Does Britain have the capacity?

Throughout the economic upswing, there have been repeated media reports of fragility, lack of a 'feel- good' factor, impending slowdown, absence of confidence and the like. The unemployment statistics, which have been falling faster than some observers expected, are dismissed as inexplicable data aberrations. The boom in exports receives less attention than the alleged weakness of the housing market, which has retained its status as a national obsession. Any signs of a slowdown in the initial estimates of either the retail sales or gross domestic product statistics are accorded large headlines, while subsequent upward revisions are barely mentioned.

It was the same last week, when government statisticians announced that GDP had risen by 'only' 0.7 per cent in the third quarter, following rises of 1.1 per cent in each of the previous two quarters. If this slowdown turns out to be fact, it is very good news indeed, since the growth rate in the previous few quarters had shown every sign of becoming unsustainably rapid.

But will it prove to be a fact?

Recent quarterly estimates for GDP have tended to be revised upwards as time passes, and this may happen again in the third quarter. Much of the slowdown was due to a rise of only 0.5 per cent in manufacturing output, down from 1.5 per cent in the second quarter. Service output, meanwhile, rose by 0.8 per cent, compared with 0.7 per cent in the previous three months.

This supposed slowdown in manufacturing output is entirely inconsistent with output expectations in the Confederation of British Industry survey, which have been running at levels equal to the peaks reached in 1988, when manufacturing output was rising by 7 per cent per annum. It would be extremely surprising if the 'slowdown' in manufacturing turned out to be either accurate or sustained.

Nor has retail spending slowed down very much, contrary to most reports during the summer. Last week, the statisticians not only announced that retail sales had increased by a robust 0.5 per cent in September, but also revised away much of the 'slowdown' in sales that had been apparent in the summer. We now find that the annualised growth rate in retail spending in the last quarter has been 3.6 per cent, insignificantly different from the 4 per cent recorded before the Budget tax increases took effect in the spring.

Nor is the consumer any longer frightened to borrow. In two of the last three months, consumer credit has registered record monthly rises, while M0 growth (cash in the consumer's pocket) is running at a very high year-on-year rate of 7.2 per cent. Admittedly, house prices have been flat, volume in the housing market has been weakening, and car sales have turned down a bit. But we should have realised by now that this is a 'small ticket' recovery. If economists are determined to wait until they see a recovery in 'big ticket' spending, they may miss the upswing altogether.

Important new evidence on the strength of the upswing will come in the CBI survey due out tomorrow. It would be surprising if this showed any significant slowdown in activity, since the CBI results are normally mirrored quite accurately by the British Chambers of Commerce (BCC) survey, which has already appeared. It showed business confidence remaining unchanged at a very high level, with both domestic and export order books strengthening.

This growth in demand would be all very well if it were accompanied by equivalent growth in the economy's underlying supply capacity, but this does not appear to be happening. Instead, the economy seems to be absorbing some of the spare capacity that developed during the recession. The BCC survey showed an alarming rise in the number of manufacturing firms working at full capacity - up to 37 per cent from 29 per cent in the previous quarter.

This does not sound too problematic but, as the graph shows, it has taken capacity utilisation back to the levels seen at the peak of the 1980s boom.

Neither the services nor the construction industries are yet approaching their peak levels of capacity utilisation, but both are now above their mid-cycle readings.

Supply side optimists would say this rise in capacity utilisation is nothing to worry about, since extra plant capacity can always be put in place to meet the extra demand. On this argument, the ultimate constraint on the economy is not a shortage of physical capacity, but a shortage of labour, especially skilled labour. And here the news is more encouraging, since the surveys do not suggest that labour strains are anywhere near the levels of the late 1980s.

Furthermore, claim the optimists, it is much easier for firms to install new capacity in today's industries than it was a decade or two ago. This is partly because of the more flexible nature of capital equipment, and partly because firms have realised that idle machines cost money, and have tried to work to higher capacity specifications than they used to.

Over the last decade, the average delivery time for capital equipment in the US has declined by more than two-thirds (it is now down to only three months) and the same is probably true of the UK. This should mean that firms will typically say they are working closer to capacity than they did before, but this will not prove such an important constraint on economic growth. Of course, this presupposes that firms will find it profitable to install the new capacity, but that will probably be the case as long as the demand is there, and as long as wage cost increases are under control.

Nevertheless, even if plant capacity does not represent an absolute constraint on growth at this stage of the cycle, it does impose a speed limit above which it is not safe for demand to grow. Based on past UK experience - including the tendency for policy-makers to overestimate supply side improvements at this stage of the cycle - it would be very optimistic to assume that this speed limit for GDP is much above 3 per cent per annum.

Furthermore, in the past three years, the extreme levels of spare capacity in the rest of the world, especially in our close trading partners in continental Europe, have helped dampen any inflationary pressures that the upswing in the UK might have caused. Shortages of any products at home - and a year ago there were, for example, reports of sudden shortages of construction materials - have been quickly eliminated by cheap imports.

This will no longer be so easy. I doubt if everyone realises that the upswing in continental Europe, while quite recent, is now remarkably strong, at least in the manufacturing sector. Since last winter, the annualised growth rate in industrial output on the Continent has been running at 9 per cent, much the fastest rate among the world's main trading blocs. No wonder that UK and US exports are now growing at double-digit rates. They are selling into a European market that has joined the global boom with a vengeance.

As the world boom mounts, there will be less excess capacity for us to 'tap' in other economies, and less downward pressure on price inflation everywhere. We do not need to join the mega-pessimists, who have suffered such a bloody nose this year with the excellent performance from trade and inflation, to have an uneasy feeling that this recovery is now proceeding too fast.

(Graph omitted)

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