In the ten years from 1997, the British economy grew at a remarkably even rate. Then, five years ago, it fell off a cliff and, despite the recent recovery, it is still a long way from getting back to where it would have been had the ten-year trend continued.
In a brilliant post for the Financial Times, Chris Giles says that this missing growth has become the central, if unexplained, fact of Britain’s recent economic history:
“Output is now 18 per cent below the previous trend and this purports to signal the failure of the British authorities to stimulate the economy sufficiently over the past five years.
“Of course, such an inference is impossible to make from this chart. The graphic is merely descriptive, showing what has happened, not what was possible, nor whether the 1997 to 2008 growth rate was sustainable.”
It’s easy to see why so many people have turned to a demand-side explanation for what happened. With one financial crisis following another, a collapse in consumer and lender confidence would seem to be a plausible theory.
Many economists have taken the demand-side explanation further, arguing that governments didn’t do nearly enough to prop-up demand through emergency tax cuts and/or public spending programmes. The money would have been channelled into productive capacity that was instead left idle.
It all sounds perfectly reasonable – except that, in Britain, the evidence points the other way. In other words, what pushed our economy over the edge five years ago wasn’t a collapse in demand, but a supply shock.
A key piece of evidence is inflation. If dropping demand really had been the main driver of such a serious disruption of growth, then Japanese-style deflation should have been a problem too. But, in the event, the opposite appears to have happened:
“…since 2008, [prediction] errors on growth and inflation have been negatively correlated. Forecasters have been over-optimistic on growth, but inflation has exceeded forecasts too. This is the pattern you would expect with a supply shock, hitting growth but not pulling inflation down.”
That still leaves a mystery as to the nature of this supply shock – though there are some clues:
“The Organisation for Economic Cooperation and Development produces estimates of how fast an economy is able to grow by looking at changes in the stock of labour (hours worked) and the capital stock and then a residual – total factor productivity – which represents the ability of an economy to use its labour and capital resources to good effect. The concern for the UK is that the current estimated 1 per cent potential growth rate… stems mostly from a drop in this total factor productivity [TFP] rather than a drop in labour or capital resources. It suggests a fundamental drop in the efficiency of the UK economy which started more than a decade ago.”
TFP might just explain how Britain’s productive capacity could have declined so far and so fast. Capital and labour don’t just disappear without trace – some visible cause is required (such as the physical destruction of infrastructure or mass redundancies in the workforce. If, however, the problem is not in the availability of these factors of production, but the efficiency with which they’re deployed, then the supply-side can take a hit despite the non-disappearance of labour and capital resources.
If this is right, then the next thing to work out is why efficiency (or TFP) deteriorated so rapidly in the course of the previous decade.
Perhaps it was because much of the pre-crash TFP was illusory to begin with. In the short term, a boost to GDP from a speculative property bubble is just as good as any other economic activity. After all, a financial return is a financial return. But when the bubble bursts, what seemed to be an efficient use of capital and labour is suddenly revealed to be anything but.