Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday, 27 June 2013

UK Growth has been even worse than we thought

That is one headline on the Office for National Statistics (ONS) latest data revisions. Output in the UK economy is now estimated to be currently almost 4% below its previous peak, compared to previous estimates of 2.5% below. Or alternatively, the headline could be that the UK never had a double dip recession: at the beginning of 2012 growth was flat rather than falling by 0.1% (not annualised), a 0.1% that has been reallocated to the subsequent quarter. The chart below shows the old and new data for GDP growth, quarter on quarter. So GDP went fall, flat, fall, which technically is not a recession. I’ll leave you to decide which the more informative headline is.*

As you can see the big revision is in how much GDP fell in the recession. GDP is now thought to have decreased by a little over 5% in 2009 as a whole, compared to the previous estimate of -4%. At this point I cannot resist telling a small story about this number, but for those who are fed up with my personal anecdotes there is a serious point about inflation to follow. I make a weak attempt to connect the two at the end.

Quarter on quarter changes to UK GDP (not annualised): ONS

At the beginning of 2009, I was asked to attend a breakfast meeting with the then Chancellor, Alistair Darling, along with some non-academic economists. I had never attended one of these before, so I did not know what to expect. I had not met Darling, but all the other economists invited appeared much more comfortable with the format and surroundings, so to be honest I was rather nervous. Academics in particular can appear out of touch because they do not have all the latest data at their fingertips.

Sure enough, one of the first questions Darling asked was just how bad we each thought things could get. I cannot remember what each person said, but the general view was that GDP could fall by as much as 3% in 2009. I was the last to give my opinion. I could have ducked out, but instead I remembered one thing from my earlier days as a forecaster. This was that forecasts typically underestimate the extent of large swings in GDP, particularly if they are globally synchronised. So I said that I thought things could be worse than that, and GDP could fall by 5%.

Impossible! was the immediate retort of one of the other economists: someone who is very well known and very sensible, although I will not say who it was here. This person then used their detailed knowledge of the data to say why it was inconceivable that GDP could fall by so much. One by one everyone else agreed that although things were bad, they could not get that bad, and 5% was an outlandish number. Just as I wished I had kept my mouth shut, or better still just not come, the senior economist from the Treasury who was there came to my defence: a fall that large could happen, and they described how it might happen. I of course take no pleasure in the fact that my forecast has been vindicated, and it was little more than luck, but it is one of those moments I will not forget.

Now for something more consequential. The chart below compares two different measures of UK inflation: the CPI (green) and the GDP deflator (blue). CPI inflation has been significantly above the 2% target since 2010. In contrast over the last year growth in the GDP deflator has been well below 2%. This is the deflator at market prices, so it includes indirect taxes. The dashed line is the GDP deflator at basic prices, which excludes these. The press release only includes numbers going back to 2010 for this series, but you can see that growth has been below 2% for the last three years. The dotted line is growth in the US GDP deflator - this moved in a more immediately understandable way after the recession, but over the last two years the UK and US measures have not been that different.

Alternative measures of inflation

The fact that output price inflation (which is what the GDP deflator measures) has been below CPI inflation is neither surprising, nor unique to the UK. What is less appreciated is that there is no reason from an economic point of view to focus on one series (the CPI) rather than the other (the GDP deflator) when setting monetary policy. At an intuitive level looking at the output price measure makes more sense, because policy has more control over things produced in the same country. At a deeper level, inflation matters because some prices are sticky, and the GDP deflator generally excludes volatile commodity prices. It should be less influenced by volatility in the exchange rate, so it may be better for that reason too.

I cannot help but reflect on how different UK monetary policy might have been if it had focused on output prices rather than consumer prices. In 2011 interest rates were almost raised (3 out of 9 MPC members voted for doing so), despite the lack of a recovery. Would this have happened if the target inflation measure had been below 2%, as growth in GDP at basic prices was? Since then Quantitative Easing has largely stalled, which would have been very hard to justify if the focus had been on output prices.

One of the reasons often given for focusing on the CPI (which has come up again in discussion of nominal GDP targets) is that this data is available quickly and is not revised. [1] Which brings me back to the beginning, because the GDP deflator numbers for the first quarter of 2013 and earlier have been significantly revised (and are smoother as a result). I have never understood this argument. We should start with why inflation is costly, and then think about how best to measure these costs. If measurements change because information gets better, policy should respond to that. If that causes problems, improve the measurement. Perhaps policy needs to obsess a bit less about this bit of data or that, and think more about the fundamentals of what it is trying to do. 

* I changed the text here from the original version to make the nature of the adjustment clearer. As one economic journalist put it, reallocating 0.1% of GDP between quarters makes no difference in terms of the economics, but revising away the double dip recession will play well for George Osborne politically. I think that says a lot about the quality of political debate.

[1] Another argument is that the CPI is easily understood by the non-economist. If this impresses, why not use wages rather than the CPI, as I suggested here. As wages are clearly sticky, there are good theoretical reasons to focus on this as a measure of inflation.


  1. 1. In the UK the data are at least sort of reliable. In the EZ (mainly South to confirm prejudices) they look simply crap. Have eg a look at Spain's, simply donot add up (prognosis look even worse). Which means in a longer crisis like this one at a later time in the crisis they will pop up. Probably one of the reasons (one of the many) the recovery doesnot really get started (not by a mile).
    I do however believe that 'Merv' was doing things that his Mother would not have been proud of re inflation. Well it worked at the end so he is absolved for that.

    2. The UK is much more relying on foreign trade than the US. Furthermore GBP dropped compared to the USD. This could be one of the reasons for the difference with the US. Several imports, eg most energy leads nearly always immediately to higher prices.

    3. Actually I donot have a clue what most forecasters are doing. A lot looks simply highly politically motivated and/or wishful thinking. Re the EZ, the worst culprit I checked my initial back of an enveloppe calculations (well not even that) with official prognosis and I won with considerably over 90%. Unfortunately it looks to say more for the totally unprofessional way most prognosis are made than over my intelligence. Data is more difficult to control. But seen the level of prognosis hardly give much confidence.
    To use the only famous quote from the Dutch language area (by Mr Van Gaal, the football manager, on a stupid question by a journalist): Am I so clever or are you so stupid? It looks to be clearly the latter here.
    EU also have not yet found a way to make the ECB stuff agree with that of their Stat Office.

    4. I think if there are 2 possibilities to calculate in general only one is used. For this sort of important decision you should do both. Differences come up and you have to find a way how to explain those (and nearly always a lot of funny stuff comes to the surface that way).

    5. I think a lot of the problems by the simple data hunters can be explained because they are simply too stupid to oversee the whole field (unlike you do). They are happy to use a formula plug in the data and voila an outcome and that must be it. They simply are not able to play with/combine formulas like you can (above is an example).
    Another thing is you see always normal distribution when stats play. For the same reason: they havenot got a clue about other ones.
    And have no structured way of working to compensate that. If always you have to ask yourself the question when stats play which distribution to take, you bump into it and even a big idiot knows at that point he needs a good answer or help.

    6. My personal experience with this.
    I usually kicked the too complicated stuff out (for things you have to 'sell' to the intellectually challenged or unknowns unless you could bluff or bully them into it).
    In a normal situation you simply cannot sell it. And even if you could, they likely mess it up in the implementation or execution phase.
    Or invested most of the effort in making it as simple and easily digestible as possible. Often much more than in the basic things.
    One of the problems now imho. A lot of the economic stuff works counter to human experience for daily issues (counter-intuitive). And is furthermore explained in much too complicated ways.
    The economy and anti-recession is now top of the agenda (next to the new information society (aka every idiot has an opinion and all opinions are as valuable for most at least), it has to fit in that world. It has to be sold to the electorate. Look at polls on this sort of issues (or earlier the EU membership or Euro crisis) with questions that are more or less similar (and percentages are all over the place even within the same poll). Public clearly doesnot catch these topics. It is simply too difficult and explained in a too difficult way. Next to being in denial (that cuts are necessary but only with other people).

  2. I think you were very kind about the non academic economists. I've yet to meet (and I've met a few), hear or read a chief economist, with the exception of miles, whose primary qualification was anything other than that they could do a good "turn" I.e. a warm up for the subsequent sales pitch or some pretty graphs and supposedly wise words for the board of a plc. It's always good sport when one ends up on the mpc give or take the discrepancy between their analytical competency and the importance of their actual responsibilities. There again, there's not many impressive academic economists either.

  3. Krugman blog October 5, 2012 'Wages, Prices, Depressions, Deficits (Wonkish)':

    "I mentioned the piece by Capital Economics arguing that policy makers in Britain are greatly understating the output gap...the starting point here is the official estimate by the Office of Budget Responsibility that Britain right now has an output gap of less than 3 percent. This is a remarkable assertion, when you bear in mind that real GDP remains well below its level pre-crisis, and that we used to think that Britain’s long-run growth rate was around 2.5 percent. As the CE guys say, simple trend projection would indicate a shortfall of 14 percent."

  4. I guess it's a variation on the theme of the drunk looking under the lamp post. You use CPI because that's easy, not because it the best place to find what you're looking for.

  5. I heard today that productivity fell in the UK. Productivity is a function of real wages and labor share. So as real wages are hitting lows in the UK, one should not be surprised that productivity is falling.
    Productivity = real wage/labor share


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