Financial Times 10/24/2012

Stuck in low gear

Economy Britain’s freedom to devalue the pound and set interest rates has not allowed it to steer clear of the doldrums in which the eurozone is caught. By Chris Giles

Just as Britain appears to be seeking some distance from the rest of Europe, its economic performance looks remarkably similar to that of its neighbours. Despite the freedom of having its own currency and the ability to set monetary policy, Britain is growing at about the same rate as a middling performer in the eurozone.

Such a mediocre showing hides many superlatives – and a few sins. Although growth tallies almost exactly with the eurozone, proving Britain is far from an economic island, the country is at the mercy of a peculiarly British set of economic circumstances.

Its banks are more important to its economy than those in the single European currency and are now better capitalised. Its labour market is stronger, with unemployment falling to 7.9 per cent instead of rising to 11.4 per cent. But the total UK debt burden is higher: public sector deficits at 8.2 per cent of national income compare unfavourably with the 3.3 per cent eurozone average and British inflation has stayed stubbornly high since 2008, eroding household and corporate incomes.

The British economy slid into a double-dip recession this year, with output in the second quarter 1 per cent lower than last autumn. Government ministers, mired in midterm blues, hope that a turnround will start this week with much more positive gross domestic product for the third quarter expected on Thursday.

Barring an unseen disaster, their prayers are likely to be answered. Economists expect the figures to show third-quarter growth of about 0.6 per cent. But this growth, which at an annualised rate would be above 2 per cent, would exaggerate the strength of the renewed recovery. Much of that growth is likely to represent a one-off bounce from second-quarter output artificially depressed by an additional public holiday to celebrate the Queen’s diamond jubilee. The third-quarter figures will also benefit from ticket sales and television rights for the Olympics, which accrued in August even though the money was spent much earlier.

“The big picture,” as repeated last night by Sir Mervyn King, the outgoing Bank of England governor, “is that GDP is barely higher than two years ago.”

For the two years of the coalition government led by Conservative David Cameron, efforts at consolidating the budget deficit have been accompanied by disappointing household consumption, business investment and exports.

The combination has sparked a furious debate. Ed Balls, the Labour party’s shadow chancellor, blames spending cuts and tax increases for what he calls a “flatlining” economy. Calling for looser fiscal policy, he says: “There can be no question that action to kick-start the economy is urgently needed.”

George Osborne, chancellor, shows no signs of performing a U-turn, insisting that his deficit reduction strategy is a necessary condition for market confidence and any recovery.

Influential independent voices are hedging their bets. Fretting that the effects of austerity were larger than thought, the International Monetary Fund has called on Britain, among others, to “smooth their planned adjustment over 2013 and beyond” if growth again fell short of forecasts.

Domestically, the Office for Budget Responsibility saw things differently, explaining low growth as the result of “stubborn inflation hitting consumption and export markets hitting net trade”, but was not willing to exclude the “possibility that fiscal consolidation hit growth harder than thought”.

Significantly, forecasters are more pessimistic about the UK’s scope for rapid medium-term growth. Strong employment growth accompanied by weakness in output has shifted productivity growth far from its long-term trend, implying Britain’s economy is stuck in low gear.

The hope is that the worst is over. Incomes are again growing and GDP will start a gradual jobs-light recovery that will, in itself, repair some of the damage to productivity. That has been the government’s ambition for almost two years, without any clear sign it will come to fruition.

Jobs

Amid a torrent of bad economic news over the past four years, Britain’s labour market has stood out as a beacon.

The total number of people in work is at a record high. In the three months from June to August, it surpassed the previous 2008 peak to reach 29.59m. This performance puts the US, France and peripheral European economies in the shade. The employment rate hit 71.3 per cent, just below the pre-crisis high of 73 per cent.

With more than 1m net new private sector jobs created since the start of 2010, a growth of 4.5 per cent, there has been a transformation in Britain’s labour market compared with the recessions in the 1980s and 1990s. Then, much milder downturns were accompanied by depressed employment for almost a decade.

Three features stand out. First, wage moderation has been crucial to the strong performance. Cheaper labour has helped struggling companies to minimise redundancies and encouraged companies to boost jobs quickly as the economy stabilised.

Second, new employment is not a perfect substitute for lost jobs. Full-time employment remains well below the peak and is offset by a sharp rise in part-time, self-employed and temporary workers. Employment may be back to its peak but the total hours worked remain 1.3 per cent below it and income security is lower.

Third, it matters who you are. Employment is rising fastest for groups above 50 years old. Employment for the under 25s still has some way to go before it regains its peak, while the skill requirements of jobs is also more demanding. Bank of England figures show that growth in private sector jobs is almost exclusively in high-skill occupations.

Productivity

Stagnant output plus rapidly growing employment are an unusual combination.

The simple implication is Britain’s ability to convert human toil into marketable products has taken a dive. Since the second world war, Britain’s labour productivity growth has been a constant at roughly 2 per cent a year, during periods of stop-go, inflation, high unemployment, and boom and bust.

Just at the moment everyone took underlying productivity growth to be a constant in the British economy, the past relationship broke down. Output per worker has not budged since the start of 2007, leaving the level 11 per cent lower than the previous trend would imply.

The cause of this structural shift is not known; many explanations fit the facts but few appear sufficiently powerful to be the single cause.

One important reason has been the dwindling of North Sea oil production, which still requires a sizeable workforce. Another is the 16 per cent fall in the measured output of banks and insurance companies over the past five years without a significant decline in employment.

While manufacturing productivity has resumed a steady rate of growth since the depth of the crisis, there have been huge drops in productivity growth in information, communication and professional services since the crisis.

Small companies, perhaps kept alive in zombie form by banks fearing further losses, are also at the epicentre of the productivity dive, according to the Bank of England, also suggesting specific locations of the productivity malaise rather than a general cause.

But the productivity puzzle has not been solved to anyone’s satisfaction and remains a crucial uncertainty regarding Britain’s economic future.

Deficit reduction

Nothing is more important to the British government than reducing the budget deficit. It is willing to suffer prolonged stagnation and huge unpopularity if it can demonstrate it has cut borrowing successfully.

So far, the Conservative-Liberal Democrat coalition has lopped 30 per cent off the deficit since it blew out to 11.2 per cent of national income in 2009-10 as tax revenues plummeted.

Things were going relatively well until a year ago when the coalition’s independent fiscal watchdog declared that the government had blown its chance to eliminate the underlying deficit by the time of the next election in 2015. The Office for Budget Responsibility’s more pessimistic medium-term growth outlook left the government having to tell the public that austerity measures would last seven years, not five, and that the hole would not be filled until 2017.

More recent bad news on tax revenues as the economy has stagnated makes it likely the OBR will have even worse news for the Treasury in its December forecasts. It is likely another year of fierce spending control will be needed to bring the books back into the black and debt as a share of national income will not start falling until 2016-17 at the earliest.

But not all the news has been bad recently. Unlike in Spain, the government has found local authorities have been squirrelling money away rather than spending it, leading to large downward revisions in borrowing over the past few months. And tax revenue growth has been strong in social security and value added taxation. Corporation tax receipts are very disappointing but the public finances are much stronger than would have been expected with the double-dip recession this year.

Prices

While minds have been focused on persistent over-optimism in UK growth forecasts since the crisis started five years ago, Britain’s sticky inflation problem has been overlooked.

Of the past 60 monthly inflation publications, the annual rate has exceeded the Bank of England’s 2 per cent target 54 times and has averaged 3.2 per cent. Last week, the central bank admitted its most recent inflation forecast was again too optimistic and inflation would stick at a higher level than hoped for the rest of the year.

Next year does not look much better, according to Barclays Capital, with higher oil prices, new student tuition fees, and higher gas and electricity prices likely to keep inflation stubbornly above target and hovering close to 3 per cent for the whole of 2013.

The stickiness of inflation has hit household and corporate incomes and explains why many forecasters accurately predicted how much British households would spend but were overoptimistic about the real purchasing power of the currency.

Stubborn inflation has come as a nasty shock to the UK’s central bank, which has predicted that economic weakness will limit companies’ pricing power from 2007.

Unless inflation has become much less responsive to unemployment and economic woes, the persistent disappointment over the past five years, not matched to the same extent in other countries, suggests that the British economy’s potential for non-inflationary growth has deteriorated.

No one knows exactly by how much or whether this is a temporary hangover from the global financial crisis, but the BoE’s ability to take corrective measures has been severely hampered by stagflation.

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