This tantalising argument for easy money doesn't quite add up
Tuesday 19 March 1996
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.
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