Sunday, September 11, 2022
Just wanting a 2.5% growth rate won't make it happen
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. Not to be reproduced without permission

You may have heard enough about the new government already. I call it that because, while it is the same party, it is very different to the one we had until last Tuesday. But bear with me, there are a couple of questions to address.

The first is the impact of the energy price freeze. I am accustomed to using the word bazooka to describe occasions when governments bring out the big guns in response to a crisis. But this very high-cost intervention, like those during the pandemic, takes us towards the Schwerer Gustav as a more appropriate analogy. This was the German heavy artillery – said to be the biggest conventional gun ever – used, though not that successfully, in WW2.

An energy-price freeze is a massive, if untargeted intervention, though so far it is a menu without official prices, in terms of cost. Many of those who condemned it as unrealistic when it was proposed by Sir Keith Starmer have now become great fans. It will bring down measured inflation and help stave off recession. You will remember I and others pointing out that when the Bank of England predicted a significant, five-quarter recession last month, it did not assume any further action from the government, as is its standard procedure. That action has arrived, and it is significant, though it will reduce rather than eliminate the pain for many households and firms.

As an indication of the impact on measured inflation, Goldman Sachs, which a few days ago was suggesting that inflation could peak at 22 per cent early next year, and which had a main forecast of a 14.8 per cent peak then, now thinks the peak will be 10.8 per cent in October.

I use the term “measured” inflation advisedly. As long as gas prices stay high – and there are reasons as I suggested the other day that they might not – this is no more a genuine reduction in inflation than when Denis Healey claimed in the 1970s to have cut inflation at a stroke by reducing VAT. All that is happening is that the inflation is being absorbed by taxpayers, at considerable cost. It remains to be seen how comfortable markets are with that cost. Analysts are already warning of further upward pressure on gilt yields and more sterling weakness. Perhaps paradoxically, they also think this will persuade the Bank of England to raise interest rates by more, not less.

In the meantime, let me turn to another issue, which is the new administration’s ambition to get the economy back up to 2.5 per cent growth, which the chancellor Kwasi Kwarteng reiterated at a meeting with business leaders shortly after taking up his post.

It is an ambition which sounds a bit geeky but which is very important. The economy’s trend growth rate is what determines our prosperity and 2.5 per cent is an interesting number. It is, in fact, exactly the average growth rate for the UK economy since 1949, which is as far back as the Office for National Statistics has formal and reliable data for.

That 2.5 per cent average, however, reflects different experiences for different time periods. Growth was strong in the second half of the 20th century, and the UK outperformed most competitors after joining the European economic Community in 1973. But growth this century has been slower, averaging just 1.8 per cent, and has been particularly weak since the financial crisis, when the average has been just 1 per cent.

Apart from last year’s bounce-back from the pandemic, which followed an even bigger fall in 2020, the only two years of 2.5 per cent-plus growth were 2014 and 2015, s the economy was getting into its stride after the crisis but ahead of the EU referendum.

Pre-crisis, in the 2000s, 2.5 per cent was a very modest ambition for the economy’s trend growth rate. In fact the Treasury, these days thought by the new batch of cabinet ministers to be some kind of malevolent growth-destroyer, used 2.5 per cent as its “cautious” assumption for meeting the government’s fiscal rules, believing that the true trend growth rate at the time was 2.75 or 3 per cent.

When 2.5 per cent trend growth was thought to be the (cautious) norm, it was easily described. Simply put, it consisted of 2 per cent annual growth in productivity, the long-term norm, and 0.5 per cent workforce growth.

Now, 2.5 per cent trend growth looks harder. The Office for Budget Responsibility (OBR), which has always taken a relatively optimistic view on the prospects for productivity recovery, assuming its growth will get back to 1.5 per cent a year after more than a decade of near stagnation. But the OB R also expects the workforce to shrink by 0.1 per cent a year and its estimate of long-run trend growth, published in its Fiscal Risks and Sustainability report in July, is just 1.4 per cent a year. If productivity does not perk up, that might be optimistic.

The trend has been undone by four growth-damaging events; the financial crisis, Brexit, the pandemic and now the cost-of-living crisis. We are back to the age-old question of whether it is possible to waken productivity out of its slumber to get back to the kind of growth we were used to in the past.

Kwarteng, in his meeting with business leaders, was right to focus on “unlocking” business investment as one of the keys to doing this. Rishi Sunak, having identified the problem, was working on this before he stepped down as chancellor. Perhaps his successor will bring forward some of his ideas in coming weeks.

But the challenge of boosting business investment is considerable. Despite a small rise in the second quarter, it remains below pre-pandemic and, indeed, is at pre-referendum levels, despite a large incentive to invest now because of the so-called super-deduction tax incentive.

An excellent new Institute of Government paper by Giles Wilkes, ‘Business investment: not just one big problem’, outlines the difficulty. There are no easy levers for the government to pull to stimulate investment. Merely cancelling next April’s planned corporation tax rise will not do the trick.

“Policy makers once hoped that steadying the macro economy would create the conditions needed for a rise in business investment,” Wilkes writes. “But such stability is often elusive – for reasons both within and beyond the control of politicians … And while macro-economic stability is a necessary condition for growing investment, it may not be sufficient. Nor are the standard recourses of chancellors in the past: financial help for investment, lower interest rates, targeted subsidies or the perennial call for tax cuts. All can make a difference but given the ‘lumpy’ nature of investment none is able to drive new projects when conditions are not otherwise encouraging.”

The policy debate is in danger of getting a bit circular. Business investment would pick up strongly if firms were more confident about UK growth, but long-term growth will not recover without a rise in business investment. It is a bit of a catch-22. Merely talking about growth will not ensure that it happens.