This tantalising argument for easy money doesn't quite add up

ECONOMIC VIEW

The Governor of the Bank of England may feel that the appropriate stance for the central bank should be to err on the side of caution - as he said in Sweden yesterday - but that would not be the market view of current UK monetary policy.

There are two main arguments for erring on the other side, the first of which has received a great deal of attention, the second of which has not. The first is that within Europe the principal danger remains one of deflation, not inflation, and the UK economy is sufficiently closely integrated with the Continental one that some overspill of this deflation is bound to take place. The second is the extent to which the UK natural rate of growth may have risen as a result of the structural changes which have taken place during the last few years. If this natural rate of growth has risen, it is argued, it should be possible to run the economy closer to capacity without running into capacity constraints. So the present easy money policy is less dangerous than it might appear.

The second argument is a tantalising one because it is impossible to prove until after the event, in which case it may be too late. Eddie George was talking yesterday about the catastrophe of economic policy in the late 1980s when sterling shadowed the mark, leading to too loose a monetary policy and an unsustainable boom. But at the time the relaxed policy stance was justified, in part at least, by the argument that thanks to the structural changes of the 1980s, the economy had a capacity for faster growth. In short, exactly the same arguments were used then as are being used now.

Yet there ought to be some truth in it. If one looks not at the possible rise in the natural rate of growth but at the possible fall in the natural (or non-inflationary) rate of unemployment, it is clear that there have been an improvement. The OECD calculates that the latter has come down at least a couple of percentage points: unemployment is now below 8 per cent and there is virtually no sign of a resumption of wage-generated inflation, in contrast to the situation in the late 1980s. The trouble is that when one looks at the growth of capacity it is very hard to demonstrate statistically that anything has changed at all.

Intuitively it would be reasonable to expect that a predominantly service economy would respond more quickly to changes in demand than a predominantly manufacturing one. Manufacturing plants take months, maybe years, to equip. Service industries do not in general have large plants with long lead times, and so can increase their output quite quickly by taking on more staff. The way that employment has responded more quickly to increased demand this cycle would support this point.

Besides, investment in a service industry is not just proportionately smaller; it is also qualitatively different from that of a manufacturing one. It is more a question of investing in training, or in computer software, or in management, rather than in investing in plant.

If there is a shortage of trained staff because of over-rapid expansion you would expect that to show up in rising wage rates; if the shortage is in computer software, rising prices for software packages or (again) wage rates for experts; if in management, well, the way round that is to out-source management by bringing in consultants - something that is clearly taking place, but so far without evident signs of strain.

The trouble is that what ought intuitively to be happening is not showing up in the figures. The most useful work here is being done by the British Chambers of Commerce, which carries out a quarterly survey of capacity utilisation in manufacturing and in service industries. Since 1989 it has been asking both types of company whether they are operating at full capacity, and recording the percentage that say they are. The results are shown in the graph.

You can see the problem. If service industry was really much more flexible than manufacturing you would expect fewer companies to report that they were at full capacity: you would expect more of them to be able to find ways of upping their output. Yet the two lines move pretty much together. Sure, service companies have tended through the recession to have had more spare capacity, or rather fewer of them have claimed to be at full output. But the similarities are more noticeable than the differences. And at the end of last year there was no significant difference at all: 40 per cent of manufacturing firms were at full capacity, while 38 per cent of service firms were. This latter figure is the highest since 1989.

The Chambers of Commerce data does not go back before 1989, so it is hard to compare the situation now with that at the height of the last boom in 1987 and 1988. But some calculations by JP Morgan suggest that the comparable figure would have been about 44 per cent then. If that is right we are not quite as close to the limit, but not that far off it. Indeed the speed at which the recovery over the last two years mopped up capacity suggests that the natural growth rate of service industries may not even be as high as it was in the 1980s. JP Morgan's conclusion is that there is no sign of an increase in the UK potential growth rate.

Statistically that is right, but I would like to think it is wrong. How might we tell, without testing the proposition to destruction? The most sensible way forward, perhaps, is to listen to what firms are saying, in particular about reasons why they might be unable to expand.

According to the Chambers of Commerce, there seem to be two main constraints: people and premises. Companies always complain that they cannot find good people, which may say more about their training and employment policies than about the underlying availability. But the proof of this particular pudding is in the eating, for provided the shortages do not show up in a sharp rise in wages, we do not need to worry about them. The market will signal if things are going wrong.

Premises is more of a surprise for you might imagine, given the scale of the recession, that there would be no problem. In fact many companies, particularly small ones, do seem to have difficulties finding suitable property. There may be a constraint to growth there, but again the commercial property market is a transparent one, so it should be possible to pick up problems before they impact on inflation.

Where else might one pick up capacity constraints? General pressure on the infrastructure is an obvious area, but our newest infrastructure - telecommunications - has vast overcapacity. There are things like congestion on the roads (services involve a lot of travel) but that is difficult to distinguish. Airport throughput is up sharply this year, but actual capacity constraints are hardly evident.

So you end up with a rather unsatisfactory conclusion: that there is no evidence that the natural rate of growth of our service-oriented economy has risen, but also no evidence yet of overheating. Policy conclusion? Press on until there are clear signs of strain, but be ever-ready to jack up interest rates to slow things down, if signals go to amber. Trouble is, they will do the first, but not the second. Or that is what Eddie George doubtless fears.

Sport
The sun rises over St Andrews golf course, but will it be a new dawn for the Royal and Ancient Golf Club?
sportAnd it's Yes to women (at the R&A)
Arts and Entertainment
Friends is celebrating its 20th anniversary this year
tvSeries celebrates 20th anniversary
Sport
Yaya Touré (left) and Bayern Munich’s Spanish defender Juan Bernat
footballToure's lack of defensive work is big problem for City
Voices
voicesApple continually kill off smaller app developers, and that's no good for anyone
PROMOTED VIDEO
Arts and Entertainment
Liam Neeson said he wouldn't
tv

Liam Neeson's Downton dreams

Sport
Wembley Stadium
footballNews follows deal with Germany
Arts and Entertainment
A spell in the sun: Emma Stone and Colin Firth star in ‘Magic in the Moonlight’
filmReview: Magic In The Moonlight
News
ebooksAn unforgettable anthology of contemporary reportage
Sport
A 'Sir Alex Feguson' tattoo
football

Arts and Entertainment
Ben Whishaw is replacing Colin Firth as the voice of Paddington Bear
tv

Thriller is set in the secret world of British espionage

Life and Style
life

News
ScienceGallery: Otherwise known as 'the best damn photos of space you'll see till 2015'
Life and Style
fashion

Bomber jacket worn by Mary Berry sells out within an hour

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

SQL Developer - Watford/NW London - £320 - £330 p/d - 6 months

£320 - £330 per day: Ashdown Group: The Ashdown Group have been engaged by a l...

Head of Audit

To £75,000 + Pension + Benefits + Bonus: Saxton Leigh: My client is looking f...

Audit Manager Central Functions

To £85,000 + banking benefits: Saxton Leigh: You will be expected to carry out...

Credit Risk Audit Manager

Up to £90,000 + benefits: Saxton Leigh: Credit Risk Audit Manager required to ...

Day In a Page

Mystery of the Ground Zero wedding photo

A shot in the dark

Mystery of the wedding photo from Ground Zero
His life, the universe and everything

His life, the universe and everything

New biography sheds light on comic genius of Douglas Adams
Save us from small screen superheroes

Save us from small screen superheroes

Shows like Agents of S.H.I.E.L.D are little more than marketing tools
Reach for the skies

Reach for the skies

From pools to football pitches, rooftop living is looking up
These are the 12 best hotel spas in the UK

12 best hotel spas in the UK

Some hotels go all out on facilities; others stand out for the sheer quality of treatments
These Iranian-controlled Shia militias used to specialise in killing American soldiers. Now they are fighting Isis, backed up by US airstrikes

Widespread fear of Isis is producing strange bedfellows

Iranian-controlled Shia militias that used to kill American soldiers are now fighting Isis, helped by US airstrikes
Topshop goes part Athena poster, part last spring Prada

Topshop goes part Athena poster, part last spring Prada

Shoppers don't come to Topshop for the unique
How to make a Lego masterpiece

How to make a Lego masterpiece

Toy breaks out of the nursery and heads for the gallery
Meet the ‘Endies’ – city dwellers who are too poor to have fun

Meet the ‘Endies’ – city dwellers who are too poor to have fun

Urbanites are cursed with an acronym pointing to Employed but No Disposable Income or Savings
Paisley’s decision to make peace with IRA enemies might remind the Arabs of Sadat

Ian Paisley’s decision to make peace with his IRA enemies

His Save Ulster from Sodomy campaign would surely have been supported by many a Sunni imam
'She was a singer, a superstar, an addict, but to me, her mother, she is simply Amy'

'She was a singer, a superstar, an addict, but to me, her mother, she is simply Amy'

Exclusive extract from Janis Winehouse's poignant new memoir
Is this the role to win Cumberbatch an Oscar?

Is this the role to win Cumberbatch an Oscar?

The Imitation Game, film review
England and Roy Hodgson take a joint step towards redemption in Basel

England and Hodgson take a joint step towards redemption

Welbeck double puts England on the road to Euro 2016
Relatives fight over Vivian Maier’s rare photos

Relatives fight over Vivian Maier’s rare photos

Pictures removed from public view as courts decide ownership
‘Fashion has to be fun. It’s a big business, not a cure for cancer’

‘Fashion has to be fun. It’s a big business, not a cure for cancer’

Donatella Versace at New York Fashion Week