As good as it gets?
With inflation at levels not seen since the early 1980s, it is clear that the UK is in the midst of a huge hit to real incomes. But the seeds for the devastating impact of the cost of living crisis were sown by a slump in growth that is unprecedented in the post-war period and that has led to weak income growth and a lack of financial resilience among British households. This briefing note considers the extent of the slump, what the data have to say about its underlying cause, and what policy makers should take away about prospects for the future.
Since the financial crisis we have been locked in a debate about whether the growth slump is a supply-side phenomenon. But it is far from obvious what factors might have driven a such a long-term slowing in supply growth. Meanwhile, demographic headwinds to spending and weak post-financial-crisis stabilisation policy are plausible demand side drivers of weak growth following the financial crisis. But the recovery from the pandemic has made it clear that the country is now bumping up against supply constraints meaning that insufficient demand cannot be our only challenge right now. While debates about relative roles of supply and demand are not conclusive, something else is: the UK has lots of catch-up potential. A country like the UK – that is well behind the technological frontier – should be able to catch up by learning from how things are done at the frontier. The case for optimism here is supported.
- Average growth in GDP per capita in the 15 years to 2019 was the lowest for any such period since the 1930s, with the level of per capita GDP around 20 per cent below the pre-financial-crisis trend.
- Around 80 per cent of the slump can be accounted for by a slowdown in total factor productivity growth. This is sometimes interpreted as a slowdown in the rate of technological innovation in the UK but this is not necessarily the case because.
- Macroeconomic stabilisation policy weakened markedly in the aftermath of the financial crisis as the low level of rates meant it was difficult for the Bank of England to respond as the growth outlook weakened: between 2007 and 2012, policy was loosened by the equivalent of a 0.34 percentage point rate cut in rates for each 1 per cent of weaker GDP, but, after 2012, that figure fell to just 0.07 percentage points.
- UK GDP per capita is around 27 per cent below the frontier (the US), putting us roughly as far behind the US as Hungary or Poland are behind the UK.
- There is statistically-significant evidence of catchup among a group of 21 advanced countries. Our estimates imply that this is a slow process with countries behind the frontier converging at a rate of just 1.5 per cent each year.
- While the near-term priority for policy makers should be dealing with the cost of living crisis, the high likelihood that low growth will reassert itself means that policy makers should not lose sight of the need to put a return to broad-based growth at the centre of their renewed approach to the economy.
- The case for this approach is strengthened by evidence that faster growth in and of itself could catalyse a more long-lasting improvement on the supply side by boosting business investment and allowing the UK to make the most of the opportunities for catch-up growth.
- The post-financial-crisis experience tells us that we should be careful to avoid past mistakes in terms of under-supporting the economy during the recovery from future recessions; weak stabilisation policy is an unnecessary self-inflicted wound.
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