Britain takes pole position for global 'catch up'
Monday 20 May 1996
Britain seems to have resisted an inherent tendency for economies to ''catch up'' with the most prosperous country - the United States. This catch-up process may be fast, as in the case of the Far East, or it may be slow. Barriers to economic growth-obstacles to the efficient use of economic resources - may be difficult to identify, but their removal can lead to growth spurts like that of China after decades of stagnation. And their presence may also mean that some countries fail to catch up with the United States completely.
As the chart shows, Britain actually slipped relative to the United States in the 1970s, but has made up ground since 1980. France and Germany made steady but slow progress and Japan much faster progress. Income levels per capita in continental Europe are still below those in the United States, but any catch-up is slow. Japan's recent recession may indicate that it, too, is catching up much more slowly now; its per capita income level is still well below that of the United States.
Recent work at the National Institute suggests that Britain's growth rate since 1970 may have been reduced by poor demand management leading to three deep recessions. But the view that Britain is condemned for ever to a third division is probably mistaken.
In both the short and the long run it appears that Britain has room for relatively rapid growth, allowing us to reduce the gap with both continental Europe and with the United States. If this growth is realised, inflation may well stay above the Government's target of two and a half per cent per annum (which is an upper limit and not the centre of a target range) but there is not likely to be any return to the inflation of the late 1980s.
In the short term the level of potential output, and thus the room for economic growth depends broadly on the level and quality of capital and labour available in the economy. The degree to which potential output exceeds actual output then depends on how far the potential supply of labour and capital exceed their current use. But it us very difficult and quite foolish to attempt to give precise estimates of the ''output gap'', as an indicator of the scope for economic growth without an increase in inflation; indeed the magnitude of the inflationary pressures which result from closing the gap almost certainly depend on the speed with which the gap is closed. This means that it is much more helpful to consider the growth prospects of the economy in general terms that it is to try to measure an output gap.
In the short term demand and supply are probably in reasonable balance. There are no obvious signs of domestically generated inflationary pressure. This is especially true in the labour market where average earnings, which can usually be expected to grow in real terms in line with the growth rate of productivity, are still rising relatively slowly.
Nor are there any particular sectors of the economy where demand appears to be outstripping supply. This time last year, there were fears that demand in the manufacturing sector might be getting too strong. But since then demand has stagnated as domestic demand has switched to services and external demand has slowed down. In the meantime, fixed investment in manufacturing grew by over 7 per cent last year, thereby raising the potential output of that sector.
This suggests that there is some room in the short term for the economy to expand at a faster rate than its long-term potential and so absorb some of the output gap, but it is difficult to estimate just how far this process can go. Part of the difficulty is that the level of potential output may itself be affected by how fast the economy is allowed to grow. This is because it depends in part on existing levels of fixed capital and human skills which can be built up when the need arises. This can be achieved more easily when time is available for the necessary investment.
In the long run, the only constraint on the potential output of the economy is the amount of labour available. Other factors like physical capital and human skills can be adjusted to what is needed. At present, the amount of unused labour is at historically high levels. We hear a great deal about the increased number of women who now participate in the labour force, but it is not as well appreciated that the proportion of people of working age who are not working is far higher than was the norm in the 1960s and 1970s. Part of the explanation lies in the early retirement of men and in the increased participation of young people in higher education as well as the much higher rate of unemployment that we are now used to.
It seems very likely that the degree of non- participation would fall if more jobs became available. This does not mean that men who have retired early would return to work, although this may happen in some cases, or that students would give up their courses to take jobs. Rather it means that the next generation of men would not choose early retirement and the next generation of school-leavers would take jobs rather than moving into higher education.
This suggests that the potential growth rate of the economy is now likely to be higher than rates of growth seen over the past because there is a substantial pool of unused labour resources to draw from. In addition, improvements to the working of the economy and management changes in the public sector are likely to have raised the productivity growth of each individual worker. For this reason we now expect that the long-run rate of growth of potential output in the UK economy is 2.7 per cent per annum, substantially higher than the average rate of growth of 1.85 per cent seen between 1973 and 1990. While these numbers may not seem very different it is worth noting that it takes 38 years for an economy to double its output if it grows at 1.8 per cent per annum; this is accomplished in only 26 years if it grows at 2.7 per cent per annum.
In our latest forecast published today in the National Institute Economic Review we predict that economic growth will rise from 2.3 per cent this year to 3.5 per cent in 1997 and remain above three per cent for the rest of the decade. Above-trend growth of this nature will help to use up the slack in the economy and help unemployment to fall further. This will also allow real incomes to increase in a sustainable way and, eventually, lead to an improvement in economic well-being. These growth rates are faster than those which seem likely in continental Europe and the US. After a century of poor economic performance, it looks as though things are moving in Britain's favour.
Martin Weale is Director of the National Institute of Economic and Social Research and a member of the Treasury's panel of independent advisers. Garry Young is a Research Fellow at the National Institute of Economic and Social Research. The NI won the Independent's golden guru award for the best economic forecast in 1995.
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