"Obsessing about triple dips misses the point. We haven't had the recovery yet."
Simon Kirby, UK Economist at NIESR, argues the UK is being held back by a lack of investment and too much focus on the Bank of England.
Q: Looking at NIESR’s recent forecasts for the UK is it fair to describe the current situation as “stagflation”?
A: The problem when you look at the data is, as Mervyn King said, the economy will be zigzagging from quarter to quarter. Yet when you look at what’s happened the economy over the past two and a half years it has effectively been flat.
Obsessing about double dips or triple dips really does miss the important point which is that we haven’t had the recovery yet. If you define a recovery as a period of above trend growth that closes the negative output gap then you would be thinking of growth rates in excess of 2% per annum. We’ve clearly got nowhere near that.
A lot of people point to 2010, where current estimates suggest the economy grew just under 2% but that period of growth was largely due to temporary factors. We saw the inventory cycle turn very aggressively and that was not sustainable.
We do expect the economy to expand gradually over the next couple of years but the real risk is that the economy flatlines this year.
Q: How do you view the Office for Budget Responsibility’s downgrades to their growth forecasts?
A: They’ve come much more into line not only with us but also with the mean of external forecasters as well.
We need to recognise that the potential growth of the UK economy in the OBR’s forecast hasn’t changed. What has changed is their view of when that output gap will close.
In a normal type of business cycle you would expect the output gap to be closing in the next couple of years or so at the longest, whereas the OBR is now talking about it being sustained for the next five years at least. The risk is that they, and we, are overoptimistic on that and there has been a larger structural hit to the economy that is currently estimated.
Q: How can we hope to establish how much of the current economic weakness reflects structural damage and how much is unfulfilled potential?
A: At the best of times we are having a debate about an unobservable. Different methodologies will give you different results, as the OBR has made particularly clear by the fact that they now openly use a production function approach rather than their cyclical indicators approach.
Q: What effect has the Budget had on forecasts?
A: The OBR has a box on what effects policy decisions made by the Chancellor have had on forecasts and their conclusion is that it’s zero.
Hypothetically you could get an impact on the macroeconomic level from following a balanced budget approach as there is general agreement that multipliers vary by fiscal instrument. As such by changing around your spending and tax composition you could get a net positive effect, but overall given the changes that were announced in the Budget it’s likely to have little or no effect.
There was a £3 billion increase in capital expenditure in 2015 but any impact that has is likely to be swallowed up by ONS revisions. That’s not to say that the Chancellor shouldn’t be doing these kinds of things, it is just that earlier would have been better.
Q: Can the Bank of England’s new mandate improve the outlook for the UK economy?
A: Monetary policy won’t close the output gap. The change to the target was a very slight tweak that is really just reflecting what the Bank is already doing.
Mark Carney may be able to get the Bank to start buying private sector assets rather than relying solely on purchasing gilts, we’ll have to wait and see. The one thing to bear in mind is that Carney is just one of nine on the Monetary Policy Committee and he’s replacing a Governor who’s already voting for more QE. I think those expecting fundamental change are likely to be disappointed.
But [this focus on monetary policy] does narrow the debate somewhat because we are ignoring the fact that fiscal policy can be used in the short term to try and boost demand. One of the major things that did happen under the fiscal consolidation plan is scaling back public sector net investment and that has a large multiplier in the OBR’s calculation. If you take into account that multipliers are time varying and are probably much larger given the current state of the UK economy that kind of approach would likely have a significant affect in the near term.
The government has the in-depth knowledge of the infrastructure that the UK economy needs. If they were to redo the cost/benefit analyses of infrastructure projects cancelled under the previous Comprehensive Spending Review (2010) then more would likely be given the go ahead. Picking the right ones has clear long-run growth benefits and fits within the plan for growth.
Q: Could the lack of public sector investment have long-term costs for the UK?
A: There seems to be increasingly a view that cutting back on investment so aggressively was the wrong way to approach fiscal consolidation. We’ve always made the point that aggressive consolidation too early when the economy’s weak is the wrong thing to do but even ignoring that point the sheer scale of cutbacks in public sector investment is worrying.
You may be able to get away with this lower level of investment for a little while but given that we know there’s increasing demand on infrastructure – social housing, transport, energy and so forth – the government will have to deliver something eventually.
Q: Yet despite the cuts hasn’t unemployment been falling at a faster pace than many expected considering the UK’s economic performance?
A: Completely. I’m not aware of anyone who expected employment to be as high as it is now in the absence of any meaningful GDP growth.
If you look at the labour market it’s not just that employment has held up but that labour market participation of 16-64 year-olds is now higher than it was prior to the onset of the Great Recession. When you take into account the numbers of people in education as well then the number of economically inactive is surprisingly low, which is welcome.
The one sector that is an exception to this trend is construction, which is still significantly weaker than in 2008. In terms of employment it’s something like 327,000 below the level of the first quarter of 2008. That’s where fiscal policy could have a noticeable impact.
Q: What role should private sector investment play in pulling the UK out of its current malaise?
A: A sustained economic recovery will, in part, depend on private sector investment. At the moment uncertainty about future demand is weighing heavily on their decisions to invest in the UK economy. We need to remember that even in terms of infrastructure the majority of spending is undertaken by the private sector and this will continue to be the case over the long run.
Aside from providing a policy framework that provides certainty to the private sector in their decision making over large-scale investment decisions, government can have an impact on the short-term through increasing their direct spending on infrastructure and housing projects.There is a growing consensus that the government should be increasing infrastructure investment but the debate now appears to be over how that should be funded. Should it be paid for with a balanced budget approach or financed through borrowing?