The State of the Economy

Fig.1 Depressions Compared

At the end of the 1st quarter in 2016 the current crisis was 8 years old, approaching a ‘lost decade’. As the chart shows the current crisis is much worse than either the Great Depression or under Thatcher. SEB previously suggested that this slump would be “twice as bad as Thatcher”, and this judgement has proved correct.

There is no suggestion that the course of this slump will necessarily follow the earlier periods. Major events or external factors intervened. The Great Depression ended with rearmament for World War II. The Thatcher experiment was boosted by the huge windfall from North Sea oil, although the Tories created another recession after the consumption splurge of the ‘Lawson Boom.’

There can be no crystal ball about the trajectory of the economy, but it is possible to identify the key internal dynamics which determine growth. This slump and its predecessors were all led by a crisis of investment. At the same time, it is impossible for an economy to grow sustainably over the medium-term if it has a low and/or falling level of investment. This characterises the current crisis in the economy (Fig.2).

 

Fig.2 Change in GDP and its components since the crisis began

 

The economy overall remains close to stagnation, so that average living standards cannot rise. But the modest increase in GDP since the crisis is almost entirely driven by rising consumption. The combined increase in household and government consumption amounts to £84.3bn. But the rise in investment is just £5.8bn. Since the crisis the proportion of investment has amounted to just 5% of GDP. As this is below the rate of capital consumption (capital used up in production, or which dilapidates), the stock of capital in the British economy is falling. As a result the capacity for future increases in output is declining. At the same time, an inevitable consequence of growth which relies almost entirely on consumption while net investment falls is a rising trade deficit. The trade gap has widened once more to record levels even during a period of stagnation.

The key factor in this investment-led crisis is the weakness of business investment (Fig.3). There has been no recovery at all in business investment and it remains below its pre-crisis level, even though both GDP and consumption have recovered. As the chart shows, the fall in business investment preceded the decline in GDP and led the whole downturn. Business investment as a proportion of GDP has declined markedly over the period and is now falling once more in outright terms. ‘Demand’, by which is meant consumption, has not led growth.

 

Fig.3 Weakness of UK Business Investment

Source: ONS

Over time, Britain and the other advanced industrialised economies have increasingly adopted the US model of economic growth, particularly from the 1980s onwards (Fig.4). This is a model based on rising consumption as a proportion of GDP and consequently a declining proportion of GDP directed towards investment.

However, the consequence of this is plain. As consumption has risen as a proportion of GDP, the growth rate of consumption has slowed sharply. This apparent paradox relates to the sources of growth. Investment is a key input into economic growth while consumption is not. So, as consumption claims an ever-greater share of GDP and investment a diminishing share, the growth rate of the whole economy slows. Consumption then slows with it.

By contrast economies with a high and/or rising proportion of GDP directed to investment will produce higher rates of GDP growth and consumption can grow more rapidly. But this is not the US or Western model.

 

Fig.4 US Consumption share in GDP and consumption growth

 

The same trends are evident in the British economy (Fig 5.). The proportion of consumption and the growth rate of consumption in the UK are inversely correlated. As the proportion of consumption in the economy rises, the growth rate of consumption falls, and vice versa.

The US-led Western model of growth can be summarised as ‘shop till you drop’ and consumers frequently do. Slow growth economies produce flat or falling real incomes and consumption is

increasingly financed by debt, until the point at which the debt becomes unsustainable.

 

Fig.5 UK Consumption share in GDP and consumption growth

 

This fundamental economic context demonstrates why the fiscal framework set out by John McDonnell is correct. The commitment to borrow only for investment provides the optimal basis for sustainably higher rates of growth. The claims that this is austerity-lite or similar to failed Labour policies of the past are misplaced or disingenuous.

The crucial difference lies less in the specific fiscal rules than in the economic context. The entire theme of the State of the Economy conference was the need to substantially increase investment. Previous governments cut investment and adopted Tory spending plans. In those circumstances, it is only possible to balance the current spending budget by applying a brake to it. The level of government spending as a proportion of GDP was on average lower in the New Labour years than under Thatcher.

By contrast, if investment is increased the economy will grow more rapidly and consequently tax revenues will grow more rapidly. It is also likely that social welfare payments will fall as more people are in better-paid work. Both of these revenue and expenditure headings are in the Government current spending account. Increased investment will cut the current spending deficit.

The scale of problem requires this break from past economic orthodoxy in Britain. The depth of the crisis means that traditional ‘demand management’ and muddling through will not work. It may even be that ‘People’s Quantitative Easing’, that is money creation for investment purposes, is necessary.

The general rule is that the greater the increase in investment the faster the economy can sustainably grow and the more rapidly the deficit on current spending will decline, which is the basis for Labour’s economic plans. There is no sign that anything else is likely to rescue the British economy.