Did 2010 austerity permanently reduce UK output?

 

An issue that is likely to preoccupy economists for some time, and which I have written the occasional post about, is whether 2010 austerity led to a permanent reduction in UK output. Permanent is probably too strong a word, but we can safely substitute ‘output today’ for ‘permanent’. Let’s start by redrawing a chart I have shown many times, which contrasts the path of UK GDP per capita with its pre-Global Financial Crisis (GFC) trend to show the extent of the sea-change that appeared to happen after the GFC. (Looking at GDP alone understates that sea-change, because GDP growth in the latter half of the period was supported by much higher immigration. GDP per capita is also more relevant for individual incomes.)

The GFC appeared to lead to an immediate and sustained loss of 10% in income per capita, and rather than that gap shrinking during a subsequent recovery (as it had after all previous recessions) the gap grew to be around 15% by 2019. Both figures are well above calculations done at the time of the GFC which suggested a permanent output loss of around 5% at most.

The first point to make is that there were signs that underlying growth was slowing before the GFC, particularly if you allow for the excessive growth in the banking sector before the GFC, so using a constant trend line exaggerates the amount of lost output, by a small amount in 2010 but by much more in 2019. But there is no doubt that a significant puzzle remains about why the 2008/9 recession led to such a large permanent loss in output.

Output growth is all about productivity growth, and the decline in the growth in output per head or output per hour since 2010 is well documented (the UK ‘productivity puzzle’). A key way that productivity growth occurs is through investment (‘embodied technical progress’), so if investment was substantially lower as a result of 2010 austerity then this might account for some (certainly not all) of the productivity shortfall.

Below is a chart of the share of business investment in GDP. I look at business investment so as to exclude investment in housing and the public sector.

Investment always falls by more than GDP in a recession, so its share also falls. A notable point we can make immediately is that the investment share did eventually recover to pre-GFC levels by 2016, but has subsequently fallen as a result of Brexit. Whether the share would have risen above the pre-GFC peak without Brexit, as it did following the 1980/1 and 1991 recessions, we will never know.

The chart below compares how the investment share evolved in three recessions and recoveries. (indexed to 100 at the start of each recession, and plotted from two years before that date.)

In the 1980/1 recession the business investment to GDP share fell least, by around 8%. In 1991 the business investment share fell more sharply (by over 15%, although with a bit of a delay), but it recovered rapidly. In 2008/9 we saw similar sharp falls in the investment share, but with a more protracted recovery.

How much potentially productivity improving investment was lost in each recession? Suppose we average the investment share in the three years before each recession, calculate how much the investment share was lower than this average during the recession, and then accumulate these losses in investment share up until it regained that pre-recession average. After the 1980/1 recession the investment share had recovered to its pre-recession average by 1985, with an accumulated loss of only 2%. After the 1991 recession the share had recovered by 1996, with an accumulated loss of 4%. Following the 2008/9 recession, it took two additional years for the investment share to regain its pre-recession average, with an accumulated loss of nearly 7%, which amounts to losing the best part of a whole year’s worth of business investment.

The following chart looks at the growth in productivity (output per hour) from the start of each recession.

Output per hour recovered more rapidly following the 80/81 recession than the 91 recession, perhaps reflecting the larger fall in investment in the latter. What stands out, of course, is that the recovery in productivity following the 2008/9 recession was almost non-existent by comparison. That suggests that lower business investment is associated with lower productivity growth, but it also points to other factors contributing to low growth after the GFC recession, as there was still plenty of business investment going on but productivity hardly improved.

If we accept that lower business investment can result in lower productivity growth, then it also follows that anything that delayed the recovery from the 2008/9 recession is likely to have led to more postponed or delayed investment projects, and therefore almost certainly to less productivity growth. Without austerity, the 2008/9 recession might have looked more like the 1991 recession, with a rapid recovery to a higher level of GDP by 2016.

I have made the point before that productivity improving investment often requires output growth to make it happen. Without output growth, a firm needs to trade off the cost of investment against the future reduction in costs the investment will generate. In contrast if demand is growing, the firm will probably want to invest to meet that demand anyway, and so the trade-off largely disappears. In other words how much firms initially invest in productivity improvements will depend on how much they expect output to expand after a recession.

As I have already noted, after the 2008/9 recession firms could reasonably expect a period of reasonably strong growth. Output had fallen by nearly 5% between 2007 and 2009, so there was still the potential for above trend growth. That appeared to be happening, with GDP rising by 2.4% in 2010. However these expectations were dashed over the next two years, with growth of only just over 1% in 2011 and just under 1.5% in 2012. At that point firms might have revised down their expectations about future demand, and delayed productivity enhancing investment projects.

The Chart below looks at the growth in output per hour during and after the 2008/9 recession

Productivity fell in the recession as it always does, as firms try to hang on to at least some of its workforce. But in 2010 productivity rebounded as the recovery started. The collapse in productivity happened subsequently, as this early promise of a quick rebound from the recession was dashed. Austerity, and in particular the large cuts in public investment in 2011 and 2012, played a key role in reducing output growth in 2011/12.

I therefore think there is evidence that austerity, in creating an unusually protracted recovery in aggregate demand from the GFC recession, did have a negative impact on productivity growth and therefore a persistent negative impact on output supply. What we cannot know is how long that negative impact on output supply would have lasted in the absence of Brexit. Without Brexit, perhaps business investment would have stayed at 10.5% of GDP, and the productivity enhancing investment projects that had been delayed after the weak recovery from the GFC would have finally been undertaken. In other words, while Brexit in itself was always going to reduce UK output permanently, it may have also prevented an eventual recovery in terms of investment led productivity from the impact of austerity. 

If an economy gets hit hard by a global economic shock, it seems reasonable to hope for an almost full recovery fairly quickly if policymakers do the right thing. Hit it hard again as that recovery starts, and any recovery is bound to be more delayed and may not be as complete as it might have otherwise been. If you hit it with a third big negative shock less than a decade after the first, then it is much more likely that the first two shocks will leave lasting scars.