UK economic growth since 2010: is it as bad as it seems?
Crafts, Nicholas
This paper reviews UK supply-side policies since 2010 in terms of
their impact on growth and considers medium-term growth prospects in the
context of the puzzle of disappointing post-crisis TFP performance. It
is argued that there is no reason to believe that growth prospects have
deteriorated significantly compared with the pre-crisis period. Changes
in policy under the Coalition government are unlikely to have made a big
difference to growth potential. On the one hand, this means
opportunities for radical reform have been ignored; on the other hand,
there has been no repeat of the 1930s' debacle.
Keywords: economic growth; industrial strategy; productivity
puzzle; supply-side policy
JEL Classifications: NI4; 025; 052
Introduction
On the eve of the crisis, the growth performance of the UK economy
was generally seen as quite satisfactory (Van Reenen, 2013). A long
period of relative economic decline vis-a-vis other European economies
seemed to have come to an end under the auspices of the supply-side
policies initiated under the Thatcher government and continued in most
respects by New Labour (cf. table 1). Subsequent developments have come
as a rude shock; in 2014 quarter 2, real GDP per person was still only
at 98.2 per cent of the previous peak level in 2008 quarter 1, while
real GDP per hour worked at the end of 2013 was about 16 per cent below
what would have been expected on the basis of its pre-crisis trend
(Barnett et al., 2014).
The context for UK growth has changed in the past few years in
several important respects. First, and most obvious, the economy has
been through its worst financial crisis since the 19th century. This has
surely had a permanent and sizeable adverse effect on the level of
potential output and may even mean that estimates of future trend growth
need to be revised down. (1) Second, the concept of 'secular
stagnation' which haunted economists in the 1930s and 1940s has
been re-discovered (Teulings and Baldwin, 2014) with the implication
that long-term growth in all advanced economies may slow down as a
result of unfavourable trends in demography and technology. (2) Third, a
major consequence of the crisis is that public finances have been
seriously damaged. This has raised the level of public debt to GDP
significantly and has led the government to initiate what promises to be
a lengthy period of fiscal consolidation. Fourth, the crisis has also
raised questions about the structure of the UK economy, in particular,
as to whether the financial sector had become too big and manufacturing
too small. 'Re-balancing' the economy under the auspices of a
return to 'industrial policy' started to be discussed for the
first time in a generation. Fifth, the 2010 election resulted in a
coalition government which has had to make compromises on economic
policy between the Conservatives and the Liberal Democrats. There has
been no possibility of coherent radical change on the scale of the
Attlee or Thatcher governments.
All this prompts two questions which this paper will address.
First, are UK medium-term growth prospects now much worse than would
have been thought in 2007? Second, how effective have the Coalition
government's supply-side policies been in improving likely future
growth performance? Informed by modern growth economics, my approach to
these questions will be based on the premise that government can affect
the growth rate to some extent through its choice and implementation of
supply-side policies and the main focus of this paper is to consider the
government's record in this regard. I also take the view that the
disappointing growth outcomes of the past few years do not of themselves
make the answers to these questions obvious.
The paper proceeds as follows. In the next section, the details of
recent growth performance and some future projections are presented in
an internationally comparative perspective. Then, quantitative
indicators of key components of supply-side policy are reviewed. After
that, several important aspects of policymaking that might affect growth
are examined in more depth, including the composition of fiscal
consolidation, the 'industrial strategy', and the extent to
which supply-side policy is vulnerable to 'government
failure'. Finally, conclusions are presented.
Past performance and future projections
The period 1995 to 2007 covers the years from the point at which
the ICT revolution became a very significant aspect of productivity
performance to the eve of the crisis and can be thought of as the
'old normal'. Although there was a change in government in
1997, there was no radical revision of supply-side policy which
exhibited a high degree of continuity under the 'post-Thatcher
consensus'. Prima facie at least, growth outcomes were very
respectable for an advanced economy without the scope for rapid catch-up
growth of post-war 'Golden Age' Europe or the contemporary
BRIC economies. (3)
The estimates reported in table 2 show the growth rate of real GDP
per person at 2.87 per cent per year and of labour productivity
(measured per hour worked) at 2.52 per cent per year. (4) This was
fairly similar to Sweden, a good deal better than France, Germany and
especially Italy, but below Ireland which for the first half of this
period was still in its Celtic Tiger catch-up phase. Table 3 shows that
the labour productivity gap with the United States fell a little during
these years and stood at just over 15 per cent in 2007. At this point,
labour productivity seems to have been below the level in both France
and Germany but adjusting for the impact of labour market distortions
there was probably little or no difference from these countries. (5)
The growth accounting estimates which are presented in table 4 show
that the UK had relatively strong contributions from the growth of ICT
capital and of labour quality. The former reflected the relatively rapid
take-up of the new technology by the UK, at least when compared with
mainland Europe, and the latter the rapidly increasing educational
attainment of the labour force in terms of higher-level qualifications.
Labour productivity growth in market services was notably strong in the
UK based on substantial contributions from business services, financial
services and, especially, distribution (Crafts, 2012a). TFP growth of
0.74 per cent per year was also very respectable when it is remembered
that the highflyers, Finland, Ireland and Sweden, had a significant
boost from much larger ICT production sectors than the UK (Timmer et
al., 2010).
Despite a welcome recovery in the past two years, overall since
2007 growth, especially of labour productivity, has been disappointing.
The estimates in table 2 show that the change in the growth rate of real
GDP per hour worked, at -3.03 percentage points per year, was the
strongest reversal of fortune recorded. This has resulted in a widening
of the labour productivity gap with the United States to 23.6 per cent.
In table 4, the growth accounting estimates show that the really big
change in the sources of growth in the short term has been in TFP
growth, which went from 0.74 per cent per year in 1995-2007 to -1.36 per
cent per year in 2007-13. This exceeds the rate of decline of labour
productivity in the latter period (-0.87 per cent per year) because
there was an offset in terms of continued capital deepening and labour
quality growth (albeit at slower rates than pre-crisis).
This raises the question of the extent to which negative
productivity growth over these recent years reflects a onetime
adjustment to a lower level of potential output or a 'new
normal' lower trend rate of growth of productivity. It is
well-known that financial crises can have permanent adverse direct
effects on the level and possibly also the trend growth rate of
potential output. Thinking in terms of a production function or growth
accounting, there may be direct adverse effects on capital inputs as
investment is interrupted, on human capital if skills are lost or
restructuring makes them redundant, on labour inputs through increases
in equilibrium unemployment, and on TFP if R&D is cut back or
innovative firms cannot get finance.
The orthodox view, embraced by the OECD and the Office for Budget
Responsibility (OBR) among others, is that there has been a big levels
effect but no impact on future trend growth such that log labour
productivity will maintain a trend path parallel to what would have been
expected in 2007. (6) Thus OBR (2014b) believes that the future long-run
trend rate of growth of labour productivity will be 2.2 per cent per
year while the current output gap is only about 1 per cent of GDP. (7)
The views of OECD economists are captured in tables 5 and 6.
The estimates by Ollivaud and Turner (2014) reported in table 5
show a levels effect on labour productivity of 9.1 per cent, most of
which comes from a fall in TFP of 7.4 per cent. At the same time, these
authors estimate that the output gap is only 1.3 per cent of GDP so the
adverse effect is expected to be permanent. It is striking that the
estimated impact of the crisis on TFP is much larger than that in other
countries (with the exception of Finland).
The long-run growth projections reported in table 6 are based on a
growth model which allows for TFP growth in the leader (United States)
and a component based on scope for catch-up by other countries and how
well this scope will be exploited which depends on supply-side policy
settings and institutions. In effect, the assumptions underlying OECD
(2014a) are that secular stagnation will not undermine American TFP
growth and that there has been no significant change in UK policy either
for better or worse. The former seems to be reasonable based on
mainstream opinion among American economists (Fernald, 2014). It is true
that projections of growth rates over the next 10 to 15 years in the
United States have been reduced somewhat since the Great Recession and
it is generally accepted that employment growth and the rate of
improvement of labour quality will slow down. However, even Gordon
(2014), often cited as a notorious pessimist, expects labour
productivity growth at 1.3 per cent per year based on TFP growth around
the average of the past 40 years. New technologies such as artificial
intelligence and small robots will no doubt contribute but the most
obvious factor underpinning TFP growth will be continuing progress in
ICT (Byrne et al., 2013). Future technological progress is notoriously
hard to predict but there is quite possibly scope for a significant
acceleration in TFP growth since a major legacy of the ICT revolution
will be much higher productivity in undertaking R&D (Mokyr, 2014).
Not only is it likely that productivity will continue to increase
steadily in the United States but there is also a bit more scope for
catch-up growth in the UK than before the crisis since the productivity
gap with the United States has widened. Whether the OECD is right to
assume that the UK is still as well positioned to exploit this source of
growth will be considered in later sections of this paper. However, even
at this point, it is worth noting that there has been no dramatic change
of the kind that the UK experienced in the crisis of the 1930s, which
saw the abandonment of free trade and a serious weakening of competition
in product markets that took decades fully to reverse and undermined
productivity performance in the decades after World War II (Crafts,
2012b).
The persistent weakness of labour productivity has spawned a large
literature on the 'productivity puzzle'. It is important to
know whether the orthodox view that it basically reflects a large levels
effect, resulting from the financial crisis and accruing primarily
through a one-off decline in TFP, is correct. A more pessimistic
interpretation would be that it is partly the result of a slowdown in
trend labour productivity growth. A more optimistic interpretation would
be that some of what is now counted as a permanent effect will actually
be regained as the economy returns to normal.
There is still considerable uncertainty about these issues,
especially with regard to TFP. (8) A recent overview suggested that as
much as 6 percentage points (3/8ths) of the shortfall is currently
unexplained (Barnett et al., 2014) but found quite strong evidence that
the crisis had led to impairment of resource reallocation, and thus had
decreased efficiency as well as holding back implementation of
innovations, while also noting that there is little evidence of spare
capacity and that labour hoarding seems unlikely still to be a strong
factor. The decline in TFP seems quite large (by at least 4 percentage
points) compared with what might be predicted on the basis of earlier
financial crises (Oulton, 2013b). Thus, it still seems possible to fear
that trend TFP growth will be weaker in future or to hope that as
uncertainty among businesses recedes and normal patterns of entry and
exit return there will be an increase in efficiency that will repair
some of the damage.
An overview of supply-side policy
Despite attaining laughing-stock status in Punch-and-Judy politics,
'post-neoclassical endogenous growth theory' offers important
insights into the way supply-side policy can be designed to promote
productivity growth. The main thrust is that growth depends on
investment in tangible and intangible capital, in education and
training, and on innovation. Decisions to invest and innovate respond to
economic incentives such that well-designed policy which addresses
market failures can raise the growth rate a bit. This implies
governments need to pay attention to making investments that complement
private sector capital accumulation, for example in infrastructure, to
supporting activities like education and research and development where
social returns exceed private returns, to avoiding the imposition of
high marginal direct tax rates, to recognising that regulations can
undermine productivity, and to fostering competitive pressure on
management to develop and adopt cost-effective innovations.
After the election of the Thatcher government, the stance of
supply-side policy changed markedly. Selective industrial policies were
phased out, horizontal policies were downsized and narrowed in scope
with the ending of most investment and employment subsidies, and
competition in product markets was strengthened considerably, initially
through reducing trade barriers and deregulation rather than by
strengthening antitrust policy. The effect of greater competition on
productivity performance was substantial (Crafts, 2012b). Privatisation,
industrial relations reform, and restructuring taxation were new
priorities. Taken together, these might be seen as policy changes
designed to improve the workings of a 'liberal market economy'
(Hall and Soskice, 2001).
When Labour won a landslide victory in the 1997 election, it was
possible to wonder whether in government it would revert to 'Old
Labour' policies. The answer soon became apparent and was a
resounding 'No'. 1970s-style policy was conspicuous by its
absence: there was no nationalisation programme, no move to subsidise
manufacturing investment, no counterpart of the National Enterprise
Board, no return to high marginal rates of direct tax, no attempt to
resist de-industrialisation by supporting declining industries, and no
major reversal of industrial relations reform. Implicitly, the Thatcher
supply-side reforms had been accepted. The changes that Labour made were
to strengthen some aspects of horizontal industrial policies with a new
emphasis on education, R&D, investing in public capital, and
strengthening competition policy.
The Coalition government has to a considerable extent continued in
the same vein. The statement of its growth strategy (HMT and BIS, 2011)
had four declared aims, namely, to create the most competitive tax
system in the G20, to make the UK one of the best places in Europe to
start, finance and grow a business, to encourage investment and exports
as a route to a more balanced economy, and to create a more educated
workforce that is the most flexible in Europe. This can largely be
construed as continuity in terms of signalling an intention to improve
horizontal industrial policies and this impression is strengthened by
much of the detailed discussion in the document. Nevertheless, the
aspiration to achieve a 'more balanced economy' did mark
something of a change in response to the shock of the financial crisis,
clearly represented a desire to strengthen sectors which were deemed to
be central to these goals through an 'industrial strategy',
and entailed a move back towards more selective industrial policies
albeit without the corporatist overtones of the 1970s or any grand
ambition to move to develop a 'co-ordinated market economy'.
(9)
Given these ambitions to improve key areas of supply-side policy,
what has happened in key areas? The government would like to be judged
at least in part by the ranking assigned to the UK in indices of
'competitiveness' and is no doubt pleased by a move up from
12th to 9th in the World Economic Forum's league table between
2010/11 and 2014/15. (10) However, the relationship between such
measures and long-run growth potential is tenuous at best. It is
possible to look at more meaningful quantitative indicators which
empirical work has found to be linked to growth performance and this
approach is followed here. In some cases, it is too soon for the numbers
to have changed but it is possible to say something about whether it
seems likely that they will improve in due course. The obvious starting
point is policies towards education and innovation, the importance of
which is emphasised by many growth economists, and this resonates with
the rhetoric of The Plan for Growth. In each of these areas, there have
been some interesting policy developments.
The quality of education is generally seen as important for growth
and there is evidence that cognitive skills matter. As measured by
international test scores, UK schooling improved slowly between 1975 and
2000 but has been flat-lining recently and is well below the top
performers as measured by OECD's PISA (Programme for International
Student Assessment) scores, a benchmark highlighted in HMT and BIS
(2011). The average for maths and science in 2012 was 504 compared with
503 in 2009 and 505 in 2006; the UK remains at 7th out of the 14
countries listed in table 2 as it was in 2006. Hanushek and Woessmann
(2012) estimate that increasing this score by 25 points--a bit less than
half the difference between the UK and Singapore--would raise the
long-run growth rate by about 0.3-0.4 percentage points.
A key finding of the literature on schooling outcomes is that it is
crucial effectively to address principal-agent problems in the delivery
of education. Across countries, about 80 per cent of the variance in
cognitive skills is explained by the organisation of the education
system (Woessmann et al, 2007). The most important implications of this
study for English schools seem to be to improve the accountability
provided by the examinations system, to strengthen the autonomy of head
teachers in running schools, and to provide effective competition in the
provision of schooling. Broadly speaking, this is the direction of
travel of the present government's policies which have been
introduced as major reforms. These have included the announcement of
significant changes in the design of GCSEs and A-Levels, changes in the
design of school league tables to measure progress scores, a major
expansion of schools with academy status from about 200 in 2010 to over
4000 in 2014, and new entry by Free Schools, of which there were over
250 in autumn 2014. Whether these reforms have the desired effect on
PISA scores (let alone growth rates!) will only be seen in the fullness
of time.
There is consensus in the literature that R&D has a strong
impact on TFP growth (with an elasticity of perhaps 0.15) and has a very
high social rate of return, on average two to three times as high as the
median private rate of return of around 20 to 25 per cent (Frontier
Economics, 2014). More generally, the process of innovation is exposed
to market failures and there is a strong prima facie case for government
intervention. This has long been recognised by UK governments yet the UK
level of R&D (1.73 per cent of GDP of which business R&D
comprised 1.10 per cent of GDP) is less than half that of the biggest
spending OECD countries and little changed since 2007 (OECD, 2014b).
The flagship policy of New Labour, R&D tax credit, has been
continued. A careful ex-ante study suggested that the policy might raise
UK TFP growth by about 0.3 percentage points per year (Griffith et al.,
2001), and it probably has stimulated R&D expenditure by roughly the
predicted amount (Bond and Guceri, 2012). Foreman-Peck (2013) found that
the social rate of return to policies to support innovation by SMEs has
been high--at least 46 per cent and probably considerably more but, for
this sector at least, grant-based schemes such as SMART achieved
benefit-cost ratios which were double those from the tax credit. The 1bn
[pounds sterling] per year 'patent box' scheme introduced in
2013 will not, however, increase innovative activity (Griffith and
Miller, 2011) whereas public funding of R&D through the Research
Councils does have significant effects on TFP spillovers in the market
economy (Haskel and Wallis, 2013). (11) Overall, this suggests that
support for R&D has been underfunded and could have been better
targeted but these remarks also apply to the previous government.
From a growth perspective, the UK has been investing too little in
infrastructure. Investment in public capital has positive effects on
real GDP, where an output elasticity of about 0.2 is a reasonable
assumption, and also 'crowds in' private capital in the medium
term (Kamps, 2005a). The UK net stock of public capital relative to GDP
fell substantially between 1980 and 2010 (from 64 per cent to 36 per
cent). To maintain the level of public capital to GDP at a
growth-maximising level, public investment of about 2.7 per cent of GDP
per year would be needed but UK investment has fallen from 2.4 to 1.9
per cent of GDP since 2010 and during 2014/15 through 2018/19 this will
fall to an average of 1.8 per cent (OBR, 2014a). (12) This is an
unhelpful policy development.
Transport infrastructure, especially roads, is a notorious case of
underinvestment. Eddington (2006, pp. 204-6) estimated that, in the
absence of road pricing, there was a case for investment of 30 billion
[pounds sterling] on strategic roads between 2015 and 2025 to deliver
annual welfare benefits of 3.4 billion [pounds sterling] per year and a
GDP impact of 2.3 billion [pounds sterling] per year in 2025. Most of
this investment has not been made, although reviews of unfunded
transport schemes regularly show a large number of schemes with high
benefit-cost ratios (Smith et al., 2011). Current proposals for the
period through 2021 include only 0.5 billion [pounds sterling] per year
for strategic roads compared with 3 billion [pounds sterling] for HS2.
(13) Continuing the traditional roads policy, memorably described by
Glaister (2002) as 'predict but don't provide', runs the
risk of a growing disincentive to private investment and of productivity
being impaired as journey times increase (Rice et al., 2006).
Reforming taxation with a view to increasing the growth rate would
generally entail reducing marginal direct tax rates and increasing
indirect and property taxes (Mirrlees et al., 2011). The coalition
government has cut corporate taxes. Calculations of Effective Average
and Effective Marginal Tax Rates (taking into account capital
allowances) indicate that by 2015 the former will be 20.3 and the latter
18.9 per cent, compared with 26.9 and 20.0 per cent, respectively, in
2007 (Bilicka and Devereux, 2012). Estimates by OECD economists suggest
that this might raise labour productivity growth by about 0.1 percentage
points per year (Johansson et al., 2008). This is some progress but
hardly matches the 2011 aspiration; in fact, on the EMTR measure the UK
will be 13th/14 of the countries listed in table 2.
Regulations can inhibit innovation or slow down adjustment to new
technologies or changes in comparative advantage. Empirical studies
indicate that product market regulations that create barriers to entry
(Nicoletti and Scarpetta, 2005) and employment protection that makes
reorganisation of the labour force costly (Caballero et al., 2013) have
a significant cost in terms of foregone productivity growth. Both
aspects of regulation have been shown to retard the diffusion of ICT
(Cette and Lopez, 2012). The most commonly used indices, PMR and EP, are
those constructed by OECD. The UK has benefited from relatively low
scores on both measures since the 1990s and that has continued to be the
case since 2010. On a scale of 0 to 6 (lowest best), the UK scored 1.09
for PMR and 1.03 for EP in 2013, in each case a small improvement on
2008 and ranked 2nd of the countries listed in table 2. This can help
underpin future productivity growth given the continuing scope for
technological progress in ICT. (14)
It should be noted, however, that not all UK regulation is
productivity friendly. Land-use planning reduces labour productivity
both by making land unduly expensive and by restricting city size, which
means that agglomeration economies are foregone and spatial adjustment
is impeded--successful British cities are too small (Leunig and Overman,
2008). Cheshire and Sheppard (2005, p. 660) concluded that
"controlling land supply by fiat has created price distortions on a
par with those observed in Soviet-bloc countries". One of the
implications is an implicit regulatory tax rate of around 300 per cent,
which makes office space in cities like Leeds and Manchester much more
expensive than even New York and San Francisco (Cheshire and Hilber,
2008). Similarly, planning policy by making land for retailing very
expensive and by constraining retailers to choose less productive sites
has reduced the level of TFP in the supermarkets by about 32 per cent in
post-1996 compared with pre-1988 stores, thereby significantly reducing
the rate of TFP growth in the sector (Cheshire et al., 2015). The
National Planning Policy Framework introduced in 2012 addresses some of
these issues by introducing a presumption in favour of development where
there is no local plan but still retains the Green Belt and did not
liberalise the rules for retailing. Again, this represents only a timid
step in a direction favourable to growth--a bit underwhelming compared
with the rhetoric of The Plan for Growth.
Another aspect of UK regulation which potentially affects
productivity is immigration policy, where the government wishes to be
more restrictive than Labour had been prior to 2010 with a target of
reducing net migration from hundreds of thousands to tens of thousands
and has imposed a cap on non-EEA economic migration. The key issue here
is what impact migration (especially high-skill migration) has on the
productivity of the domestic labour force and thus on the income of the
resident population through spillover effects. Obtaining reliable
estimates is challenging but the international evidence points to
positive effects (MAC, 2010) and a recent study suggests that the
increase in the migrant share of the UK labour force between 1997 and
2007 might have raised labour productivity by between 0.27 and 0.40
percentage points (Rolfe et al., 2013). The impact of a more restrictive
migration policy on productivity may not be dramatic but the
government's vote-seeking approach to this aspect of policymaking
does not really match the aspiration of The Plan for Growth to create a
more educated workforce that is the most flexible in Europe.
It is widely agreed that increased product-market competition has
been strongly positive for UK productivity performance. New Labour
accepted this analysis, maintained a pro-globalisation stance, and
strengthened competition policy quite considerably with the Competition
Act of 1998 and the Enterprise Act of 2003, which increased the
independence of the competition authorities, removed the old
'public-interest' defence, and introduced criminal penalties
for running cartels. The quantitative index of competition policy
devised by Buccirossi et al. (2013), which they found has a strong
causal effect on productivity growth, shows major improvement for the UK
between 1995 and 2005 sufficient to raise TFP growth by about 0.3
percentage points.
The main change in competition policy introduced by the present
government has been the innovation of the Competition and Markets
Authority in 2014. This basically aims to consolidate Labour's
reforms by improving enforcement through increasing the speed and number
of competition investigations (Graham, 2012). A recent evaluation by
OECD found that UK competition policy is quite close to international
best practice at a time when there is relatively little difference
across advanced economies (Alemani et al., 2013). If there is a cause
for concern with regard to competition, it is rather to be found in
'murky protectionism' as flagged up by Global Trade Alert. The
UK ranks 9th in their list of countries which have introduced the most
protectionist measures since 2008, with a total that is fairly similar
to Germany and Italy (Evenett, 2014).
Thus far, this review of supply-side policies since 2010 suggests a
strong element of continuity from the previous government in terms both
of strengths (competition and regulation) and weaknesses (innovation and
infrastructure). The most striking changes have been in education but
any positive impact that they may have on growth performance will only
emerge in the long run. Overall, there is no real reason to think that
significant damage has been done to the outlook for productivity
performance but if there are grounds for complaint perhaps they reside
more in errors of omission than of commission. This theme is pursued in
the following section.
Three key policy issues
Three areas of policy deserve some critical scrutiny, namely, the
approach to fiscal consolidation, the re-thinking of industrial policy
in the context of re-balancing the economy, and the institutional
framework within which supply-side policy is designed and monitored. The
first two of these have been central concerns for policymakers since
2010 but concerns about the last appear to have fallen on deaf ears
despite being given a high profile by the LSE's Growth Commission
(2013).
A key decision by (and perhaps the chief rationale of) the
Coalition was to address the incipient problem of fiscal sustainability
by embarking immediately on a policy of fiscal consolidation. From the
perspective of supply-side policy towards growth, this raises the key
issue of the composition of the fiscal adjustment, given its size, with
regard to the balance between expenditure and tax, capital and current
expenditure, direct and indirect taxes etc. If it is thought that crises
offer a greater opportunity for radical change, fiscal consolidation
could even entail a serious reform of the tax system.
Table 7 reports that government expenditure will have risen by 67.4
billion [pounds sterling] and tax receipts by 132.5 billion [pounds
sterling] during the current parliament. Net investment by government is
projected to have fallen by 44 per cent from 2009/10 to 2014/15, while
current expenditure will have risen by 12 per cent and an increase in
spending on social security of 27.9 billion [pounds sterling] will
largely be paid for by a cut of 21.8 billion [pounds sterling] in net
investment. In 2019/20, interest payments on the national debt are
expected to be about double and net investment about half the 2009/10
level. On the tax side, the standard rate of VAT was increased to 20 per
cent at the start of 2011 and the headline corporate tax rate is coming
down from 28 per cent in 2009/10 to 21 per cent in 2014/15. Between
2009/10 and 2014/15 the increase in receipts from VAT and Fuel Duties
will exceed that from income tax and NICs by 9.5 billion [pounds
sterling] but by 2019/20 the reverse will be true, with income tax and
NICs contributing an additional 50 billion [pounds sterling] more. The
number of higher-rate income tax payers is projected to be 5.0 million
in 2014/15 (about twice the 1999/2000 figure) compared with 3.2 million
in 2009/10 while the VAT revenue base remains narrow by OECD standards.
This does not really represent a supply-side friendly model of
fiscal consolidation although, clearly, the impact could have been a
good deal worse. Equally, however, the government has lacked any
semblance of a coherent strategy of tax reform (Johnson, 2014) although
blueprints have been provided. The Mirrlees Review provided a powerful
case for tax reforms which would have significant positive effects on
the level of GDP and its growth rate. The key is to reduce personal and,
especially, corporate income tax paid for by raising consumption and
property taxes. The proposals made include implementing a land value
tax, ending exemptions from VAT, making a normal rate of return
non-taxable (Mirrlees et al., 2011).To be fair, while some of these
changes could be made quickly, the Mirrlees-Review agenda is, as its
authors themselves say, really a long-term programme for reform and it
is 'politically challenging' especially for a coalition
government.
The distinctive feature of supply-side policy under the Coalition
compared with the recent past is the pursuit of an 'industrial
strategy' which aims to promote growth through boosting eleven
selected sectors and to stimulate the advance and commercialisation of
eight selected technologies with the underlying objective of
re-balancing the economy (Rhodes, 2014). (15) The government is in the
process of developing 'strategic partnerships' in key sectors
with growth potential to address market failures, especially with regard
to innovation, and to underpin investment (BIS, 2012). These entail a
high-level forum, skills improvement initiatives, and public support for
research centres. An interesting component of this approach is the
funding of 'catapult centres' which aim to enhance business
capabilities in the exploitation of new technologies. (16) Industrial
strategy expenditure is running at about 2 billion [pounds sterling] per
year.
Although this is a return to 'selective industrial
policy', it is not really 'back to the 1970s'. Back then,
there is no doubt that such policies were a very expensive failure
characterised by costly support for declining industries and vain
attempts to compete with the United States in high-technology industries
(Crafts, 2012a). The current approach is on a much smaller scale and is
closer to 'soft industrial policy' with the government as a
facilitator that seeks to address coordination failures rather than to
'pick winners' (Warwick, 2013). In particular, the aim is to
address market failures associated with the so-called 'valley of
death' in terms of the phase of technology platform research (which
often entails high risk, high cost and provision of public goods) that
comes between basic research and applied R&D (Tassey, 2014).
It is quite possible that, if the share of manufacturing in the
economy were to rise, labour productivity growth would increase; in the
pre-crisis period the growth rate of real output per hour worked in
manufacturing exceeded that in market services by about 1 percentage
point per year. (17) However, there is as yet no sign of an upturn in
manufacturing's share of economic activity and it is difficult to
think of a credible scenario in which it could occur (Foresight, 2013).
Manufacturing was 9.5 per cent of GDP and 9.8 per cent of employment in
the first three quarters of 2014 compared with 10.2 per cent and 9.8 per
cent, respectively, in 2010, and 10.8 per cent and 11.0 per cent,
respectively, in 2007. The notion that the industrial strategy will lead
to significantly faster growth through re-industrialisation any time
soon seems far-fetched.
It is also difficult to believe that the industrial strategy really
tackles the most important reasons for the business (and manufacturing)
innovation shortfall which the Coalition wishes to remedy and in this
respect it is no different from earlier governments. In particular,
R&D is an activity which is vulnerable to short-termism and
impatient capital where future returns are myopically discounted, a
problem more likely to be found in a liberal market economy than a
co-ordinated market economy. It has been regularly documented that UK
equity markets are notably short-termist (Miles, 1993; Black and Fraser,
2000; Davies et al., 2014) and that this has adverse effects on
long-term innovation related investment (Bond et al., 2003; Hughes,
2013). The Kay Review (Kay, 2012) reaffirmed this point and argued the
need for changes to incentive structures in equity markets if shortfalls
in long-term investments were to be redressed. The government has made
positive noises and this is work in progress which, if successfully
implemented, could eventually matter more than the industrial strategy
per se.
The LSE Growth Commission (2013) has recently suggested that
failures in the institutional architecture are at the roots of the
persistent and serious failure in UK investment in public capital which
has continued under the present government. (Vote-seeking politicians
cannot be expected to make good policy or respect cost-benefit
analysis). They propose a solution in terms of several new institutions
with powers delegated by parliament with statutory responsibility for
strategy, an infrastructure planning commission with responsibility for
delivery and an infrastructure bank to provide finance.
Whether this solution is the best one or not, the diagnosis is
surely correct and applies quite widely to supply-side policy. (18)
Supply-side policy is exposed to government failure but this has not
been addressed by institutional innovation in the UK. In other aspects
of public policy, it is accepted that politicians cannot be trusted to
deliver efficient outcomes. Recent examples include the delegation of
monetary policy to an independent Bank of England, the establishment of
NICE to consider the costs and benefits of new drugs, the
de-politicisation of competition policy by removing the ministerial
prerogative to over-rule the competition authorities, and the Office of
Budget Responsibility to evaluate macroeconomic forecasts and the
implications of government policy for fiscal sustainability. With regard
to the politics of protectionism, we long ago signed up to international
treaties (GATT/WTO/EU) which remove political discretion and which have
guarded against a repeat of the policy errors of the 1930s.
At a minimum, there is a need for serious surveillance of
supply-side policy. An agency tasked with this function might be asked
inter alia to require government departments to provide information for
the public domain and to audit government policies for their effects on
medium-term productivity performance. It might also be asked to
benchmark supply-side policies against international best practice and
be expected to provide a regular strategic assessment and evidence
papers. (19) A reconsideration of the framework in which supply-side
policy is generated is made all the more urgent by the return of
selective industrial policy, the recent upsurge of populism, and the
likelihood of an indecisive General Election in 2015. The present
government's lack of interest in reform of the institutional
architecture of supply-side policy has been unfortunate. (20)
Conclusions
In the introduction, I posed two quite difficult questions, namely
'are UK medium-term growth prospects much worse than would have
been thought in 2007?' and 'how effective have the Coalition
government's supply-side policies been in improving likely future
growth performance?'. Here are tentative answers informed by the
discussion of the previous three sections.
My answer to the first question is 'probably not'. I
suggest that the fashionable notion of 'secular stagnation'
based on a major decline in future productivity growth in the United
States probably is a mirage, whereas decent UK productivity performance
prior to 2007 is not. There has been no major change in quantifiable
supply-side fundamentals either in terms of strengths or weaknesses.
However, the continuing, still not well understood, weakness of TFP so
long after the crisis, which is the essence of the 'productivity
puzzle', is a serious concern.
My answer to the second question is 'not very'. The
picture is mixed and certainly does not correspond to the grandiose
claims of The Plan for Growth. Radical reform has not been the order of
the day, which is perhaps not surprising under a coalition government,
but no significant damage has been done. It might be argued that there
have been marginal improvements in competition policy, innovation
policies, land-use planning, and the structure of taxation. In contrast,
infrastructure policy continues to disappoint and the composition of
fiscal consolidation has not been very growth-friendly. The much-vaunted
'industrial strategy' is a quite modest repositioning of
industrial policy which is most unlikely to re-balance the economy in
the direction of a larger share of GDP originating in manufacturing.
Changes in education policy may eventually improve the quality of
schooling but this remains to be seen and will, in any case, take many
years to affect growth performance. The institutional architecture has
not been reformed so as effectively to address government failure in
supply-side policy.
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NOTES
(1) It is generally agreed that serious financial crises reduce the
level of potential output, although by how much is debatable. There is
no strong evidence that post-crisis trend growth is reduced but the
transition period while the levels effect materialises may be quite long
(IMF, 2009).
(2) In the context of a focus on medium-term growth, in this paper
I treat 'secular stagnation' as a concept related to the
natural (trend) rate of growth rather than as related to a need for
negative real interest rates to achieve full employment in the short
term.
(3) It is sometimes claimed that mismeasurement of financial
services output distorted the pre-crisis picture; Oulton (2013a) shows
that any such effect is very small--at most 0.1 per cent per year during
2000-2007.
(4) The output gap was positive in 2007 but probably small enough
--2 per cent according to Murray (2014)--that it does not distort these
growth rate estimates.
(5) In 2007 the employment to working-age population ratio was 66.3
per cent in the UK, 65.9 per cent in the USA, 62.9 per cent in Germany
and 59.8 per cent in France. In the lower employment countries,
low-productivity workers were disproportionately excluded from
employment by institutional arrangements. There were also big
differences in hours worked with the UK and USA much higher than France
or Germany. Normalising for these differences is difficult but would
probably have a substantial impact, as the work of Bourles and Cette
(2007) suggests. Using their formula, the UK-France and the UK-Germany
labour productivity gap in 2007 would be, respectively, about 6 and 8
percentage points lower.
(6) This would actually be quite similar to what analysis based on
time-series econometrics suggests for the experience of the United
States in the context of the massive financial crisis during the Great
Depression (Ben-David et al., 2003).
(7) This projection and those of tables 5 and 6 imply that the
sustainable trend rate of growth pre-crisis was a little below the
end-point calculation of the growth rate between 1995 and 2007 reported
in table 2.
(8) Falling real wages may well explain the (smaller) contribution
from lower than counterfactual capital per worker (Blundell et al.,
2014; Pessoa and Van Reenen, 2014)
(9) The change in thinking at BIS was already gathering pace under
Peter Mandelson during the last months of the Labour government.
(10) There may be less pleasure in the downward move in the World
Bank's Doing Business rankings from 4th in the 2011 edition to 8th
in the 2015 edition.
(11) The policy will be phased out after 2016 following objections
by Germany and the EU that it is an illegal subsidy.
(12) The growth-maximising ratio of public to private capital is
where the marginal product of public capital equals the after-tax
marginal product of private capital and the interest rate on government
debt. For a Cobb-Douglas production function using the two types of
capital this ratio [OMEGA] = [gamma]/[(1 - [gamma]).sup.2] where [gamma]
is the output elasticity of public capital and the growth maximising
ratio of public capital to output [PHI] = [[OMEGA].sup.1] - [gamma]. For
[gamma] = 0.21, this is 42.3 per cent and, given the 95 per cent
confidence interval around [gamma], the 95 per cent confidence interval
on [PHI] is 32.4 per cent to 52.1 per cent (Kamps, 2005b). The growth
maximising rate of public investment can then be shown to be ([delta] +
g)[PHI] where [delta] is the depreciation rate of public capital and g
is the trend growth rate for the UK, assumed to be 4 per cent and 2.4
per cent, respectively. In the long run, public capital/GDP =
([1.sub.pub]/Y)/([delta] + g) so investing 1.8 per cent of GDP in public
capital implies that this ratio would be only 28.1 per cent.
(13) The official ex-ante BCR of 2.3 for the full HS2 (which will
cost about 50 billion [pounds sterling]) would make this project a very
low priority compared with the typical unfunded scheme. Allowing for the
optimism bias typical of non-routine 'grand projets'
(Flyvberg, 2009), an ex-post BCR 2.3 seems rather unlikely.
(14) Given current supply-side policy, Oulton (2012) projects a
contribution to labour productivity growth from ICT capital deepening at
0.60 per cent per year over the medium term.
(15) The sectors are aerospace, agricultural technologies,
automotives, construction, information economy, international education,
life science, nuclear, offshore wind, oil & gas, and professional
& business services while the technologies are advanced materials,
agri-science, big data, energy storage, regenerative medicine, robotics
and autonomous systems, satellites, and synthetic biology.
(16) There are nine catapult centres so far in cell therapy,
digital economy, energy systems, future cities, high-value
manufacturing, offshore renewable energy, precision medicine, satellite
technology, and transport systems
(17) However, a smaller financial services sector might not help;
it should be noted that labour productivity growth in financial services
was appreciably higher than in manufacturing, 4.23 per cent per year
compared with 3.48 per cent per year in the ten years to 2007 (EU KLEMS,
2011).
(18) For example, with regard to investment in roads a more
attractive solution may be to make the road network a regulated utility
with statutory obligations, a regulatory asset base and a revenue stream
(Glaister and Smith, 2009; Newbery, 2005), a proposal from which the
government has backed away.
(19) An example of a somewhat similar remit is the Australian
government's independent research and advisory body, the Australian
Productivity Commission.
(20) For example, this attitude was demonstrated by its summary
rejection of the proposal by the Foresight Project to establish an
'Office for Manufacturing'.
Nicholas Crafts, University of Warwick. E-mail:
N.Crafts@warwick.ac.uk. I thank Tim Hatton, Tim Leunig and Jonathan
Portes for valuable advice and an anonymous referee for helpful comments
which improved an earlier version of the paper. The usual disclaimer
applies.
Table 1. Real GDP/head (UK=I00 in each year)
USA West Germany France
1870 76.6 57.6 58.8
1913 107.7 74.1 70.8
1929 125.3 73.6 85.6
1950 137.8 61.7 74.7
1979 142.7 115.9 111.1
2007 124.3 101.9 87.4
2013 132.2 107.8 89.8
Sources: Maddison (2010) and The Conference Board (2014); West
Germany in 2007 and 2013 calculated from Statistiches Bundesamt
Deutschland 2014.
Notes: estimates refer to Germany from 1870 to 1937. Purchasing
power parity estimates in $ 1990GK for 1870 through 1979 and in
$2005EKS from Penn World Table for 2007 and 2013.
Table 2. Growth of real GDP/person and real GDP/hour
worked, 1995-2007 and 2007-13 (% per year)
1995-2007 2007-13
Y/P Y/HW Y/P Y/HW
Austria 2.45 1.88 0.57 0.73
Belgium 2.14 1.23 0.27 -0.14
Denmark 1.77 1.19 -0.88 0.34
Finland 3.66 2.61 -0.58 -0.30
France 1.64 1.67 -0.46 0.23
Germany 1.55 1.78 0.94 0.30
Ireland 5.08 3.42 -2.36 1.61
Italy 1.18 0.54 -1.65 -0.22
Netherlands 2.38 1.67 -0.67 -0.30
Portugal 1.96 1.42 -1.48 0.96
Spain 2.60 0.50 -1.67 1.91
Sweden 3.08 2.58 0.42 0.57
UK 2.87 2.52 -0.87 -0.51
United States 2.18 2.12 0.14 1.22
Source: The Conference Board (2014).
Table 3. Levels of real GDP/person and real GDP/hour worked, 1995,
2007 and 2013 (USA=100 in each year)
Y/P Y/HW
1995 2007 2013 1995 2007 2013
Austria 82.0 84.9 87.0 86.4 84.0 81.6
Belgium 79.0 78.5 79.1 109.0 98.2 90.6
Denmark 83.9 79.9 75.0 97.5 87.4 82.9
Finland 64.5 76.9 73.5 74.9 79.4 72.5
France 74.8 70.3 68.0 98.6 93.5 88.1
Germany 79.7 74.0 77.5 93.8 90.1 85.3
Ireland 52.7 73.8 62.3 58.9 68.7 70.3
Italy 75.2 67.0 59.5 88.1 73.0 67.0
Netherlands 83.6 85.6 81.6 103.1 97.8 89.3
Portugal 47.1 45.9 41.4 44.6 41.1 40.4
Spain 61.1 64.3 57.2 85.8 70.8 73.7
Sweden 74.3 82.6 86.1 80.9 85.5 82.2
UK 74.1 80.4 75.7 80.7 84.7 76.4
Source: The Conference Board (2014).
Note: Comparison for Ireland is based on GNP.
Table 4. Sources of growth, 1995-2007 and 2007-13 (% per year)
Non-ICT ICT Labour Labour TFP Real GDP
capital capital quantity quality growth
a) 1995-2007
Austria 0.49 0.43 0.50 0.25 0.92 2.59
Belgium 0.71 0.51 0.71 0.26 0.10 2.29
Denmark 0.48 0.80 0.62 0.20 0.00 2.10
Finland 0.30 0.77 0.82 0.16 1.78 3.83
France 0.74 0.41 0.33 0.30 0.39 2.17
Germany 0.28 0.33 -0.12 0.02 1.07 1.58
Ireland 2.26 0.99 1.87 0.36 1.46 6.94
Italy 0.67 0.28 0.64 0.20 -0.27 1.52
Netherlands 0.46 0.52 0.76 0.32 0.74 2.80
Portugal 1.01 0.67 0.66 0.41 -0.36 2.39
Spain 1.38 0.47 2.01 0.46 -0.68 3.64
Sweden 0.70 0.46 0.39 0.26 1.36 3.17
UK 0.70 0.82 0.51 0.48 0.74 3.25
United States 0.72 0.78 0.67 0.26 0.74 3.17
b) 2007-13
Austria 0.32 0.28 -0.06 0.06 -0.01 0.59
Belgium 0.36 0.47 0.32 0.22 -1.02 0.35
Denmark -0.02 0.75 -0.69 0.06 -0.73 -0.63
Finland 0.23 0.96 -0.18 0.20 -1.74 -0.53
France 0.65 0.11 -0.07 0.16 -0.74 0.11
Germany 0.17 0.41 0.24 0.10 -0.24 0.68
Ireland 0.90 0.61 -1.90 0.16 -0.85 -1.08
Italy 0.04 0.14 -0.72 0.05 -0.83 -1.32
Netherlands 0.27 0.22 0.06 0.08 -0.84 -0.21
Portugal 0.12 0.75 -1.52 0.55 -1.22 -1.32
Spain 0.67 0.28 -1.74 0.30 -0.56 -1.05
Sweden 0.52 0.63 0.28 0.10 -0.55 0.98
UK 0.56 0.21 0.14 0.14 -1.36 -0.31
United States 0.27 0.39 -0.16 0.14 0.33 0.97
Source: The Conference Board (2014).
Notes: Based on standard neoclassical growth accounting formula.
Table 5. Crisis effect on level of potential output in 2014 (% fall
relative to pre-crisis level)
Labour Due to Due to Employment Total
productivity capital/ TFP
worker
Austria 3.0 1.5 1.5 -2.1 0.9
Belgium 3.4 0.5 2.9 -0.1 3.3
Denmark 2.6 1.2 1.4 2.1 4.7
Finland 8.6 -1.2 9.8 -1.7 6.9
France -0.2 -0.3 0.1 -0.9 -1.1
Germany 0.4 0.5 -0.1 -4.3 -3.9
Ireland 5.4 0.2 5.2 5.6 11.0
Italy 2.3 1.7 0.6 1.8 4.1
Netherlands 3.2 -0.6 3.8 0.2 3.4
Portugal 2.4 3.0 -0.6 7.3 9.7
Spain -4.4 -3.5 -0.9 12.4 8.0
Sweden 5.8 0.6 5.2 -1.0 4.8
UK 9.1 1.7 7.4 -0.5 8.6
United States 1.8 1.3 0.5 0.7 2.5
Source: Ollivaud and Turner (2014).
Note: Column (I) is based on output per worker.
Table 6. OECD growth projections, 2014-30 (% per year)
Real GDP Employment GDP/worker TFP
Austria 1.9 0.2 1.7 1.5
Belgium 2.0 0.4 1.6 1.1
Denmark 1.6 0.1 1.5 1.0
Finland 2.0 -0.1 2.1 1.9
France 2.2 0.3 1.9 1.2
Germany 1.1 -0.5 1.6 1.5
Ireland 2.3 1.2 1.1 0.8
Italy 1.5 0.3 1.2 0.7
Netherlands 2.1 0.2 1.9 1.6
Portugal 1.4 0.3 1.1 0.9
Spain 1.5 0.9 0.6 0.4
Sweden 2.6 0.5 2.1 1.8
UK 2.6 0.6 2.0 1.5
United States 2.4 0.5 1.9 1.6
Source: OECD (2014a).
Table 7. Public finances, 2009/10 to 2019/20 (billion [pounds sterling]
current)
2009/10 2014/15 2019/20
outturn projected projected
Expenditure
Current 600.9 671.7 707.0
Welfare 187.1 215.0 240.7
Debt interest 30.9 35.9 60.1
Net investment 49.5 27.7 26.9
Total managed
expenditure 669.7 719.9 779.9
Revenue
Income tax and
NICs 244.1 272.0 354.1
Corporate tax 36.5 41.7 45.9
VAT 73.5 110.1 130.2
Fuel duties 26.2 27.0 29.8
Current receipts 513.3 645.8 803.0
Sources: OBR (2011, 2014a).
