Hamish McRae: Here's hoping that Britain's economy has the capacity to keep boosting output for some time to come

Economic View: Not only is headline unemployment coming down but vacancy rates are rising

How much spare capacity is there in the economy? Or put another way, how swiftly can the economy grow without overheating?

It is a debate that is currently absorbing the Bank of England's Monetary Policy Committee (MPC), for the obvious reason that the closer we are to full capacity the sooner interest rates will have to be raised.

There are, as we see in the MPC minutes, a range of views. But there is a wider point here about the pace, nature and sustainability of the present expansion, for our economy now is structurally quite different from what it was a decade ago. Indeed it may be that we have an asset-price problem rather than a capacity problem.

The best place to start is to look at the puzzle over the size of the economy now. Employment (including self-employment) has boomed. Consumption has been strong. Yet GDP as officially measured is still a bit short of its previous peak, at least if you include the falling output of North Sea oil. The standard response to this is to say there must have been a decline in productivity, and to wonder whether as output rises productivity will pick up. But suppose GDP is wrong, not just a bit wrong but completely wrong.

There was a really interesting paper a couple of weeks ago, picked up by my colleague Russell Lynch in the London Evening Standard, from Morgan Stanley and written by its economic consultant, Charles Goodhart. The main thrust of his argument was about the rise in self-employment (an issue which is tackled today by Ben Chu on page 58), but almost as an aside he noted that there may have been a rapid increase in the size of the cash economy, which might have risen from around 12 per cent of the official economy in 2007 to 16-17 per cent now. We are under-counting the economy by 4-5 per cent, and that is just as likely to be an underestimate as an overestimate.

There are various bits of corroborating evidence, of which the one I find most convincing is the surge in the amount of cash in the economy relative to GDP since VAT went up to 20 per cent. You can see this in the first graph.

The amount of cash had been gradually falling through the 1980s as credit cards replaced folding money. But the recent increase is quite remarkable – and puzzling. Did you know that there is roughly £2,000 in cash floating about for every man, women and child in the country? Of course there is some in shop tills and bank cash machines, so it is not all in our wallets and purses, but that is still a huge amount. So much for the cashless society.

If this is roughly right – and I would trust Mr Goodhart's judgement – a lot is explained. There is still a big shortfall as to where GDP would have been had growth continued as before, and this is still a relatively disappointing recovery. But the higher GDP figure would square more with the employment numbers, consumption, hours worked and so on. Productivity growth has been poor, but not dreadful.

You can catch a slightly different element of the answer to "why is consumption so strong?" from the second graph, which comes from Coutts and shows the squeeze on wages, but also how total real disposable income has performed much better than wages. It shows there has been much less of an earnings squeeze than a wage squeeze. There are a number of reasons for this, including the fact that more people have gone out to work.

Now let's turn to the question about the amount of spare capacity. There is little doubt that the labour market is tightening. Not only is headline unemployment coming down but vacancy rates are rising and are now above their long-term average. You would expect wage rates to start climbing pretty soon, but this improvement has been running for some months and there has been zero movement in pay. So it may be that the combination of being able to attract workers from the rest of Europe and our very flexible labour market will be able to adjust to meet the additional demand.

That is the key. Our labour market is quite different from what it was 10 years ago: many more part-timers, many more self-employed, many more people with two jobs, many more workers beyond the normal retirement age. So it may be that companies will figure out ways of increasing output without adding disproportionately to their fixed costs.

The principal tool they have available is technology, which has made matching labour to demand much easier. Service industries are learning all the time to use their capacity more efficiently. The prime example is the way airline seats are priced so that they generate some revenue even in slack times.

While we all know about the zero-hours contracts, a lesser-known example is the way service industries fine-tune their demand for labour, using technology to predict more accurately how many shifts they need to add at any particular time.

A further flexibility in the labour market is the growth of teleworking, for anyone at home has as good a kit, maybe better, than he or she would have in the office.

We think of investment as something that companies do, but individuals who have put in super-fast broadband have in fact invested in productive equipment. As demand picks up, expect to see a host of innovative ways to increase output without adding to costs.

All this may seem wishful thinking and in a way it is. Since this is the first strong expansion to occur for the best part of a decade, we simply don't know how the economy will respond to it.

Anecdotal evidence would suggest that quite a lot of people who are doing some work at the moment feel they are somewhat under-employed, but if that is right then it should be easy to boost output for quite a long time.

Instinctively I feel that is right, but let's hope so – and watch the evidence very closely.

Start your day with The Independent, sign up for daily news emails
News
ebooksAn unforgettable anthology of contemporary reportage
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Digital Optimisation Executive - Marketing

£30000 - £35000 per annum: Recruitment Genius: The UK's fastest growing, multi...

Recruitment Genius: Financial Reporting Manager

£70000 - £90000 per annum: Recruitment Genius: A Financial Reporting Manager i...

Recruitment Genius: Payments Operations Assistant

£23000 - £25000 per annum: Recruitment Genius: They win lots of awards for the...

Recruitment Genius: Telephone Debt Negotiator

£13500 - £20000 per annum: Recruitment Genius: This nationwide enforcement com...

Day In a Page

Sepp Blatter resignation: The beginning of Fifa's long road to reform?

Does Blatter's departure mean Fifa will automatically clean up its act?

Don't bet on it, says Tom Peck
Charles Kennedy: The baby of the House who grew into a Lib Dem giant

The baby of the House who grew into a Lib Dem giant

Charles Kennedy was consistently a man of the centre-left, dedicated to social justice, but was also a champion of liberty and an opponent of the nanny-state, says Baroness Williams
Syria civil war: The harrowing testament of a five-year-old victim of this endless conflict

The harrowing testament of a five-year-old victim of Syria's endless civil war

Sahar Qanbar lost her mother and brother as civilians and government soldiers fought side by side after being surrounded by brutal Islamist fighters. Robert Fisk visited her
The future of songwriting: How streaming is changing everything we know about making music

The future of songwriting

How streaming is changing everything we know about making music
William Shemin and Henry Johnson: Jewish and black soldiers receive World War I Medal of Honor amid claims of discrimination

Recognition at long last

Jewish and black soldiers who fought in WWI finally receive medals after claims of discrimination
Beating obesity: The new pacemaker which helps over-eaters

Beating obesity

The new pacemaker which helps over-eaters
9 best women's festival waterproofs

Ready for rain: 9 best women's festival waterproofs

These are the macs to keep your denim dry and your hair frizz-free(ish)
Cycling World Hour Record: Nervous Sir Bradley Wiggins ready for pain as he prepares to go distance

Wiggins worried

Nervous Sir Bradley ready for pain as he prepares to attempt cycling's World Hour Record
Liverpool close in on Milner signing

Liverpool close in on Milner signing

Reds baulk at Christian Benteke £32.5m release clause
On your feet! Spending at least two hours a day standing reduces the risk of heart attacks, cancer and diabetes, according to new research

On your feet!

Spending half the day standing 'reduces risk of heart attacks and cancer'
With scores of surgeries closing, what hope is there for the David Cameron's promise of 5,000 more GPs and a 24/7 NHS?

The big NHS question

Why are there so few new GPs when so many want to study medicine?
Big knickers are back: Thongs ain't what they used to be

Thongs ain't what they used to be

Big knickers are back
Thurston Moore interview

Thurston Moore interview

On living in London, Sonic Youth and musical memoirs
In full bloom

In full bloom

Floral print womenswear
From leading man to Elephant Man, Bradley Cooper is terrific

From leading man to Elephant Man

Bradley Cooper is terrific