Does the new paradigm apply to UK?

We will have to catch up with the American burst in technical progress, capital spending and productivity
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THE NINE-YEAR upswing in the American economy has led to suggestions that the US has entered a new era of unparalelled growth and prosperity. The bedrock of this claim, discussed here last week, is that a wave of technical innovation has unleashed investment opportunities and productivity growth in dimensions not seen for many decades. A secondary claim, not necessarily related to new technology, is that the economy can now operate with a permanently lower level of unemployment than in past cycles without this triggering any rise in inflation. Originally dismissive of these claims, mainstream macro-economists have recently become more open to the "new paradigm" in America, primarily because of exceptionally strong growth in productivity data in several recent quarters.

The question for discussion this week is whether the UK has also been benefiting from the same phenomenon. Does the "new paradigm" apply on this side of the Atlantic?

In some ways, there is superficial evidence that it does. After all, the economy embarked on a prolonged upswing in 1991, roughly in synchronisation with events in the US. And while GDP growth has ground to a virtual standstill in the past couple of quarters, there has so far been virtually no increase in unemployment, and none of the usual financial distress associated with recession. If, as now seems feasible, output growth soon begins to rebound, the downturn of 1998-99 will barely have been noticed by the majority of the electorate.

To what extent can any of this be attributed to a burst of technical progress of the type lauded by new paradigmists in the US? If any economy in Europe is susceptible to the 1990s revolution in information and communication technology (ICT), then Britain - with its deregulated telecoms sector and thriving services economy - should be the one.

It is the ICT sector which has really fuelled the take-off in American growth in the past four years, contributing around 15 per cent of the increase in GDP each year, roughly twice its weight in the economy. Not only that, but the precipitous decline in the output prices in this sector (especially the price of computer memory) have exerted a major disinflationary force on the entire economy. Recent calculations by the OECD suggest that this force alone has reduced the overall inflation rate by 1 per cent per annum, without taking any account of the impact of new technology in reducing costs in other sectors. This indeed has been America's secret weapon in the second half of the 1990s.

Strangely, though, very little of this phenomenon seems to have crossed the Atlantic - at least so far. The latest edition of the Bank of England's "Inflation Report" contained some useful calculations concerning the contribution of the growth in the high technology communications sector to the UK economy. As in America, this sector has been growing exceptionally fast since 1992 (in fact by about 10 per cent per annum, or three times the growth rate of the rest of the economy), and prices for telecom services have been dropping at a rate of about 3 per cent per annum. However, the difference between Britain and America is that this vibrant sector accounts for a much smaller share of GDP this side of the Atlantic.

Partly because of this, the surge in capital spending which has fuelled the boom in the US (with growth at double digit rates for most of this decade) has not been matched anywhere in Europe - not even in the UK, though the growth in investment has been strong enough to surprise the Bank of England in recent quarters. Despite this, the ratio of the capital stock of plant and equipment to GDP stands at almost exactly its long term average at the present time. Encouragingly, this ratio has been increasing of late, but it would have to rise much more before it would have any chance of fuelling a British economic miracle.

An interesting, if somewhat depressing, fact is that 80 to 85 per cent of the Internet users in the world are American, while only about 10 per cent are European. The UK is not doing badly within the context of the European Union, yet the per capita penetration of the Internet is twice as high in the US as it is over here. Hence the rapid expansion of information and communication technologies - with annual productivity growth in excess of 8 per cent per annum even in Britain - has not been enough to trigger a productivity miracle in the economy as a whole.

In sharp contrast with the accelerating productivity growth in the US, the growth in productivity in the UK during the current upswing has been only 2 per cent per annum, which is exactly its long term average. Since 1995, as the technology revolution has gathered momentum, British productivity growth has actually slowed down to only 1.5 per cent a year. No wonder the Chancellor has spent much of the past year trying to identify solutions to this perennial British problem.

There is therefore no evidence whatever to suggest that the productivity breakthrough which is at the heart of the new paradigm in the US has yet been transported to this side of the Atlantic. Yet the overall performance of the UK economy during the 1990s has been good enough to rival the excellent performance of the US. In the absence of an equivalent surge in technical progress, how has this been the case? The answer lies in the second facet of the new paradigm - the behaviour of the labour market - which has actually improved more in Britain than in America.

The key to analysing the labour market is to estimate something which is in fact unobservable - the rate of unemployment which, on average over the economic cycle, will result in a stable rate of inflation. This is usually known as the NAIRU, and is the rate of unemployment which will tend to emerge over time, since any attempt to deviate from it will simply result either in accelerating inflation or deflation. As was explained here last week, the NAIRU in the US might have dropped from about 6 per cent at the beginning of the decade to about 4.5 per cent now, and the adjustment to this lower rate has allowed output to grow faster than it otherwise could have done during the 1990s without triggering any rise in inflation.

In the UK, the NAIRU at the start of the 1990s was usually estimated to be of the order of 8-9 per cent of the labour force. Recently, with the actual unemployment rate having fallen below 5 per cent , price inflation has been rock steady at 2.5 per cent, and there have been encouraging signs of deceleration in wage inflation. It is too early to say for sure that the British NAIRU has fallen by 3-4 per cent of the labour force, but it does seem likely that it has fallen by more than it has in the US.

This has allowed a temporary period of faster output growth in the UK as the economy has adjusted to the lower NAIRU. But to keep this up in the future, Britain will have to accomplish something even more difficult, which is to catch up with the recent American burst of technical progress, capital spending and productivity enhancements. Only then will its growth rate permanently rise.