The UK recovery and the pessimists’ refrain

In two recent posts I plotted UK GDP per person since 1950. What is remarkable to me about that time series is how well a simple trend tracks the data – until the current recession. In reality trend growth rates have probably moved around a bit, but the important point is that past recessions have essentially turned out to be temporary deviations from trend growth, rather than signaling fundamental shifts. In particular, following both the major recessions of the early 1980s and 1990s, we achieved recoveries that brought us back to something close to the level of output we could have achieved if there had been no recession.

There are two arguments that this time will be different: what I will call the pessimists’ refrain. The first is that we were fooling ourselves before the recession, because in reality we were ‘living beyond our means’. This argument suggests that output in 2007 was unsustainably high, so our trend line should be lower and flatter. The second is that since 2008/9 productivity has stalled because the financial system in the UK has been broken. I call these ‘refrains’, because they usually come with a repeated message: we should stop stimulating the economy, because if we try to get back the ground we lost, we will fail and instead generate inflation. (A third argument focuses on hysteresis effects of high unemployment, but this is more important for the US than the UK.)

Larry Summers has recently reminded us that there was something odd about the pre-recession period in a number of countries including the US and UK. Although inflation was reasonably stable, we had the kind of housing bubbles that we normally associate with booms. Now Summers argued that this indicated an underlying demand weakness: we could only get people to buy all the stuff we could produce by encouraging them to take out an unusual amount of debt. There is an alternative explanation, which is that - despite appearances - there was a boom before the recession. We were, in 2007, living beyond our means. 

This idea is not the view of a small minority. Organisations like the OECD and IMF now calculate that in 2007 output gaps were large and positive. The latest OECD Economic Outlook gives 3.3% for the OECD area as a whole, 3.5% for the Euro area, 2.9% for the US and 4.4% for the UK. That is not what these organisations were saying at the time. In the June 2008 Economic Outlook, the equivalent numbers were 0.4%, 0.0%, 0.4% and 0.2%. At the time it looked like output in 2007 was close to the natural rate in many countries, including the UK. [1]

This change of view on output gaps, where 2007 goes from balance to a significant boom, is largely inevitable given the way the OECD and IMF calculate these numbers. Since the recession productivity in many countries has been much lower than we might have expected (in the UK it’s the ‘productivity puzzle’), which seems to indicate a fall in how much technical progress has been embodied in production. Traditionally we have thought of technical progress changing gradually, and as being largely unrelated to the economic cycle. If productivity is low today and technical progress only changes gradually, then it follows that some of this slackening in the pace of technical progress must have started before the recession. So in 2007 the economy was not capable of producing as much as we thought at the time.

What hard evidence do we have for all this? The living beyond our means case really comes down to the idea that both the housing bubble and the build up of personal debt must imply there was a boom. Yet this is really one piece of evidence rather than two. As Ben Broadbent shows, the build-up of debt was matched by an increase in assets: the value of houses. (The same appears to be true in the US.) This increase in personal sector indebtedness might have been foolish given what happened to house prices, but the underlying problem was the housing bubble.

Was the housing bubble an indication of a ‘hidden boom’ in 2007? There is a quite plausible alternative explanation, which is that you can get housing booms when real interest rates are low. Many economists, including Ben Bernanke, pointed out before the recession the unusually low returns on long term assets like government debt, an idea that became known as the ‘savings glut’. The return on assets was being driven down because consumers in China and its neighbours were saving extraordinary amounts, leading to large current account surpluses there. When returns on safe assets like government debt are low, people look elsewhere for higher returns, and this includes the housing market. This is probably why we are seeing rapid increases in house prices today in a number of major cities (e.g. London, Paris, Germany).

Not only is there this alternative explanation for the housing bubble, but the living beyond our means case cannot satisfactorily account for why - if we had a huge boom - inflation remained so subdued. What upward movement there was could easily be explained by large increases in oil and commodity prices. It is sometimes argued that inflation targeting, or cheap goods from China, kept a lid on consumer price inflation, but there was no indication of any overheating in the labour market either.

The second refrain, much more specific to the UK, focuses on the banking sector. The argument is not that the financial sector grew too rapidly before the recession, and must inevitably shrink back to a more normal size. That is almost certainly true, but the numbers just do not seem large enough. As Martin Wolf points out, the financial sector went from 6% of GDP in 1998 to 9% in 2008. Even if it returns to 6%, for the economy as a whole much of that should be recoverable, because most of those who have lost their jobs in the financial sector are highly skilled and so can be redeployed in other high productivity activities.

The argument is instead that, for the supply side of the economy to grow, more productive firms need to replace inefficient competitors, and new innovative start-ups should challenge existing firms. Both processes almost certainly require borrowing, and in the UK in particular that borrowing usually comes from a few large banks. If these banks stop lending, productivity growth will fall away. This argument is plausible, and can help explain two puzzles about the current recession. The first is why, when UK firms are asked how much spare capacity they have, they respond that they have very little. This is not consistent with the recession being only about lack of demand. The second is that inflation has not been falling more rapidly. If firms cannot get the finance to grow, there is little point in trying to expand your market by cutting prices.

What is frustrating about this idea is that there is little hard evidence either way. Bank lending to firms has certainly fallen, but how much of this is down to banks, and how much is simply that firms think it is too risky to borrow? (This study suggests at least some of the former.) There is a great deal of anecdotal evidence that some banks have in the last few years might have been hindering rather than helping small businesses, but translating this into actual numbers for productivity lost is almost impossible. The most compelling argument that something like this has been going on is that other explanations for the UK’s productivity puzzle are either implausible or inadequate in terms of scale.

Perhaps the key question, though, is how permanent this all is? If bank lending starts to recover, can we get back the productivity we have lost? We can look at past financial crises in other countries, as Nick Oulton has done. (His paper also provides useful detail on why other explanations for the productivity puzzle do not seem to work. The section on fiscal policy, however, departs from his usual high standards, as this article in Pieria suggests.) His analysis indicates some permanent hit to GDP from a financial crisis, but the larger numbers come from Latin America. The example of Sweden in the early 1990s is much more optimistic. A priori we might expect a good deal of the innovation to have been ‘put on hold’ because of lack of finance, and this could be activated once banks’ balance sheets are repaired. But perhaps some opportunities may have been lost forever.

Given these uncertainties, two implications for policy seem clear. First, we should stimulate demand until there are clear signs of overheating in both the goods and labour markets. We should only do otherwise if the pessimistic case is compelling, and it is not.

Second, to the extent that we do not recover the ground that we lost in the recession, the costs of the financial crisis are even larger than we thought. This suggests we must do something to make the economy less dependent on the behaviour of a small number of large UK banks. What is interesting about at least some of those who sing the pessimists’ refrain is that they seem to treat this implied loss of UK capacity like an act of God: not only is it something we can do nothing to reverse, but there is little point in investigating it further. That is a strange attitude to take, particularly given that there has been no equivalent productivity puzzle in the country where the banking crisis really started. (This may be another reason to praise small US banks: see Felix Salmon here.) Some who are pessimistic preach the usual neoliberal message for enhancing growth, including lower taxes on high incomes, but seem strangely uninterested in what has caused this alleged huge reduction in supply. Perhaps they fear the answers to the UK’s productivity puzzle will not be to their liking.

[1] For the CBO’s assessment of US potential, see Menzie Chinn.