Keynesians, this one’s for you. At the heart of the stimulus versus austerity debate lies the vexing question: to what extent have advanced countries’ structural growth prospects been downgraded by the financial crisis, due to high indebtedness, weak banking systems and potentially weak demographic potential?
In the 1970s, UK policymakers fuelled inflation by relaxing monetary policy to boost demand based on estimates of potential output, or spare capacity in the economy, which were too high. Fast-forward to 2012 and the opposite risk rears its head: estimates of spare capacity are too bearish thanks to the demand-side deniers in Westminster, argue mostly centre-left economists. In short, the larger the negative output gap – ie below-potential growth – the lower the inflation risks from a looser fiscal or monetary policy, while suggesting public sector borrowing is more cyclical rather than structural in nature.
However, the rationale for both the government’s austerity-driven programme and the Bank of England’s monetary stance have been boosted in recent years by the consensus among economists that the UK’s long-run growth rate is depressed, citing the permanent erosion of supply capacity. This suggests the economy is running with limited spare capacity. Given the fact the OECD and IMF have repeatedly admitted the new-found challenge in calculating the output gap, this consensus is even more remarkable.
Enter Capital Economics, the research shop of Roger Bootle – no leftie. This week, Capital Economics penned a report that could form the manifesto for the Labour Party – challenging the Office for Budget Responsibility’s (OBR) estimates head-on – by justifying a looser fiscal policy.
The report maintains that, as of the second quarter of this year, output was 14% below its pre-recession trend in 2008 while all sectors of the economy are experiencing a double-digit shortfall in output, relative to historical trend. The breadth of sectors affected – save for mining and agricultural, which experienced a secular decline in output pre-crisis – suggests the output gap is large. And yet, the OBR reckons the output gap in the first half of the year was just 2.6%, roughly in line with consensus.
In addition to high inflation, growing employment and an unsustainable growth rate pre-crisis, which the OBR argues is evidence of a small output gap, Capital Economics sums up the pessimistic consensus, based on permanent loss of productive capacity in the new normal:
| Labour productivity will be persistently lower due to weak growth in the capital stock following the fall in business investment observed since 2008. If the fall in investment is not made up, output per worker will be permanently lower. |
Capacity could suffer as firms go out of business and fewer new firms are created. Since productivity growth is largely a function of the entry into markets of new firms, rather than innovations within existing firms, a lower rate of
company formation could also undermine productivity growth.
Higher unemployment may result in a loss of skills and a lasting fall in the size of the labour force, as discouraged workers give up looking for work and employers are reluctant to take on the long-term unemployed.
Finally, the financial sector may be permanently smaller as a result of the crisis. Even if workers previously employed in finance are re-employed elsewhere, the loss of the very high levels of value-added they were previously generating implies a reduction in economic capacity.
But Capital Economics rebuts the bulk of these arguments for a permanent loss in economic capacity:
|"Historical experience suggests that economies can sometimes weather very severe recessions without any lasting |
adverse impact on supply capacity. As the academics Bill Martin and Robert Rowthorn have pointed out, the scale of loss that the OBR has factored in would put the impact of the financial crisis and recession on the same footing as a major natural disaster.
"The fact that investment is low at present does not necessarily mean it will remain permanently low. Investment in new capacity may have been postponed until economic prospects improve. After all, investment is a function of how much demand firms expect there to be for their products, as well as factors like the availability and cost of credit, which have been affected by the financial crisis. Indeed, since 2008, the CBI’s Industrial Trends survey has consistently showed that the most important factor holding back investment is uncertainty over demand, an obstacle far more significant than problems with access to finance.
"So if demand were to recover, this could well lead to a surge in investment as firms make up lost ground. What some currently interpret as a structural decline in investment would prove to be cyclical.
"...As for the argument that a rise in unemployment and underemployment may have caused workers to lose skills or become detached from the labour market, the evidence is not convincing either. According to the Labour Force Survey, the proportion of workers receiving job-related training in 2011 was only a fraction below the share in 2007. While the incidence of training declined during the 2008-09 recession, the fall was not out of line with a trend evident since the beginning of that decade. And, in 2011, the proportion of employees receiving training began to pick up."
Finally, the argument that a smaller financial sector will inflict an economy-wide toll doesn't wash either:
|"In theory, if this shrinkage were permanent and those leaving the financial sector moved into ‘average’ occupations elsewhere in the economy, this in itself would be enough to knock [more than] £3 billion off the economy’s potential output, at current prices. But this is still only a very modest sum relative to the size of the economy, at about 0.2% of actual GDP, and, recently, employment in the sector has begun to pick up."|
In summary, internally driven inflation is low, employment has been concentrated in low-productivity sectors and arguments for the permanent loss in economic capacity have been exaggerated. In conclusion:
|"If we assume (generously in our view) that the economy was operating 2% or 3% above potential in 2007, and that the financial crisis dealt a permanent blow to the economy of 5% of GDP, the output gap should still be about 6% of GDP. If our view is correct, this implies unnecessary fiscal consolidation under current plans of about 2.5% of GDP, or £35 billion in current prices. |
"A large output gap offers the prospect of the UK being able to enjoy strong economic growth, if and when demand recovers, without inflation taking off. But as long as monetary and fiscal policies are conditioned on a pessimistic view of spare capacity, this prospect may be frustrated. Accordingly, supply pessimism may be self-reinforcing."
A devastating critique of the consensus.