Sunday, May 27, 2012
Britain has plenty of capacity for growth
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

Plenty of people have been giving advice on the British economy, including the International Monetary Fund, the Organisation for Economic Co-operation and Development (OECD) and others.

The IMF exercise was a bit odd. Pleasing though it is to have the elegant Christine Lagarde, its managing director, breezing through London, this kind of detailed dispensing of advice, in public, is normally reserved for countries in IMF programmes.

Yet Britain is giving the IMF money, not the other way around. I can’t remember Dominique Strauss-Kahn, her predecessor, doing this kind of thing. Maybe he had other things to think about.

Anyway, the IMF says the Bank of England should act now, and the government not too long afterwards. Not doing so could consign the economy to permanently weak growth. Grow slowly too long, and you get used to it. People who do not work for long periods may never do so.

Many of these ideas have been around for a long time. The Bank of England, which is urged to cut interest rates even further from the current ultra-low 0.5% level, considered and rejected this last October.

As for more quantitative easing, it is now plainly back on the agenda, but the monetary policy committee (MPC) voted 8-1 against it this month. Another idea, that the Bank should buy private sector assets rather than government gilts, has been debated for more than three years.

On fiscal policy, the IMF praised the government’s approach, Lagarde reacting with horror to what might have happened in the absence of the coalition plan.

But it also said that some things could be done better. The government could cut public pay and welfare harder, and raising more from unspecified property taxes, to pay for more infrastructure spending.

The other recommendation was a more explicit “Plan B”, including temporary VAT and national insurance cuts, though only if “downside risks materialize and the recovery fails to take off”. Not yet, in other words, but certainly in the event of a messy eurozone outcome hitting Britain hard.

Some will be delighted by this prospect, having argued for a Plan B even in the absence of a eurozone accident. Others will be horrified, pointing to the fact that Britain is already running a budget deficit of more than 8% of gross domestic product.

Last week saw a downward revision of public borrowing for 2011-12 but only to £124 billion. The deficit may be gradually coming down (from a peak of £156 billion in 2009-10) but debt, as conservative commentators keep pointing out, is rising strongly. Any minister wanting to cause mass apoplexy has only to confuse debt and deficit.

The big question, whether the government’s response is to cut the deficit more slowly or is forced to unveil explicit economy-supporting measures is how much deficit-cutting work that will leave to do later.

Debt and the deficit matter in cash terms. What matters most, however, is the structural deficit, that which is left if and when the economy recovers.

The Office for Budget Responsibility, the government’s fiscal watchdog, thinks some three-quarters of the budget deficit, about 6%, is structural. That is why it said last year the chancellor would need further measures, which he interpreted as spending cuts beyond the next election.

Any temporary fiscal stimulus, on this view, would have to be followed by even bigger cuts, or tax hikes, later.

But what if the underlying picture is better than the OBR, the Bank of England, Treasury, IMF and OECD believe? This is what Bill Martin and Robert Rowthorn of the University of Cambridge claim.

Martin, who had a long City career with UBS and Philips & Drew, published a paper in July last year, called Is the British Economy Supply Constrained? Now he has returned to the them, with Rowthorn, in a paper to be published this week: 'Is the British Economy Supply Constrained II? A renewed critique of productivity pessismism', available from Cambridge’s Centre for Business Research.

Since the first paper, productivity pessisism has become more ingrained in official circles. So they take on the pessimists.

The economy is 14% below where it would have been had growth continued at its pre-crisis pace, suggesting plenty of spare capacity. But policymakers are operating on the basis that it is only operating about 2.5% below capacity limits.

I have a great deal of sympathy with this. Spare capacity, the “output gap” is an elusive concept in a largely service-based economy. You do not need to build a new factory to expand output. The labour market has spare capacity, the 2.6m unemployed, as well as migrant workers.

Martin and Rowthorn take on the argument that growth in private sector employment over the past couple of years means employers have given up on productivity. Otherwise, why would they not squeeze more output out of existing workers?

The answer, they say, is that the higher-productivity sectors of the economy are behaving exactly as you would expect in a weak growth environment. They are not recruiting. The growth in jobs has been in low-productivity, low-wage sectors.

What about high inflation? Though the rate dropped to 3% last month, it is high for an economy with plenty of spare capacity. But inflation has mainly been due to import price shocks, they say, not an economy running into supply bottlenecks.

The most striking conclusion that emerges is that rather than a “structural” deficit of 6% of GDP, the true figure is nearer 2%. The authorities could safely expand knowing that most of the deficit will disappear as recovery persists.

It is a potentially game-changing verdict. Martin agrees with the IMF on more quantititative easing and, if possible, even lower interest rates than the current 0.5%.

On fiscal measures, he is less attracted to temporary tax cuts than measures that preserve the government’s fiscal credibility while increasing the flow of finance to the private sector - if necessary bypassing the banks - and investing in public investment projects with, as he describes it, “non-imaginary rates of return”.

The Martin-Rowthorn thesis is that policymakers have locked themselves into a gloomy mindset, in which the economy can only grow very slowly in what they call a narrow “corridor of stability”. If they are right, we could be liberated from at least some of the austerity of the coming years.

The productivity pessimists should respond. The hope has to be that they are indeed too pessimistic.