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The UK economy contracted 0.2% in the last three months of 2011.  For 2011 as a whole, the economy grew just 0.9%.  Expect to see plenty more of Ed Balls' notorious flatline hand gesture.

Three key factors account for (though do not explain – we'll come to that shortly) the slow growth of 2011:

  • Investment growth has not been as high as hoped
  • Growth in exports has not been as high as hoped
  • Inflation has been higher than hoped

On the impact of inflation, it is of interest to consider the following graph from the OBR's November Economic and Fiscal Outlook report.

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This chart illustrates how significant price rises were in depressing household incomes in 2010 and 2011 – indeed, more so than in 2008 (because inflation was more sustained in 2010 and 2011).  It also illustrates that the net effect of tax and benefit movements (not policy changes, simply the evolution of taxes and benefits partly reflecting past policy) was positive for disposable income in 2011.  (Note, however, that the effect of the VAT rise appears in the prices effect here, rather than the net benefits and taxes effect.)  Direct tax and benefit changes are only scheduled to start to reduce household disposable incomes from 2013.


The tale on exports is also slightly curious.  Consider the following chart (from the same OBR report):

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This chart illustrates that since the March 2011 budget, statisticians' opinions about how much net exports have contributed to output has been revised up.  This was particulary so regarding how much net exports rose in 2009 and how little they fell in 2010.  But we can see that for 2011 the slope of the lighter blue line is less steep than that of the darker blue line – net exports rose in 2011 by less than had been expected.  The Eurozone crisis was one obvious factor in this.

Finally, we can see the dog that didn't bark – government spending.  Government spending rose in 2011.  Despite all the talk, there have not been any overall cuts in government consumption spending yet.

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Indeed, for 2010/11 and 2011/12 government spending has (in an accounting sense) been a contributor to GDP.  Only from 2012/13 are there scheduled to be actual reductions.  Indeed, in the latest GDP numbers, government spending rose 0.4%.

So the story of 2011 was that spending continued to rise, inflation was high, the Eurozone crisis reduced net exports, and domestic business investment did not step into the breach.  That doesn't explain slow growth, though – it merely accounts for it.

Inflation is a significant problem.  The UK economy is now in a situation where unless it is actually contracting, inflation goes to 5% and rising.  It has fallen back a little over the past couple of months (as the downturn bit).  In the first part of the year, it is about to fall artificially, through something called a "base effect".  What happened was that VAT rose 2.5% in January 2010 and again by 2.5% in January 2011.  The 2010 rise raised 2010 inflation – by of order 1.3% or so.  If VAT had not risen in 2011, then that effect would have dropped out at the start of 2011.  But because VAT rose in 2011 as well, that means that the 2011 inflation rate was neither elevated nor depressed by the VAT rise – there was the same amount of rise as the previous year, so neither acceleration nor deceleration in VAT.

As we reach January 2012, the January 2010 VAT-rise-related will be "reversed" out of the figures, artificially decelerating inflation in the early part of 2012.  (Most people writing about this seem to imagine that the January 2011 VAT rise made 2011 inflation rise, but that's wrong – the acceleration in 2011 was nothing to do with the VAT rise; all that the VAT rise meant was that inflation was not artificially decelerated.)

So inflation is likely to fall further, even if the economy does not weaken more.  Of course, if we go into a full-blown double dip, then inflation will plummet.  But it is a sorry state for the economy if the Bank of England needs to hope for a depression if it's to get anywhere close to its inflation target.  If there is any pick-up in growth, then inflation will pick up again.  (And this despite 2011 broad money growth being placid.)

Why is growth so low and inflation so present (despite slow money growth)?  The reason is that the UK economy's underlying capacity to grow is now very low – perhaps only 1% per year, versus around 2.5% in the past.  Because the capacity for the economy to grow sustainably is very low, when there is any growth it tends to be quite inflationary.

This is dangerous.  If the economy only grows at around 1% per annum on average over the next five years, we shall see an inexorable rise in household financial distress.  Some 12% of mortgages are already in forbearance.  That figure will escalate if there is not real growth or high inflation.  That will lead to defaults, and the British banks going bust even with government guarantees, epic losses on government bailouts (cf Ireland) and the sovereign going bust (a la Ireland and Greece).

Medium-term growth needs to be the government's priority.  Much discussion of growth misses the point that it needs to be medium-term sustainable growth.  Most people talking about growth ask how to "stimulate" the economy.  But stimulating the economy (even if one could do it) is a matter of getting one or two quarters of a bit faster growth now at the expense of slightly slower growth later, with no fundamental change in medium-term growth.  That would be useless – worse than useless if what one did to stimulate growth threatened a loss of bond market confidence (cf France).  We need faster medium-term growth over five to ten years, not faster growth for three or six months.

For medium-term growth, the government has a number of tools.  The most straightforward and most potent are the level of government spending and the efficiency of that government spending.  The government is planning to cut government spending from nigh on half of GDP to around 40% of GDP.  That could add around 0.5% to annual medium-term growth.  The government has not so far produced any especially credible plans for increasing the efficiency of its spending – other than the notion that that might happen automatically, as departments increased efficiency to cope with more constrained resources.  One should not underestimate the potential for that to work, and the reverse was clearly the case – as public spending boomed under Labour, public sector productivity actually fell from 1997 to 2007.  If public sector productivity had grown at the same rate as private sector productivity, actual GDP growth might have been as much as 0.5% per year faster.

If the government is serious about making the economy grow faster, it should focus on the efficiency of its own spending.  Apart from the level of spending, that's where the big numbers are available in terms of boosting growth.  If it wants to achieve private sector levels of productivity growth, it should seek to use private sector methods – competition, profit motives, consequences for failure (e.g. being sacked).  Private sector methods in health, education, defence – that's the way to get medium-term growth back.

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