Britain has been hit harder than you think
Samuel Brittan The Financial Times 05/02/10
Any British citizen who bases his or her vote in the forthcoming general election on the "flash" official national income figures showing that output rose by 0.1 per cent in the final quarter of 2009 ought to be disenfranchised. These initial estimates are not exact enough even to say where in a range of plus or minus 1 per cent the change occurred. Later revisions - which go on for years after the period in question - could be in either direction. Our hypothetical citizen ought to be doubly disenfranchised if the intended vote is changed by similar decimal percentage point movement in the estimate for the first quarter of 2010 due a few weeks before the most likely date of the general election, May 6.
The fact is that estimates of real gross domestic product are not nearly accurate enough to measure fine changes. All that one can reasonably say is that output was roughly stable in the last quarter after having fallen by perhaps 5 per cent in the year as a whole. Even that is an optimistic assessment of what can be known. Ideally, one should take a moving average of several quarters, assuming that the direction of bias in the reporting has not changed radically. Taking everything into account, including recent surveys and other data, it looks as if the UK economy has stopped contracting.
Does that mean the recession is over? Yes, if you choose to define a recession in terms of falling output and keep your fingers crossed against the possibility of a double dip. But that gives us little insight. What surely matters is the gap between actual output and the trend consistent with non-inflationary growth. You may think that that is like looking for a black cat in a dark room; and in future articles I shall suggest a slightly different approach. Meanwhile, however, the Goldman Sachs UK Economics Analyst makes a heroic attempt to limit the range of argument.
It first assumes that output was on trend in 2005 and that potential output has been growing at an annual rate of 2.6 per cent - a little below the long-term average. On that basis the "output gap" is in excess of 10 per cent. At the other extreme, a statistical method (known to its friends as Hodrick-Prescott filter), based on smoothing out past cyclical fluctuations suggests an output gap of "only" 3 per cent. You can find respectable estimates for all stations in-between. The Organisation for Economic Co-operation and Development, for instance, has a figure of 6½ per cent. Goldman Sachs itself looks at separate estimates of labour and capital growth to yield a gap of 5 per cent, which is similar to the British Treasury's own view.
Looking ahead, Goldman Sachs believes that the output gap is likely to contract - if it is not doing so already. Its starting point is that unemployment has been some 2½ percentage points lower than would be expected on the basis of past relationships with GDP. A popular explanation is that this reflects labour hoarding, in contrast to the US where unemployment has risen much more. One implication of the labour hoarding view is that in the absence of an unexpectedly rapid recovery there are many more job losses in the pipeline. An alternative explanation is that the surprisingly small rise in unemployment already reflects the adverse effects of the credit crunch on physical investment, which fell by an astonishing 14 per cent in 2009. The fact that inflation has been slightly surprising on the upside reinforces the view that spare capacity has been declining.
This may be benign from a short-term point of view, but it suggests that the scope for a long-term improvement in employment is very much less than might have been thought. Indeed, Barclays economists suggest that the sustainable rate of unemployment (sometimes known as the Nairu) will rise from 6 to 9 per cent. Actual unemployment is now 7.9 per cent, suggesting that it has to rise further in the medium term. They also suggest, for good measure, that underlying growth rate of the economy is now an annual 1¾ per cent, compared with the Treasury's assumed 2¾ per cent. This seemingly small difference becomes of great importance projected ahead.
Those economists who emphasise these physical constraints tend to believe that demand may now grow faster than potential supply, and that policy should and will become less accommodative from here. Economists with a more monetary bias, however, are worried by the sluggish growth in some measures of the money supply and bank credit. They are obviously represented inside the Bank of England, whose statement this Thursday can be paraphrased as saying in Fed parlance: "Steady as she goes with a bias towards easing." My own view is that there is little case for action just yet. But the cat may jump in either direction. (Whoever said that macroeconomics was an exact science?) In any case, I would base policy on the state of the economy - real growth and inflation - rather than on a narrow view of the government's own finances, and avoid like the plague the draconian spending cuts and tax increases set out as "options" by the Institute of Fiscal Studies.
|Published on www.samuelbrittan.co.uk
Contact - samuel dot brittan at ft dot com