Sunday, August 06, 2017
A spanner in the works for Britain's growth potential
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

This has been like one of those moments when you get somebody to look under the bonnet of your car because it has been making a strange noise and seems incapable of maintaining any sort of speed.

The mechanic takes a look and emerges with a shake of the head. Some serious damage has been done and it is going to be hard to fix. Better find some alternative arrangements.

In the case of the economy, the man with the oily rag is Mark Carney, the Bank of England governor, assisted by his colleagues on the monetary policy committee (MPC), and the bad news he delivered was in the Bank’s latest inflation report.

Let me make clear what I mean by the bad news. It was not the downgrading of the Bank’s growth forecast for this year than next, which recent weak data made inevitable. It was not the fact that Brexit uncertainty is undermining investment by making businesses unwilling to commit. Anybody with half an eye on the economy knew that too.

They also know, to take one of the Bank’s other points, that the Brexit fall in the pound is the main mechanism for the current squeeze on household real incomes, which is hitting consumer spending and thus the growth in demand.

No, the really bad news in the Bank’s report was its assessment of what is known as potential, or trend, growth in the economy. Last week I addressed the question of weak growth from the demand side: can stronger exports and investment compensate for weaker growth in consumer spending?

The Bank’s point was a related but different one. The economy’s potential growth derives from the supply side. How fast is the economy capable of growing before its speed limit is reached, before inflationary pressures return?

The answer, according to the Bank, is a lot slower than it used to be. Even very modest growth of 1.7% or 1.8% a year will be above the economy’s “reduced potential rate”, it says. The crunch will not come immediately, but it will happen in a year or so.

Hence the Bank’s St Augustine message on interest rates; “Lord make me pure but not yet”. Two members of the MPC . Michael Saunders and Ian McCafferty, think the purity should start now, and rates should be going up. The others will give it a little while longer but were still happy to sign up to the Bank’s message to the markets, that in time rates will rise by more than they think.

Let me focus on that gloomy view of potential growth. The Bank thinks the economy is capable of perhaps only about 1.5% a year. I can remember a time when we snootily used that kind of number as representing all that the sclerotic eurozone, which now has a bit of a spring in its step, was capable of.

To put it in context, just over 10 years ago, the Treasury’s estimate for trend growth was 2.75% a year, and the “cautious” assumption for the public finances was for growth of 2.5% a year. Some Treasury officials thought that the numbers could even support a trend growth estimate of 3% a year. The economy’s potential growth rate, it seems, has roughly halved, or at the very least come down by a percentage point or so.

If you want to know what that means in practical terms, contrast two versions of trend growth, the Bank’s reduced estimate and the Treasury’s old cautious assumption of 2.5% a year. An economy capable of growing by 2.5% a year is by 2030 about 15% larger than one that grows by 1.5% a year.

There are two components to this trend growth gloom. The most important is the most familiar: the failure of the economy to generate normal, or even any productivity growth, alongside continued weak investment. It remains a problem. The level of productivity, output per hour, is lower than at the end of 2007 and has weakened this year.

The other component is population, or more relevantly, labour force growth. The Bank is still using the Office for National Statistics’ assumption of net migration into Britain of 185,000 a year between now and 2039. No official body expects net migration to be reduced to the tens of thousands, the prime minister’s target. If the Bank did, it would reduce its estimate of potential growth further.

Not all the gloom about the supply side is due to Brexit, though to return to my car analogy, that clanking sound you hear is the giant spanner that it threw into the works.

To improve productivity and the economy’s productive potential you need investment and, as the Bank noted, it now expects cumulative business investment growth to be 20 percentage points lower at the end of the decade than it did in May last year.

What else do you need to boost productivity and thus trend growth? The answers are familiar, if delivering them is easier said than done. Philip Hammond has said that if every region of the UK could match the productivity performance of London and the south-east then there would not be a productivity problem, and the London School of Economics, which published its latest Growth Commission update a few weeks ago, is doing some good work on this.

Sir Charlie Mayfield, chairman of John Lewis and head of the government-backed Productivity Leadership Group, rightly says that if the productivity performance of the weakest firms in each sector could be brought up to that of the strongest, there would be a step change in Britain’s performance. Its Be The Business initiative encourages firms to assess their own productivity performance and take steps to improve it.

We know too from successive reports commissioned by many governments over the years, that education, skills and infrastructure are the key to ensuring that individuals, and the economy, achieve their potential. The trouble is that they take time, and rather a lot of it.

They also require a lot of attention. In 1997, when Gordon Brown gave the Bank independence, it was so the Treasury could become an economics ministry, concentrating specifically on improving the economy’s supply-side performance. That was in an era when Britain achieved productivity growth we would give our eye teeth for now.

In the 1980s, under Margaret Thatcher, Britain had a productivity miracle of sorts, particularly in manufacturing. That followed a relentless focus on the supply-side through extensive labour market reform, corporate tax changes which promoted investment and personal tax changes which restored incentives.

Things are different now. As was entirely predictable, Brexit has become all-enveloping for the government and for those businesses most exposed to it. The Treasury is fighting hard its corner hard in its efforts to limit the damage. The government is struggling to get out a consistent message. Thank heavens Theresa May does not tweet.

In the meantime, there is drift, and the economy’s potential is drifting lower. And that is not good news for anybody.