The trouble with trying to predict the economy

Our current account is in surplus; growth is up; wages are steady; inflation continues to fall. The economists have got it wrong again
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Just when economists think they understand some economic relationship, it goes and changes on them. It happened this week. Two under-reported items show how economic relationships which people thought were pretty secure are no longer so.

One story was the current account figures for the second quarter of this year. They were in surplus. Now, that ought not to have happened. Exports have not been particularly wonderful, because of the near-recession in Continental Europe; imports have been rising thanks to the growing consumer demand at home. The current account was in the red during the first three months of the year and everyone thought it would stay there. But thanks to strong exports of services and investment income from abroad, it was in the black to the tune of pounds 457m, the largest quarterly surplus for nine years.

The second story concerns growth. Most economists thought that growth had paused early this year; manufacturing was in recession, and early estimates of second-quarter growth confirmed this. Now the figures have been revised; it seems that growth was pretty good in the second quarter. Thanks again to strong services and to solid consumer demand, the economy was in fact up 2.2 per cent on a year ago

So on two counts this week the experts - or most of them - were utterly wrong. There are many other examples of economic relationships changing so quickly that experience gives little guide to future effects. Here are another eight:

Number three concerns wage inflation. Everyone thought that if there were rapid growth in demand, and unemployment fell too fast, wage rates would start to climb. It hasn't happened. In the last three months retail sales have shot up at the fastest rate since 1988 and unemployment has continued to fall just about every month. But there has been virtually no rise in wage settlements. Of course, there may be a delayed reaction, but there is very little sign of it now.

Four follows from this. Most people thought that unemployment could not fall below about 7.5 per cent without a surge in inflation. That was the "natural" (dreadful word) rate. Well, it is down to 7.5 per cent. Maybe - we don't know - it could fall to the 5.1 per cent level of the US without a rise in inflation, maybe even below that. At any rate, the idea that unemployment needs to remain high for a generation is demonstrably wrong.

Number five is that to get new jobs you need large companies to take on more labour. They are all doing precisely the reverse: there are so many stories about job cuts that many people simply won't believe that employment is rising. It is true that there are some ambiguities in the figures, but the clear trend over the last two years has been a gradual rise in employment, with virtually all the new jobs coming in small firms or from self-employment.

Next, fiscal policy: tighter fiscal policy depresses the economy. Of course, it must to some extent: the big squeeze in France and Germany to meet the Maastricht criteria is clearly depressing the economies there. But the gradual tightening of fiscal policy here has not stopped the economy at all. Things such as confidence, low interest rates and a competitive currency seem much more powerful drivers of growth.

Seven concerns tax rates. The usual expectation would be that higher tax rates increase revenue. But that is not invariably so. Take income tax. In 1979, when the top rate of tax on earned income was 83 per cent, the richest 10 per cent of the country paid 11 per cent of income tax revenue. Now, with the top tax rate at 40 per cent, they pay 17 per cent. It may well be that a rise in top tax rates would cut revenue.

Number eight: investment. Popular economic wisdom holds that more investment will lead to more rapid economic growth. Again, there must be some truth in this, but Britain has tended to invest a smaller proportion of output than most other countries, and yet since abut 1980 it has grown at much the same speed as other large, developed economies. In any case, in a world where capital is intellectual capital as much as (or more than) buildings and factories, maybe our measures of investment are misleading.

Number nine follows from this. We suppose that conventional education measures adequately describe quality of education. But maybe countries teach people the wrong things. The US and UK come out rather poorly on conventional measures of education, yet have the largest and second-largest net exporters of intellectual capital. Japan and Germany come out well, yet are the largest and second-largest importers. We measure conventional academic achievement; we do not measure creativity.

Finally, a rather different rule which I think has clearly been broken: that people in Britain get rich by buying houses. The experience of the last eight years has surely put paid to that.

The message is not that the old rules are useless, but simply this: economies are living, evolving things of infinite fascination. We have over the last 50 years moved from a manufacturing economy to a service one, and maybe to something beyond that. We will never fully understand what is happening around us, because by the time we do, economies will have moved on again. And that is why economics is an exciting subject, at least to economists.

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