Sunday, November 19, 2006
Economy could move to a higher speed limit
Posted by David Smith at 11:00 AM
Category: David Smith's other articles


What do economic policymakers have in common with motorists? In both cases, if they don’t know the speed limit they will probably get into trouble. But whereas for the motorist the result is likely to be a £60 fine and three points on the licence, for those running the economy the consequences can be rather more serious.

In the past, the sensible thing to do was to assume the worst about Britain’s economy, and to treat suggestions that it had entered a new era with the deepest suspicion.

Now, however, there are reasons for thinking it might be time to revisit some of the assumptions about Britain’s economic speed limit — the rate the economy can grow without triggering higher inflation (or below which unemployment goes up).

The most common speed limit assumption is that Britain can grow by 2.5% a year, or slightly higher, without falling foul of the speed cameras. The Bank of England, explaining in its inflation report last week why it raised Bank rate again this month, pointed to “solid” growth (2.8% over the past year) and the fact that there appeared to be limited spare capacity in the economy.

A new report from Goldman Sachs, UK Supply Side: From Nice to Nasty to Not So Bad, takes a different view. Britain, it says, has in effect had a tune-up, if not a new engine. “Over the medium term, we think GDP can grow at around 3% a year without posing any threat to inflation,” write Ben Broadbent and Kevin Daly.

We have been through tough times, they argue, because of higher energy prices and increased costs (and taxes) on business. But we are emerging stronger, as a result of what is happening to the supply of workers.

When economists look at the nuts and bolts of what determines long-run growth, population is important. Not so long ago (from 1975 to 1985) Britain’s population was flat. For the past 10 years it has been growing by 0.4% annually. Even before the spurt provided by Polish plumbers and Hungarian handymen in 2004, the population was being boosted by net migration.

The economy is also being helped by a rising employment rate — an increase in the proportion of people who can work in fact doing so. Mainly this has been due to an increased proportion of women working, although recently the boost, 120,000 in the past year, has been from people beyond normal retirement age (60 for women, 65 for men), either choosing to work or choosing not to retire.

The Goldman Sachs analysis has another element. In the private sector labour supply should be more plentiful than over the past few years because the public-sector taps will be turned off. It assumes no net growth in public-sector jobs over the next five years. Taking all this together, it concludes that for the next few years the economy’s trend growth rate will be 2.9% — the speed limit has been raised.

This chimes with detailed work by Peter Spencer for Ernst & Young, published in a recent Item Club report. He estimated that, largely because of the expansion of the workforce through immigration, but also because of the greater contribution of older workers and rising investment, the economy’s “potential” growth had risen to between 2.75% and 3%.

“Our judgment is that a significant improvement in the supply side of the economy has led to greater spare capacity,” he wrote. “This should help contain inflationary pressures going forward, while at the same time allowing for a stronger trend in UK economic growth.”

There is an implication in this for fiscal policy. The Treasury is working on its pre-budget report, due at the end of this month or in early December. It has a different view to the Bank on spare capacity in the economy — assuming there is more of it — but it has also taken care not to count its chickens before they are hatched.

In the budget in March, for example, it published estimates showing that “trend” growth in the period 1997-2001 was 3.15%, slipping slightly to 2.75% for 2001-6. It assumed that from now on the trend growth rate would be a modest 2.5% a year.

If the Treasury were to raise that even by a quarter point, on the basis of more rapid growth in the labour supply, the favourable effects on the public finances would be significant. It would allow officials to raise their forecasts for tax revenues, easing the pressures on Gordon Brown’s fiscal rules. Talk of the need for higher taxes would subside.

Treasury officials have been looking at this, although they are always mindful of accusations of politically convenient changes in assumptions, of the kind that dogged the chancellor recently when the timing of the economic cycle was changed.

Even more interesting are the implications for monetary policy — interest rates. The Bank’s inflation report was, by central-banking standards, remarkably relaxed. In summary, it suggested it was a fine call whether 5% Bank rate would do the trick or a small further rise to 5.25% would be needed.
But the Bank’s task would be a lot easier, said Mervyn King, the governor, if it had a clearer idea about the amount of spare capacity which, in turn, depended on the trend rate of growth. As we will see this week.

For David “Danny” Blanchflower, the dissenting voice on the monetary policy committee (MPC), the fact that unemployment is going up — it has risen by 263,000 over the past year on the Labour Force Survey measure — provides a clear indication of spare capacity. What the unemployment figures are telling us, in other words, is that the economy needed to grow by rather more than 2.8% just to keep unemployment stable at a time when the workforce is expanding.

Other members of the MPC are not convinced. The Bank’s regional agents and some of the business surveys are telling them that firms are close to capacity limits. The proof of the pudding is that firms are putting up their prices.

I think Blanchflower may have it right. The surveys that tell us capacity constraints are biting are largely related to manufacturing, which is only a small part of the economy. For many service-sector companies the only capacity constraint may be the supply of labour, as King conceded last week.

Sometimes if it looks like a duck, it probably is one. The combination of a reasonable rate of economic growth and rising unemployment tells us the economy could operate safely at a higher speed limit. It would be unfortunate if we don’t get a chance to test it.

PS: When Whitehall was required to submit to freedom of information requests, little did we realise the glimpses they would provide into the lost worlds of the past. The Treasury has just given us a glimpse into the world of exchange controls.

Younger readers may not know that, until Sir Geoffrey Howe (Margaret Thatcher’s first chancellor) abolished them in 1979, exchange controls exerted an iron grip. Controls, introduced to stop capital outflows and protect the pound, included a £50 limit on the money British holidaymakers could take abroad, a tradition I try to maintain for family holidays.

The Treasury information, correspondence with the Bank of England on a technical exchange- control infringement by two of the Beatles, John Lennon and George Harrison, tells us a lot about the times. “Dear Binns,” writes the Bank’s man, Willson-White, to his Treasury opposite number, Christian names being frowned upon. Binns writes back saying no action should be taken against the two Beatles but that “no attribution is made as to who actually made the decision”. Even in those days, the Treasury was desperate not be seen as soft.

Talking of glimpses of the past, I am still getting over the Mirror’s headline after the announcement that Adam Smith, father of modern economics, is to appear on the £20 note. “Little-known Scot gets his face on £20 banknote,” it said. Sacrilege.

From The Sunday Times, November 19 2006


Dear David,

Well, well,
sputing polish plumbers, treasury officials, ernst & young, goldman sachs, gordon browne, MPC, last but not least handy hungarians.
Are the above ingredients to somehow stave off the inevitable, but so much needed downturn.
the enclosed link takes you a story about the Negative Equity Party
also known as New Labour.
You see.....they can always spend our money to get out of trouble......somehow.

Best regards

Arik Schickendantz

Posted by: arik schickendantz at November 19, 2006 06:28 PM

dear david,

did not quite entered the link correctly, to the artice mentioned in
my comments to you.
correct link is;

Best wishes

Arik Schickendantz

Posted by: arik schickendantz at November 19, 2006 06:44 PM

Here's a more up-to-date link on that theme - their problem is not that they've been spending taxpayers' money in this case, but the money donated and lent by rich donors.

Posted by: David Smith at November 19, 2006 07:25 PM

They go on about rising employment, what about rising unemployment?

Posted by: Kev M at November 22, 2006 09:18 PM

Well that's exactly the point. The economy could grow faster - and needs to - to stop unemployment rising at a time when the labour force is growing rapidly.

Posted by: David Smith at November 23, 2006 10:01 AM