Sunday, February 14, 2010
Recession's ruins hide plenty of spare capacity
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

ruins.jpg

What does an economic wrecking ball look like? If you know, and can put a number on it, the Bank of England would love to hear from you.

The last time large parts of Britain’s economy were physically flattened was the second world war. When the wreckage of the Blitz was surveyed, it was clear how much had been lost and what needed to be done.

The nearest peacetime equivalent was the recession of the early 1980s. Then, enormous damage was done to swathes of British manufacturing and the lost capacity was plain to see in permanently padlocked or demolished factories.

This has been an invisible recession — large in scale but harder to see. The great office towers in the City and Canary Wharf, monuments to Mammon, are still standing, though not as fully occupied as they were. So are blocks of city centre flats, products of an over-exuberant buy-to-let boom.

If you wanted to find physical evidence it would be in boarded-up shops. One in eight are empty, including many former Woolworths’ stores. High streets tell us something, though the changing nature of retailing means there were boarded-up stores even during the boom years.

So the question of how much we lost, and how long it will take to rebuild, is not straightforward. It is, however, a key one. Even with uncertainty swirling around financial markets, Mervyn King, the Bank of England’s governor, last week identified the “magnitude and persistence” of the recession’s impact on the economy’s supply capacity as one of the biggest uncertainties in the outlook.

Why does it matter? Put simply, if there is plenty of spare capacity then, as long as demand picks up, the economy should be able to grow for years without running into bottlenecks and higher inflation.

At the other extreme, if enough has been lost and cannot be quickly rebuilt, even a modest recovery could run into the buffers.

So which is it? Official figures show the economy shrank 6% from peak to trough from the spring of 2008 to the autumn of last year. In normal times it might have grown 4% over that period, so if it were operating at capacity before the recession, other things being equal, a 10% “output gap” has opened up.

The Bank expects official figures to be revised up, at the peak and the trough, so I judge its estimate of the recession’s GDP fall is about 5%, which would still leave spare capacity equivalent to 9% of GDP.

How much of that was lost in the crisis? The Treasury thinks there was a permanent loss to the economy of 5% of GDP from 2007 to 2010. Because that loss was spread over three years rather than disappearing in one fell swoop, it thinks the output gap was 6% at the trough of the recession last year. That is a lot of spare capacity. Jobmarket and survey data also suggest a significant gap, though not quite as much.

How quickly it is used up depends on how fast the economy grows in relation to its long-term trend. As discussed last week, some economists think trend growth — the economy’s sustainable path — has been knocked as low as 1.75% a year by the crisis, while the Treasury is sticking to its pre-crisis assumption of 2.75%.

This year, even on gloomier trend estimates, will see spare capacity increasing further with a below-trend recovery. Next year and beyond is where it gets interesting. Despite stressing the uncertainty, the Bank comes down pretty firmly on the side of those who think there is plenty of slack for the economy to grow without restraint, if it can lift itself up from the floor.

Its inflation report attracted headlines last week for conceding that a double-dip recession could not be ruled out (though neither could a rip-roaring recovery) and for King’s phrase that the economy “has continued to bump along the bottom”.

In fact its forecast — slightly weaker growth but greater confidence that some downside risks have faded — is one any sensible person would give his right arm for.

Though the Bank does not do normal forecasts, preferring its fan charts, medians, modes, uncertainties and “skewnesses” (don’t ask), it appears to be projecting growth of about 1.5% for this year, followed by 3.5% in both 2011 and 2012. It remains more optimistic than other forecasters.

At the same time, and this is what raised most eyebrows, the Bank was able to present an aggressively optimistic inflation forecast. After a long period in which its projections have been too low, it expects a dive in inflation from over 3% this week (some say it will be more than 4%) to below 1% during the next few months.

We will know this week if there was a split in the monetary policy committee on the decision to pause its £200 billion programme of quantitative easing. There was clearly a split, a “range of views”, on inflation, with some worried it will stay higher for longer because of the lower pound and rising commodity prices.

What happens to inflation in coming months will not reflect spare capacity but gas prices, post-election tax changes, the effect of the weather on crops, and those other short-term inputs into the consumer prices index.

Further out, I suspect, notions of capacity are more flexible than they used to be. Adding to capacity is no longer about building a new factory or an additional production line. These days it may be as simple as taking a few more people on and letting them work from their computer at home.

So, while I do not think inflation will drop as fast as the Bank expects over the next few months, I do think low inflation will be a medium-term legacy of the recession because of spare capacity. It usually is.

I have got this far without mentioning bank lending. Surely the big constraint on the economy’s ability to grow will be constraints on credit as the banks restructure their balance sheets and boost capital?

The Bank thinks not. It thinks a phenomenon I have written about here, the “creditless recovery” is likely. While credit conditions will improve — loans becoming more freely available — the Bank thinks “access to the capital markets and recourse to internal finances [by companies] should enable output to grow at healthy rates without requiring a significant pick-up in net bank lending to UK households and companies.”

As a prediction, that is almost as bold as the Bank’s inflation forecast for this year.

PS: It seems certain Alistair Darling’s March budget, his third, which may be on March 17 or 24, will be the last formal political event before the election campaign. Comparisons are being drawn with Roy Jenkins’s budget, also his third, just before the 1970 election.

Lord Jenkins, as he became, eventually left Labour. When he wasn’t writing big books, or in Brussels, he spent much of his time protesting his innocence of the charge that his over-cautious budget cost Labour the 1970 election.

Looking back on that budget, April 14, 1970, he had a point. On his watch, Britain’s finances were transformed. Having taken over after sterling’s 1967 devaluation, he could report a budget surplus and a current account back in the black.

The budget took 2m people out of tax with particular emphasis on helping married couples — shades of a current debate. Mind you, the standard rate of income tax was 41.25%. Jenkins confidently predicted growth of 3%.

So is there a risk for Labour that Darling will present a Jenkins-style budget? Apart from that tax rate the answer has to be: if only. Budget and balance-ofpayments surpluses, 3% growth and a decent tax cut. The chancellor would be the hero of the hour.

From The Sunday Times, February 14 2010