GROWTH : THE HARSH LESSONS OF HISTORY / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

Growth: the harsh lessons of history

By Keith Fray

Published: March 23 2011 23:21

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On Wednesday the government unveiled a “Budget for growth”. After a period when attention has understandably been focused on the state of the public finances, the annual Budget presentation now seems to have returned to type, with “growth” as the buzzword.

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Growth – more properly the expansion of gross domestic product or the sum total of the economy’s output – provides the foundation for jobs and for rising living standards. When growth falters there are real human costs. This in essence is why politicians and economists regard it as so important.

The coalition government’s policy of rapid reduction in the budget deficit, to give private businesses space and confidence to invest, is a risky strategy. A return to growth after the worst recession since the second world war – by no means a certainty – will determine the success or otherwise of the government’s period in office.

This FT analysis seeks to provide some historical context – to look at the UK’s growth performance over the very long term, and at the structural problems that must still be tackled if sustained expansion is to resume.

Since the middle of the 19th century average growth in gross domestic product has been slightly less than 2 per cent per year. The line below shows the deviation of growth (averaged over the previous five years) from this long-term trend, in percentage points. Crudely put, it provides a “fever chart” of the economic health of the nation.

The history of the past 160 years falls into four distinct periods – determined not only by booms and slumps but by Britain’s relative importance in the global economy. Another factor is the prevailing ethos of economic policy – to what extent state involvement has been seen as necessary or desirable by the governments of the time.

Nineteenth century pre-eminence: 1850-1914

Britain 160 years ago stood alone as the first industrial nation, with the highest output per head in the world. 1851 was perhaps the zenith – the Great Exhibition underlined the astonishing scientific and industrial innovation in the “workshop of the world”, while the census of that year revealed that for the first time a major nation had most of its population living in cities and towns.

Government involvement in the economy was essentially restricted to maintaining order at home and extending the empire abroad, with minimal social protection from the vagaries of the business cycle.

Wars and depression: 1914-1950

In common with the rest of the world Britain suffered severe dislocation during the two world wars and the intervening years. The unemployment rate rose to 15 per cent during the Great Depression, but in many ways the early 1920s were even worse, with deflation exacerbating the postwar recession. An inflexible exchange rate caused problems of adjustment throughout the period and the 30 per cent devaluation of sterling in 1949 finally underlined that Britain was no longer a dominant power. The return to a peacetime economy after demobilisation saw a populace determined not to repeat the experiences of the past 30 years.

Postwar stability: 1950-1974

This period was one of relative stability – with generally low inflation, and no significant recessions – and of relative decline, as other nations, in particular the resurgent Germany and Japan, overtook the UK in the international economic pecking order. Political parties were in broad agreement that the state had a role to play in the economy, to fund the expanding welfare state and, by judicious use of fiscal and monetary policies, to maintain full employment.

Adjusting to a global market: 1950-2011

The postwar consensus broke down amid the “stagflation” of the mid-1970s, as a full-blown recession, with double-digit rates of inflation, followed the quadrupling of the oil price in 1973. Government economic policy moved towards greater acceptance of market mechanisms. While globalisation saw much of the world’s manufacturing industry moving to the emerging Asian economies, the UK economy shifted away from traditional heavy industries towards services, particularly financial services. The first decade of the new century ended with the deepest peacetime recession for 70 years.

Productivity

Behind growth lies productivity. The longer-term challenge for any government is to raise productivity in order, in turn, to raise the trend rate of growth of GDP. This has implications for most areas of government policy, particularly taxation, education, infrastructure and immigration.

A recent report from McKinsey, the management consultancy group, emphasised that a decline in the underlying trend was much more serious in the longer term than even a renewed recession. Given trend levels of growth over the next 20 years, the UK economy should expand by 65 per cent between 2007 and 2030. Another recession with a quick return to trend reduced this to 56 per cent, but a reduction of 1 percentage point in the trend reduced cumulative growth over the period to 36 per cent.

The chart above shows labour productivity performance over the past 50 years. UK levels generally closed on the US, falling behind European competitors in the late 1960s and 1970s, with a rapid improvement in the mid 1990s and stagnation since then. Last year productivity was still 5 per cent below Germany and 15 per cent below the US. Productivity has improved recently, in common with other industrialised countries, as employment levels have not grown as fast as output during the recovery.

A balanced economy

The need for the UK economy to be “rebalanced” has long been a stated goal of Britain’s policymakers – even when the opposite was happening. This can mean different things – rebalancing between industrial sectors, regions, sources of GDP growth (consumption by households and government, investment, trade), and between the public and private sectors.

In sum the government wants less reliance on the service industries, particularly financial services overwhelmingly concentrated in London and the south-east, and on public sector employment in the rest of the country. In its place it wants more emphasis on private companies making things and selling them abroad. The prospects do not look hopeful. The manufacturing sector is recovering strongly from the recession but the impact of globalisation means that it is likely to be a progressively smaller share of the economy. And for a nation whose rise to world domination was founded on trade, exporting more than we import has been a perennial problem.

Apart from the temporary boost given by North Sea oil, the trade balance has been largely in the red since the second world war. It appears especially difficult to turn this round at present, when many other countries are attempting export-led strategies for growth.
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Living standards

Bank of England governor Mervyn King’s speech in January, when he warned that rising prices and higher taxes meant that households now faced the first sustained fall in real wages since the 1920s, was a timely reminder that the return to sustained growth would not be without pain.
The coalition’s political prospects hinge on how short and how sharp this shock turns out to be.

Public sector employment has fallen from its 1970s peak following the privatisation of the nationalised industries but still provides direct employment for a fifth of the workforce. In many regions this is substantially higher and these areas will be hit hardest as public sector jobs and contracts dry up. The private sector has to be fit enough to fill the gap in demand.

Persistent inflation is adding new complications to the fragile recovery, with the Bank of England facing a finely balanced decision on interest rates. Inflation as measured by the consumer price index, is over 2 percentage points above the government’s target, and on the retail price index measure – still important for wage negotiations – inflation hit a 20-year high of 5.5 per cent last month.

So far wage pressure has been muted, but may not remain so.

Copyright The Financial Times Limited 2011