simplifying the funding streams available to SMEs is an obvious step to take.
Local knowledge of companies is essential and is being used in a pilot scheme called the Innovation Accelerator in Glasgow, Manchester and the West Midlands. Even though the monies available are just £100m over two years, there are already some striking successes.
Big infrastructure announcements generate a lot of publicity, which is why politicians of all parties like them when they are in power. But a less glamorous set of policies which target raising productivity in SMEs could well be much more effective.
As published in City AM Wednesday 15th January 2025
Paul Ormerod is an honorary professor at the Alliance Business School at the University of Manchester and an economist at Volterra Partners LLP
