Can the UK recover from the worst trend growth cut since the industrial revolution? Chris Wagstaff sees the first green shoots
In early October, the International Monetary Fund (IMF) cut its forecast for global growth in 2012 from 3.9% to 3.6%. Nothing remarkable in that, you might say. However, perhaps more remarkable was the paring of forecast growth in the UK from an expansion of 0.2% to a contraction of 0.4%. Even more remarkable was the IMF's sharply revised estimate of the UK's sustainable growth rate from 2.7% to just 1.7% per annum. Not that the world's sixth largest economy was singled out. Indeed, the US - the world's largest economy - and Japan - the third largest - both received similar treatment. Only Germany emerged unscathed, with its trend growth rate of 1.5% remaining intact.
Changes to trend growth rates of this magnitude are very rare indeed. In fact, trend growth in the UK hasn't changed much at all since the industrial revolution, despite the many innovations of the intervening 160 years. That said, the IMF admitted that its estimate of the UK's sustainable growth rate pre-crisis was over-inflated given the role of credit in exaggerating its actual rate of growth.
Trend growth matters in an investment context as it forms the bedrock to long-run investment returns. Indeed, the long-run return on any risky investment comprises the trend economic growth rate, expected inflation and an appropriate risk premium. Depending on the type of investment and the economic and political backdrop, this premium should compensate the investor for factors such as unexpected inflation, illiquidity, volatility and the risk of default.
So, why the dramatic paring of trend growth? Well, trend growth is determined by a country's potential output, which in turn is fuelled by the size and productivity of the labour force and the available capital stock. Just as trend growth tends to stay relatively constant over time, so too do its component parts. Unless, of course, the economy is hit by a massive shock that results in the economy experiencing spare capacity - a polite term for unemployment. And where that spare capacity disappears without trace as disillusioned workers drop out of the workforce and the capital stock with which they worked lays idle and becomes obsolete.
There are, however, a number of other reasons for this downgrade in sustainable growth. The first, perhaps ironically, concerns the size of the financial sector and the extension of credit to the private sector. In a working paper entitled 'Too much finance?', the IMF suggests that although the financial sector is supposed to promote growth by allocating capital to productive parts of the economy, this can backfire. If the financial sector becomes too large - defined as when credit to the private sector reaches 80% to 100% of GDP - then the odds of a crisis and the misallocation of capital to less useful sectors of the economy are dramatically increased, so lowering the trend growth rate.
There is, of course, also the size of public debt. A number of empirical studies infer that once a country's public debt-to-GDP ratio hits 90% to 100%, there is a resulting 1% decline in its trend growth rate. However, this can be reversed if debt reduction is based on enduring structural reforms, paired with an accommodative monetary policy - or, in other words, ultra-low real interest rates - and growth-supporting initiatives that benefit from the multiplier effect, such as infrastructure spending. History tells us that countries that put their indebtedness on a downward trajectory can in fact grow at a faster rate than less indebted countries whose indebtedness is on an upward path. Indeed, this is exactly what the US did post-war, eventually putting trend growth back on an even keel.
With the UK in fiscal lockdown, and with every sign that public-private infrastructure spending will take centre stage alongside an ultra-accommodative monetary policy, let's hope history is about to repeat itself.
'Too Much Finance?' can be downloaded at www.imf.org/external/pubs/ft/wp/2012/wp12161.pdf
Chris Wagstaff is a client director at Cass Executive Education
