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Philip Booth of the IEA: There's a threat to growth, despite the recovery. Here's what it is - and how to counter it.

Professor Philip Booth is Editorial and Programme Director at the Institute of Economic Affairs.

Screen shot 2013-09-09 at 18.44.44George Osborne capitalised on some good economic news in his speech yesterday. He argued that the economy has turned a corner, though he emphasised that risks remain.

If we are turning the corner, however, we are turning it slowly. After the Great Depression, the UK economy shot back to growth, and a little more than five years after the Great Depression ended the economy was back to where it would have been if there had been no depression at all.

Contrast that performance with the Great Recession. Not only have we not made up for the lost growth since 2008, we are actually producing less today than we did before the crisis. Arguably, it is the worst recovery from peacetime recession in British industrial history. In past recoveries, the economy has grown rapidly out of recession. Similarly, we should have had growth rates of over 2.5 per cent in the last two or three years.

What has happened? Firstly, there has been a banking crisis: recessions caused by banking crises are often worse than recessions caused by other factors. However, unlike in the 1930s, when we had a balanced budget, a small public sector and a liberally regulated economy, the current government presides over a very different policy background.

In research published by the IEA today - Will Flat-lining Become Normal?  - a group of leading economists argue that there has been a significant fall in Britain’s sustainable growth rate. The long-run growth rate has fallen, they argue, to about one per cent. In any given year, the economy might grow more or less rapidly and, in the next few years, we might expect growth above one per cent because we have so much catching up to do. However, we will not experience the sort of growth we should see post-recession because the long-term growth potential of the economy has declined dramatically. The main cause in the fall in the sustainable growth rate is a slump in productivity growth. The reasons for this are varied. Some are within the Government’s control and others are not. The authors of our research, however, identify the following as important factors:
  • Increased government spending and taxation. This factor alone has reduced the sustainable growth rate by around 0.5 per cent – possibly more. The government is struggling to reduce its spending to significantly below 50 per cent of national income. As a rule of thumb, for every extra 10 per cent of national income the government spends the long-term growth rate falls by one per cent.
  • Increased regulation of the energy and financial services sectors. These sectors had contributed substantially to the productivity performance of the economy in earlier decades but they are increasingly being bound up in red tape. In relation to the banking industry, this is understandable, if misguided. However, when it comes to other aspects of financial services, such as insurance, the government’s performance is just as bad. Little needs saying about energy policy, where the government’s approach involves subsidising highly inefficient mechanisms for decarbonising the economy.
  • The contraction of credit since the financial crisis – this is something that is also partly driven by regulation.

It is less easy for the government to do anything about other factors causing the fall in productivity growth, such as the depletion of North Sea Oil or the demographic pressures from an ageing population.

All this points to the UK economy turning the corner slowly. But things could get better. If the government succeeds in its plan to reduce government spending to 40 per cent of national income, this will help raise the long-term growth rate back towards a reasonable long-term average of 2.25-2.5 per cent by around 2017. Credit should naturally expand again as banks get used to tighter regulation – though a reappraisal of regulation would help significantly. Finally, if the government liberated the energy sector, including allowing fracking, this would help offset the effect of the depletion of North Sea Oil. A more coherent environmental policy would also help in this area.

So, Osborne is right in the short run – we are turning a corner. However, things are not nearly as bright as they could have been, partly due to his inheritance and partly because of decisions this Government has taken. Nevertheless, if he sticks to his deficit reduction and spending consolidation plans, the long-term outlook for the UK economy will look rosier within four or five years – not as rosy as it would look with a radical plan for deregulation and reduction in government spending, but at least we should get back to respectable growth rates again. However, we will not regain much of the ground that we have lost since 2008: that output is lost forever unless we have some really radical policy changes.

The level of Britain’s sustainable growth rate might sound like a technical and arcane concept in the context of the day-to-day news releases relating to actual economic growth. However, it does matter. At the current sustainable growth rate, we double our income every 70 years. If we get back to the rates of the pre-Brown years, we will double our income every 25 years.


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