Economic View: Scars inflicted by recession will not fade with growth

Whether you're an economic hawk or a dove, we can all agree on one thing: at some point growth will return and Europe's recession will be over. But what sort of growth will it be? The fear is it will be a distended, deformed growth. Much of Europe's economy – the UK included – has been starved, in a dark place, for several years – it will eventually emerge into the light but it won't be the same as before: the vigour will be missing.

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Recessions – particularly a double-dip one like this – tend to leave scars far wider and deeper than first thought. Consider the early 1980s when the North of England was devastated by a de-industrial policy enacted by the Thatcher government. Productivity in what were once working class areas in great swaths of the North and West was incredibly slow to recover – in some cases it never has.

Now draw this on a Europe-wide scale today. We have massive unemployment in the PIGS (Portugal, Italy, Greece and Spain) and former professional people in Madrid searching supermarket refuse for food, in echoes of Argentina and its crash of 2001.

The young are at the forefront of this, with youth unemployment rates above 50 per cent in Spain and Greece, while in the UK the number of Neets (not in education, employment or training) stands at about 23 per cent. Their youth is being spent on the dole, their skills, confidence and capacity to learn ebbing away, leaving them economically old before their time.

This is more than a tragedy for individuals. It has huge economic consequences for us all. A report to be released today by Ernst & Young highlights the way in which recession does potentially permanent damage to the economy's capacity to grow. As you can see from the chart, the likes of Italy, Spain, Ireland and Portugal, which have all experienced horrible recessions, are also the most damaged in their ability to put on growth.

Portugal, for instance (there are no figures for Greece as it is, frankly, a volatile case apart) has had its potential future output due to the recession reduced to the tune of 9 per cent, Ireland by 8.5 per cent, Spain 8 per cent and Italy 6.5 per cent. Even Germany – which exceeded growth expectations in the last quarter – has had close to 4 per cent knocked off its future growth potential.

The UK, not being in the eurozone, is not covered by this assessment but there is no reason why it would be in a better position than, say, Germany.

The authors of the Ernst & Young report outline ways in which future growth becomes distended. Firstly there is collapsing capital investment – so machines age and are not replaced, they break down more often, less can be produced when the orders eventually come in.

Second, innovation takes a back seat. This means competitors move ahead with their products and services, seizing market share. Third, there is the sheer wastage of human capital and workers becoming permanently detached from the labour market. Then, finally, there is migration – the brain drain – which is particularly true in the case of Ireland.

UK policymakers are becoming increasingly aware of this wasting away of economic vigour. Paul Fisher noted this week that either the official growth stats were "so far wrong" or the supply side of the economy "has shifted to a degree that is unprecedented."

In the UK's case, the depths of the recession have probably been overestimated, but the supply side, which was successfully transformed in the South and East of the country in the Thatcher, Major and early Blair governments, has been damaged.

That means future growth forecasts are likely to be too optimistic. Governments will not raise sufficient taxes, deficits will not reduce – without far more radical cuts in spending – and the spectre of a future sovereign debt crisis is locked-in.

In a rare moment of maturity at the LibDem conference, it emerged that Nick Clegg et al are looking at ways to knock another £15bn off the deficit after the next election. Now, mansion taxes, means-testing winter fuel payments and bus passes will have a minuscule effect on this, but at least it is out in the open now that beyond 2015 the UK Government is going to need to undertake further fiscal tightening because of the damage to the supply side wrought by the recession.

An even more serious consequence of the damage to the supply side in the UK and Europe is inflation. When the demand comes there won't be the supply – immigration can offset this to an extent, but Adam Smith knew it and even the Romans knew it: too much money chasing too few goods means higher prices.

The level of growth these distended economies can muster without suffering inflation will be lower. That is the ultimate conclusion of the Ernst & Young report. From the perspective of the Chancellor and his fellow big spenders in Europe, a dose of inflation may, on the sly, be no bad thing as it reduces the real worth of the stupendous debt that we have all built up over the past decade.

But with inflation we all get poorer. In the 1960s and 1970s the UK was branded in the German press "the sick man of Europe" because its economy could not grow at a meaningful rate without inflation and was beset by supply side weakness. Now, nearly half a century later and after a double-dip recession, it seems that Europe is now the sick continent. I think that is something doves and hawks alike can all agree on.