The UK's Prosperity Trap

It's the politics, stupid

And now for your weekend reading. This week’s post looks at the challenges of the UK’s economy drawing on an excellent recent FT piece by Martin Wolf and building on Part Five of Why Politics Fails: the prosperity trap. On which topic, this coming Wednesday, April 26th, at 5:30pm I’ll be presenting Why Politics Fails at the Blavatnik School of Government, in conversation with the BBC’s John Simpson. I’ll try to avoid being overawed! If you’re in Oxford please sign up and come along - if you’re not, you’re still in luck - the event will be online. Details here.

Euston was never London’s most attractive train station. Sandwiched between the Hogwartesque St Pancras and the chic boutique-hotel style of Marylebone, Euston’s… uh… utilitarian look fitted its function - a gateway to the North for business and leisure alike.

But it was due an exciting makeover as the London Hub for HS2. And to make this possible, vast swathes of properties to Euston’s immediate northwest were compulsorily purchased so that new platforms for HS2 could be built. Except now they won’t be for years or possibly forever as the link between Euston and HS2 has been ‘paused’, which could be a Sir Humphreyesque euphemism for a more tragic outcome.

Visitors from the north to London will now exit HS2 at Old Oak Common to the splendours of Wormwood Scrubs and Cargiant. Poor Euston will be left with a phantom limb - a construction site twin that will remain in muddy stasis until the pause is unpaused.

No doubt the planning of HS2 has been a farce, as the estimated cost has doubled over the past half decade. But it has had one beneficial side-effect - for the purpose of this Substack post, it serves as the proverbial skeleton in the scaffold; an example of the underlying mismatch between long-run needs and short-term exigencies that characterises the British polity.

In a recent, widely read column, the inimitable Martin Wolf gave his view of the parlous state of the British economy. One might say he read it its last rites. Beginning with James Carville’s famous advice “it’s the economy, stupid”, he argues that our political system itself is destabilised by the absence of economic growth. Growth’s absence has thrown us into a zero-sum bunfight for resources, providing succour only to populists.

Wolf points to long-run stagnation in real incomes, the pandemic shock, the collapse in the UK’s terms of trade, and high inflation as our four contemporary ills. And behind this he points, sometimes elliptically, to the ‘guilty men’: Britain’s housing market, its dysfunctional investment and pensions regimes, and most of all to Brexit.

And at the end of it all he laments: “The UK is not alone in hitting the economic buffers. But its plight is dire. Why are its politicians incapable of responding?”

Well, indeed. Many of us want to know Why Politics Fails…

The problem that Wolf is alluding to is that the UK’s economy woes cannot be divorced from its political ones. Not simply, per Wolf, that a lousy economy makes political decisions harder, though that is likely true. But because our political system has bequeathed us this particular economy. It’s the politics, stupid.

The Prosperity Trap

Britain keeps on falling into what I call the ‘prosperity trap’. In Why Politics Fails, I argue that sustainable long-run economic growth is always threatened by the short-term temptations faced by politicians - and indeed you and I, as citizens.

The prosperity trap comes in many flavours. Underlying them is the basic dilemma that long-run growth comes from creating a stable (though not stagnant) environment for people to make decisions about investing in themselves through education, in their businesses through private investment, or in collective infrastructure through public investment. But but but… we’re often beset by short-term incentives that cut right against this.

When the benefits of making investments only accrue in the long-run but require incurring short-term costs, it can be hard for us to align our presents and futures. Each of us will have plenty of private examples - losing weight, studying for exams, saving up for a deposit. But politicians face an even sharper tradeoff because elections aren’t forever. When you must face the electorate in a few years, months even, a policy such as HS2, whose diffuse benefits lie a decade in the future but whose costs come now, looks like a vote loser.

A neat example of this is one I draw on when discussing the solidarity trap in Why Politics Fails - Tony Blair’s baby bonds. Each British-born baby would receive £250 at birth and again at age seven - with the amounts doubled for low-income families - which would be invested and only accessible at age eighteen. The idea was that baby bonds would both create more equal opportunities and inculcate positive attitudes to investment throughout the population. Oh and it might also be a vote winner.

Blair promised this policy in the 2001 Labour election manifesto. It took until 2005 to be implemented, with babies born in 2002 to be the first recipients. That meant it wasn’t until 2020 that anyone could access their personal fund and express political gratitude to Tony Blair. By which time, not only had Blair been replaced by Gordon Brown, but Labour had lost three straight General Elections and the Conservatives were on to their third Prime Minister (and, yes, now their fifth!). Whatever the economic merits of baby bonds, it’s hard to see how there could possibly be a political reward to creating them.

This short-termism dilemma is worsened by the structure of Britain’s political institutions. For one, we’re a democracy! I say this partly in jest but the good thing about democracies is no-one is guaranteed to stay in power. That’s practically definitional (at least if you are Joseph Schumpeter). But that means necessarily all democracies will face the prosperity trap to some extent.

But the particular nature of our electoral system and centralised governance accentuates the prosperity trap. First-past-the-post electoral systems have their merits - clarity of responsibility and accountability to the electorate, MPs tied to their localities - but the list of disadvantages is just as long: wasted votes, disproportionate outcomes, fewer viable parties. The chief problem for the prosperity gap though is that first-past-the-post elections can produce scorched earth politics.

Since coalition governments are rare in the UK (and the experience of 2010-15 probably won’t make people rush back), we usually have swings back and forth between an unconstrained Conservative Party and a unconstrained Labour Party. On top of this, the hyper-centralised nature of most policymaking in the UK means that government policies can be changed en masse across vast swathes of the policy landscape that would be unimaginable in a federal system such as Germany or Canada.

All of which is to say, British politicians face both short-term all-or-nothing electoral incentives and have the ability to drastically alter the policy environment as they wish. And so we get volatile, fluctuating policies in every domain of British life: from education to housing to financial regulation to taxation. And in every case, economic growth depends on people’s abilities to make long-run decisions in a stable environment. Precisely what the British political system cuts against. We have designed a political system that practically forces us into the prosperity trap.

So that’s an answer to Martin Wolf’s cri de coeur. Britain’s politicians are incapable of responding to our economic problems because our political system won’t let them. For the rest of the Substack I want to look at a few examples drawn from my own research and from my own experience trying to make policy work in the UK.

Bleak Housing

Where the prosperity trap bites deepest in Britain is in our dysfunctional housing market. Affordability levels have collapsed since the 1990s in terms of house price to income ratios and although lower interest rates have mitigated this, younger generations are still spending substantially higher amounts of their income (either renting or buying) on housing than did their parents. The figure below from the Resolution Foundation’s Intergenerational Audit is striking:

House prices have risen from around 3 to 4 times average incomes between the 1950s and the mid 1990s to around 8 times average incomes since 2000. Whether this is because of increased demand from low interest rates, or decreased supply from a failure to build housing, is a matter of endless debate in the UK housing policy community. But what is clear is that younger generations are far less likely to own houses than they were. There are also implications for geographic mobility as the massive differentials between house prices in the Southeast and elsewhere lock out people from other regions.

We don’t know for sure if Britain’s housing affordability crisis is the root cause of our lack of economic growth. But it’s certainly a usual suspect. High house prices arguably channel savings into non-productive (aka residential) investment, prevent labour mobility, and reduce demand for non-housing goods. And our inability to resolve the housing crisis is a classic prosperity trap.

Take a look at Nextdoor.com. Count the number of posts about potential new developments. Read the replies. And now imagine trying to build new houses in the UK. The costs of new housing developments are immediate and concentrated geographically. Construction sites are ugly, roads get busier, people who already can’t get a doctors appointment or school place worry it will get worse. By contrast, the winners of building new houses by definition don’t live there yet and won’t for quite some time. What’s more, the aggregate supply-side benefit of building new houses - lower house prices in the long-run, resolving affordability issues - is off in the future, highly diffuse in who it benefits, and potentially even hurts existing homeowners.

Politically, it’s hard to imagine why an election-focused politician would ever allow houses to be built at all. It’s all short term concentrated cost for long-run diffuse benefits that you won’t be around (in office) to see. The growth is in the future - the pain comes now.

There is one further nightmarish political element to house-building in the UK. Planning decisions are made locally, where those negatively affected can organise most effectively. If the benefits of building houses in the UK are national and diffuse, even if national politicians wanted to suck up the short-term electoral costs of housebuilding for long-run gains, they still have to get past local councils, beset by angry residents. And as we saw with Rishi Sunak abandoning Liz Truss’s planning reforms, rare is the national politician willing to engage in that kind of guerrilla warfare.

Regular readers of this Substack may recall a post I wrote a couple of months back on support for building new houses at the parliamentary constituency level, using data from a YouGov survey I ran in late 2022. I used an MRP model which allowed me to estimate support at the local level. A number of people - in and out of government - asked me if I could do the same for local authorities, which after all, are where decisions about building houses are actually made.

And I couldn’t then because I didn’t have census data at the local authority level that would let me construct a ‘census frame’, which you need to run an MRP. But then the lovely people at the census released the information, meaning we can get age by gender by education by homeownership for each local authority. And with that helping hand… drumroll… I now have local authority estimates.

As before I have a question about whether people would support building new houses in their local area, with five points from Strongly Oppose to Strongly Support. I take Support and Strongly Support and code answering either as supporting building new houses. And regular readers will know that only 36.8% of people in the survey did indeed support building new houses. So there’s problem one.

But there’s more. Now I have estimates at the local authority level I can connect public opinion to what actually happens when local councillors get involved.

Below is a map of local authorities in England and Wales (I don’t have the data for Scotland or Northern Ireland, sorry!). The darker areas are those local authorities with more support for building new houses. You can see these are far and few between and largely in urban areas: London, Manchester, Bristol, Brighton, Nottingham, etc. By contrast, Essex, Lincolnshire, many coastal areas, dislike building new houses

What explains this pattern? Well the chief culprit is existing patterns of homeownership, which is both plausible and kind of tragic. Below I have plotted the level of homeownership for each local authority against my estimates of support for building houses. Where there are already lots of homeowners, fewer than a third of people, often fewer than a quarter, support building new houses. Where there are fewer homeowners, we have the reverse.

This is plausible because we might expect existing homeowners to resist building new houses that they individually don’t need and for renters to think the reverse. This is tragic because it is a mismatch between public opinion and the levels of housing available. I suppose one could call it ‘thermostatic’ - people want to ‘turn up’ housing where there’s not enough and turn it down where there’s already a lot. Another phrase one might use is ‘I’ve got mine, Jack’.

There is a political dimension to this. Below I have plotted the partisan composition of each council against local support. We can see that in councils controlled by the Conservative Party there is generally much lower support for building new houses, whereas in Labour councils, there is much higher support. I don’t think this is going to overturn any intuitions you had about local politics in Britain but it’s helpful to see.

As I mentioned earlier, looking at the local authority level means we can try to connect public opinion to actual outcomes. In particular to building. Is it the case that places where more people want to build do actually build? Um no.

Now, we need to be a little careful here. As luck would have it, this morning Neal Hudson had a useful set of tweets about different measures of homebuilding in the UK. The take-home is we need to be a bit careful about which DLUHC data we use - so for good measure I’m just going to use both competing measures. The first is DLUHC index of “permanent dwellings started and completed”, which refers only to new builds, and I’ll call new houses completed. The second is the net additional dwellings, which is a measure of the change in housing stock including not only new builds but conversions and changes of use. They correlate pretty highly (R squared of 0.55) but as we’ll see, in urban areas, the latter is much higher than the former.

Let’s start with a map of new builds, noting that I now only have data for England. Have a look at this and then compare to the map above about housing demand. They look pretty different, right? In particular, the London area has high demand for housing and very few new builds (per 1,000 residents). A bunch of more rural areas across the Midlands and East by contrast have high levels of building but low support for building.

The figure below shows the negative relationship between new house builds and support for building new houses. This is, to put it mildly, an unusual relationship in terms of congruence between what the public want and what happens. And I think it helps to explain why there is so much anger about housing in the UK. The places where people really want housing have fewer new builds and those that don’t much like housing are where it is built. And in part, that’s because it is hard, expensive and a long-term effort to build housing in southeast England. No politician is going to push this, so we end up with housing built where it’s easier and there are fewer constraints. But also where it might be further from jobs (which often stay in London).

But hold on, didn’t I say that there’s another measure of house building. The net additional dwellings index, which includes conversions, doesn’t look quite so bad for London - Tower Hamlets and Brent for example look very different in the map below. And that might weaken the negative relationship with public opinion. We’ll explore in greater detail shortly.

Before we do that, let’s return to politics. We know from earlier that Conservative controlled councils are ones where people are less supportive of building houses. So how does that play out with building? Well, with new builds at least, we see that Conservative councils are actually more likely to have more building. Which given how voters (especially Conservative voters) in these districts feel about housing, again explains why housing is especially politically contentious. And why people are so mad on Nextdoor.

We’ve got quite a lot going on now though - homeownership rates, public opinion, who runs the council - which are presumably correlated with another. So what’s doing the work in explaining differences across councils in housing supply? Here I run a couple of simple linear regressions to predict house-building, adding controls for those variables along with voting in the EU referendum, house prices, population density, and a bunch of things I won’t show you (wages, labour market structure, age structure). Here they are:

These figures show the predicted relationships in this model. It turns out not to matter which measure we use (phew!). For both measures of housebuilding, average support for building new houses is negatively correlated with actual house-building, even controlling for homeownership and all the rest. Somehow we have ended up in a situation where people who want housing don’t get it, but those who don’t do. Our short-termist political system is unable to connect our long-run needs with policies.

Can’t Invest, Won’t Invest

While I could (and often do ) write about housing all day, that’s far from the end of short-termist policymaking in Britain. Indeed, the classic accounts of the British political economy typically emphasise the negative impact of a financial sector more focused on quarterly earnings than long-run lending. Peter Hall and David Soskice’s Varieties of Capitalism is especially influential - Britain and the US are ‘liberal market economies’ where firms dance to the tune of equity markets, banks are more interested in trading than in long-run loans, and workers at the risk of unemployment don’t invest in firm-specific skills. This is contrasted with coordinated market economies such as Germany where firms rely on large industrial banks for long-term financing, with those banks in turn represented on corporate boards, and workers serve long firm-based apprenticeships.

There is a long, and for Substack tedious, debate about how well this distinction still applies, especially given German banks have hardly behaved in a risk-averse long-termist fashion over the past two decades. But the insight about UK capital markets has been made many times over several decades - by Andrew Shonfield, by Will Hutton, and by Colin Mayer. Short-termism is bound to accentuate the prosperity trap.

But not so fast. Hall and Soskice emphasise there are benefits of being a liberal market economy. They argue that it helps disruptive, innovative companies who can access speculative capital through IPOs or private equity. So instead of Bosch you get Google (or Theranos, or WeWork, or…) and that’s a tradeoff we might be willing to make. Long-termism is only good if it doesn't mean stagnation.

Which rather raises the question: where is the British Google? Or Apple? Indeed, it seems that Scandinavia has been rather better than the UK at creating dynamic tech companies like Spotify. There are of course some success stories: Revolut, ARM, DeepMind. But Britain is arguably punching below its weight in terms of innovative companies despite having a short-termist financial system that ought to promote them.

One possible answer to that is Britain’s pension regulations. In an excellent FT article on Britain’s ‘capitalism without capital’, Harriet Agnew and Katie Martin argue that the emphasis on prudential, risk-averse investment by British pensions regulators has prevented them from investing in growth companies in the way their equivalents in Canada or the US can. As a member of USS - the only investment firm in the world that seems to think that doubling down on government bonds is the best way to sustainable growth - I am inclined to agree.

This all raises the question of why we have such risk-averse pensions regulators. And this is the flip side of a short-term financial market. With the collapse of Equitable Life, the Mirror Group pension fund, and other dubious pension funds that had ridden Britain’s soft-touch, liquid financial markets to destruction, the regulatory bodies have veered in the other direction, preventing any risk at all. Like Ulysses we have tied our hands to the mast to avoid temptation - in this case to the mast of a ship sinking slowly into the sea.

Or as Dan Davies tweeted:

Skills 2020 2050

The Varieties of Capitalism approach also empathises the crucial difference in skills and training between liberal market economies such as Britain and coordinated market economies such as Germany. The idea is that in the absence of stable employment, and / or generous unemployment insurance, workers won’t be willing to invest time and money in developing skills that are only useful for some types of work or some firms. And the red in tooth and claw nature of the British jobs market means British workers won’t make these investments. Hence the perennial return by governments to promoting apprenticeships as a solution, truly the cicadas of the British political cycle.

Each new government has afresh to announce that this set of apprenticeships, unlike the previous ones, will be respected and well remunerated by employers, and students should trust us this time, please. And yet policy never seems to stick. Apprenticeships might indeed help long-run growth. We just don’t seem to be able to follow through.

And the reason for this is that British governments cannot take their hands off the wheel. As each party alternates in power it reinvents Britain’s training regime. But the time in office of a party is not much longer - if at all - than the training they seek to reinvent.

I speak from experience. In 2004, as a wide-eyed graduate student, I wrote a document for the Treasury called ‘Skills 2020’ - which was a call to invest in so-called intermediate skills (like apprenticeships) with a view to resolving Britain’s ‘missing middle’ in education. That document led in part to the Leitch Review of Skills, on which I served, from 2005 to 2006. The Review recommended a sea-change in government effort on training, including a right to train, the enhancement of Sectors Skills Council, and an expansion of Train to Gain, an employer-led training program. Over a few years most of the recommendations in the review made it into policy.

And then the Conservative-Liberal Democrat coalition government arrived in 2010 and in short order abolished the Sectors Skills Council and Train to Gain. The new government started again with its own skills agenda, much of which ended up re-painting the Leitch Review in slightly bluer / yellower colours but with disruption and institutional overhaul in between. I have no reason to believe that a similar volte-face wouldn’t happen under a Starmer government in the next few years. British politicians faced with the enormous power gifted to them by our electoral system can rarely resist the temptation to change policies, often just for the sake of change.

Britain’s Resource Curse

To finish off on our tour of British short-termism let’s see what we could have won. Maggie’s special prize was a vast trove of fossil fuels under the North Sea. A treat which Norway was also granted. Today one of these countries has arguably the world’s largest sovereign wealth fund, worth well over $1 trillion. The other is Britain.

In the UK we largely spent down the oil windfalls over the 1980s on tax cuts and paying for public spending. Giles Atkinson and Kirk Hamilton estimate that Britain has forgone around £350 billion by spending down what might have been invested in our own sovereign wealth fund,

By contrast, Norway’s coalition government created a series of independent, non-partisan institutions to manage their resources from the North Sea. This kind of model wouldn’t necessarily have resolved Britain’s investment problem I discussed above, because the Norwegian sovereign wealth fund is prevented from investing in Norwegian companies - to avoid the associated risks of corruption and dependent companies. But better long-term management of Britain’s oil wealth could have enabled a nice stream of long-run financing - Norway is able to run a structural deficit of six percent of GDP financed by its wealth fund. And crucial to doing this has been the political stability and consensus not to muck around with this deal.

Can Britain Escape the Prosperity Trap?

Are we doomed to constantly eat our own seed corn like Aesop’s proverbial grasshopper in a Union Jack waistcoat? We’re never doomed entirely. That’s the wonderful thing about being creatures endowed with memory and wisdom and the capacity for change. But our institutions - particularly our electoral ones - create a series of bad incentives. Hence our propensity to keep getting snared in the prosperity trap.

Now one ‘solution’ would be a different electoral system. I think it’s conceivable that a Britain with proportional representation would typically have centrist parties as part of governing coalitions and that might moderate some of our tendency to policy swings. But of course that might feel faintly anti-democratic as the same parties stay in power whatever the election. There are always tradeoffs.

Indeed these tradeoffs are ones economists are very familiar with - between rules and discretion. The British political system amplifies the latter - we can change policy quickly and that can be effective in times of crisis. But rules are key to stability and hence to long-run investment decisions that ultimately might help economic growth.

The irony of Liz Truss’s benighted premiership was that she talked a great game on economic growth while setting fire to what remained of the UK’s reputation for stability. The chaos of the last few years is not simply because ruling parties have few limits on their power in the UK. It’s also because we removed some of the sources of stability that traditionally mitigated that - the rules of the European Union, norms about parliamentary behaviour, trust in our institutions. Yes that’s boring and sometimes constrains majority preferences. That’s kind of the point of the liberal part of liberal democracy.

To escape the prosperity trap, we face a difficult challenge. Some of Britain’s institutions are indeed harmful to long-run growth - see our planning regime. But the experience of education policy shows that volatility can be just as detrimental. Ultimately our politicians will have to find a way to suck up the short-term costs that will come with major reforms to for example housing, but stick to the long-run plan across elections. Right now the desire for quick wins means we find it hard either to make major changes or to commit to them. So we beat on, boats following the tabloid current, borne ceaselessly around and around and around in spirals.

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