The IoD forecasts GDP growth of just 1.2 per cent in 2011 – the forces for economic deceleration reining back those for acceleration.
The recovery cycle appears to be taking the shape of a square root sign,with a temporary spurt in growth in 2010 set to level off in 2011.
There is too much doom and gloom surrounding the Spending Review but there also needs to be greater realism about weakness elsewhere in the economy.
If the IoD’s GDP forecasts prove correct, the Chancellor may need to find more spending cuts (or tax rises) to meet his budget deficit targets.
The presence of an output gap does not automatically lead to its closure.
The experience of Japan in the 1990s shows that below trend growth can persist for so long it becomes the trend.
After an extraordinary financial crisis, fiscal explosion and the introduction of
unconventional monetary policy the level of economic uncertainty remains at a very
high level. The effectiveness of traditional forecasting models – always questionable
– is open to very serious doubt when they have little or no capacity to incorporate
the effects of quantitative easing and when the size and sign of fiscal multipliers is
open to question – in the wake of the financial crisis and exploding public debt and
deficits. In such circumstances economic forecasting becomes what it always has
been, an issue of feel and judgement.
Over the past year we have consistently argued that economic recovery would take
the shape of an ‘L’ – although not a literal L with zero quarter-on-quarter GDP
growth. By L-shaped we meant a relatively gentle upward slope. However, we have
also argued that there might be a few quarters of stronger growth where the
economy grows in line with a normal cyclical bounce back but the recovery then
levels off. We called this the square root shape recovery.
The evidence thus far in 2010 suggests the square root shaped cycle might be
unfolding. GDP growth in Q2 and Q3 this year was on a par with a normal cyclical
upturn. The depth of the recession and the size of the output gap has supported the
‘up tick’ part of the square root cycle, with the level-off then attributable to factors
such as the legacy of the financial crisis, an impaired monetary policy transmission
mechanism, weak money supply growth, a fiscal squeeze and deleveraging across
the household sector.
The crucial point underpinning both the L and square root shaped cycles is that there
are significant forces accelerating the economy forward, but they are competing
with a very powerful set of decelerating influences.
It is also important to note that we do not think the decelerating forces will lead to a
double-dip recession – but the risk is there, especially if business and consumer
confidence begins to slide.
In looking forward into 2011 we divide the huge range of economic influences into
two camps – headwinds and tailwinds.
The growth accelerating influences are:
Spare capacity – Precise estimates of the output gap are impossible, but orders of
magnitude can be gauged. The 6 per cent plunge in output during the recession,
when combined with a trend rate of GDP growth of 2.5 per cent, suggests a very
crude output gap of around 10 per cent of GDP by 2010 – a huge figure which
theoretically at least, might permit a very strong and sustained period of above
Of course, this crude measure needs refining in order to allow for: (1) Initial
conditions – was the economy running well above full capacity before the recession,
with the recession merely bringing it back into line with potential output? (2) GDP
estimates – are the official figures an accurate representation of the recessionary
contraction or do companies and households have more/less capacity than
suggested in the national accounts data? (3) Potential output – what has been the
impact of the recession on the underlying potential output or the supply side of the
With regard to Q1, surveys of capacity did not suggest there was ‘hidden strength’
prior to the recession. Labour market conditions were fairly tight but had been for a
number of years – as measured by the unemployment rate and recruitment surveys.
Similarly, the inflation story was fairly subdued. It would seem that the most that can
be said is that the economy might have been slightly above full capacity, but even
this is challengeable – especially when one considers the surge in labour supply from
immigration over the period.
Turning to Q2 there might be, at first glance, a stronger case for arguing a smaller
output gap due to future upward revisions to GDP – as compared with preliminary
estimates. Moreover, one of the key characteristics of the downturn was the
structural break between output and employment – with the number of those in
employment falling by less than suggested by the historic relationship with GDP.
Explanations of the structural break range across the impact of pay flexibility (pay
cuts or reduced hours) and employment regulation (employment protection
legislation impeding firing), but it is also possible that the GDP estimates will be
revised upwards over time and reduce the size of the output gap over this period.
Surveys of capacity utilisation suggest there is currently less spare capacity than
indicated from GDP statistics.
The final question deals with potential output. Clearly the closure of a company can
result in a permanent loss of output (e.g. equipment is scrapped), but in a service
sector dominated economy we doubt the impact is massive. In the other direction,
the IoD has argued for some years that underlying supply side weaknesses – from a
growing burden of tax and regulation – could mean that UK trend growth has fallen
to 1.75 per cent and potential output is therefore lower than many believe.
Our conclusion with regard to spare capacity is that crude estimates overstate the
extent of slack in the economy but the output gap remains large. Our calculations
suggest an output gap of 5-6 per cent of GDP at the end of 2010.
With potential output growth in the 1.75 – 2.0 per cent per annum range, actual
output could then rise by around 3 per cent per annum over 2011-14 without
triggering rising inflationary pressures. If the supply side potential of the economy is
higher than 2 per cent per annum then actual GDP growth could be closer to the
historic 4 per cent clip seen in previous upswings, as the output gap is closed.
But there is one other key factor to consider. The presence of an output gap does
not automatically lead to its closure. The experience of Japan in the 1990s shows
that below trend growth can persist for so long it becomes the trend. Nevertheless it
is clear that right now the size of the output gap is not a constraint on above trend
Corporate finances – Both before and during the latest recession the corporate
sector has run a financial surplus (in sharp contrast to the boom and bust in the late
1980s/early 1990s), which rose from £89 billion in 2008 to £116 billion last year –
helped by destocking and reduced investment. Outside of the financial sector,
companies’ total liabilities have increased more slowly over recent years than in the
household and public sectors. Companies – particularly large firms through
corporate bond issuance – have taken advantage of the low interest environment to
borrow, but income gearing (interest payments as a share of pre-tax profits) still
remains low by historic standards. Non-financial companies also have high levels of
liquid assets as a proportion of debt. Yet another factor supporting the argument
that corporate finances are in relatively good shape is the level of business
insolvencies – low by historical standards. The corporate sector is sitting on a pile of cash and business investment, as a proportion of GDP, is relatively low – in nominal
terms at least.
All of these factors suggest that the corporate sector is in position to respond to the
upturn with higher business investment. However, whilst this may be true it does
not guarantee that it will happen. Whilst inability to obtain finance might not be a
constraint on investment – particularly for larger firms – demand uncertainty could
be, especially where companies already have spare capacity.
Employment – The private sector created over 300,000 jobs in the latest quarter for
which figures are available (2010Q2). Growth rates of this magnitude early in the
recovery are very positive and suggest that the private sector recovery can become
established before the public sector recession begins.(1) One of the employment
concerns surrounding the recovery was the relatively small fall in employment
during the recession (2.8 per cent versus 6 per cent falls in the 1980s and 1990s) and
the possibility that fewer losses in the downturn would also mean less recruitment in
the upturn. As yet we don’t know whether we are looking at sustained growth at the
rates seen in Q2 or merely a false dawn, with weaker employment rises from here
Unconventional monetary policy – The maintenance of near zero interest rates,
even allowing for a widening in spreads over recent years, is clearly very positive in
terms of lowering debt-servicing costs. Even though inflation is above trend and
likely to move higher still in the short-term, there is a general perception that base
rates could remain at or near current levels for a very long time. Quantitative easing
has helped push down rates at the long end and the possibility of QE2 could provide
further downward pressure on gilt yields – although the launch of QE2 depends on a
weaker not a stronger economy. Of course the flip side is that if growth prospects
exceed expectations gilt yields could spike upwards in expectation of a reversal in QE
– taking the edge off the recovery and creating a much more pronounced square
World trade – World trade (weighted by UK export shares) could rise by 5 per cent in
2011 and in combination with relative sterling weakness should help net trade make
a contribution to growth. There is no constraint on growth from the size of the
current account deficit.
Sterling weakness – The sterling effective exchange rate has devalued by around 25
per cent since mid-2007 and we do not expect a sharp reversal in the near term,
despite the launch of QE2 in the US and fears of global competitive devaluations.
Negative fiscal multiplier – Whilst we don’t wish to be dogmatic on this issue, there
remains solid empirical evidence for,(2) and the theoretical and practical possibility of, a negative fiscal multiplier. At the very least, as Table 1 shows, fiscal spending
squeezes do not necessarily prevent periods of sustained strong GDP growth. The
public spending squeeze in the UK in the 1990s was 7.4 per cent of GDP peak-to trough.
The equivalent figure for the period of the Spending Review and beyond to
2015-16 is 7.9 per cent of GDP. Another interesting statistic is that as a proportion of
GDP the spending squeeze under the first two years of the Coalition is less than that
under the first two years of New Labour. Public sector employment fell by more than
600,000 in the 1990s but this did not prevent strong growth in total employment.
The growth decelerating influences are:
Inflation target – Inflation is well above the 2 per cent target and likely to move
further above with the VAT hike in January 2011, before receding below target in
2012 as a result of spare capacity and weak money supply growth. Whilst the Bank
of England is expected to ‘see through’ the 2011 acceleration in inflation and not
respond with tighter monetary policy, there could nevertheless be considerable
media speculation about the risk of tighter monetary policy if the MPC becomes
more polarised about the presence or absence of an inflation problem. Speculation
could in turn lead to more subdued household and company expectations.
Financial crises – Output growth during the recovery phase tends to be more muted
in the wake of financial crises, owing to many influences ranging across debt and deleveraging,
money supply weakness, subdued expectations and deflationary (the risk
of falling prices) and/or inflationary (the risk of governments generating inflation to
erode the debt burden as a proportion of GDP) fears. A recent study by the OECD
found that the time taken for half the output gap to close – the ‘half life’ – is longer following a banking crisis.(3) Table 2 summarises the many and varied effects of a
banking crisis on subsequent economic activity.
Lack of oomph – The path of the official bank interest rate in previous recession recovery
cycles is very different from at present. In the early 1980s recovery cycle
the base rate fell by 500 basis points over the first two years of the recovery – along
a down, up and then down again path. During the first two years of the 1990s
recovery the base rate fell by 500 basis points again. But with the base rate at only
50 basis points the interest rate outlook is very different.
Near zero interest rates are obviously beneficial for borrowers – though not savers –
but we shouldn’t ignore the confidence boosting effects of falling interest rates
during previous upswings. This time around the ‘oomph factor’ is missing. Indeed, if
GDP growth does begin to outperform expectations then households and companies
will begin to expect higher short and long-term (because of a reversal in QE and sales
of gilts by the Bank of England) interest rates. This in turn would take the edge off
the recovery in line with the square root shaped cycle levelling out.
Money supply growth – Broad money supply growth remains anaemic particularly
for the household sector. Corporate (private non financial companies) sector broad
money growth has picked up in part at least due to capital market issuance of debt,
whilst some of the proceeds may have been used to pay down bank debt.
Bank de-leveraging and the funding gap – Wholesale financial markets face
considerable challenges over the 2011-12 period given the amount of debt which
needs to be rolled over.(4) Estimates suggest the monthly rollover could increase to
£30 billion compared with £15 billion in the recent past. Inability to satisfy this
funding requirement will lead to further contraction in bank balance sheets.
Real take-home pay – Recent statistics published by Deloitte show that real takehome
pay is falling sharply as a result of increased inflation and a higher tax burden.
This situation is likely to deteriorate further in 2011 owing to the VAT hike and wider
tax increases. Household disposable income – a wider measure across the entire
household sector which is also driven by employment changes – is very likely to
record negative growth in 2011, another key constraint on above trend growth being
Household saving ratio and de-leveraging – Incomes and spending moved in
opposite directions in 2010Q2 (latest available figures at time of writing) as weaker incomes still permitted rising consumption due to a fall in the savings ratio to just 3.2
per cent. Since the bottom of the recession in 2009Q3 the savings ratio has fallen
from 7.7 to 3.2 per cent. How does this compare with previous recovery cycles?
During the early 1980s cycle the ratio fell from 13 per cent at the trough of the
recession to 11.4 per cent after the first 3 quarters of recovery. During the early
1990s cycle the ratio fell from 11.4 per cent at the trough of the recession to 10.5
per cent after the first 3 quarters of recovery. So the difference with the current
situation is stark. In the latest cycle the savings ratio is already very low and has
fallen sharply in the early stages of recovery. It means that even if very weak rates of
consumer spending growth are to be achieved, the savings ratio will need to fall
further – from already very low levels by historic comparison.
But even this might be optimistic. A recent study from the Bank for International
Settlements(5) raised the spectre of very sharp debt reduction and private sector deleveraging
in the wake of financial crises – although the study also acknowledges
that debt ratios can run in parallel with healthy GDP growth.
The ratio of household debt to income has fallen from a peak of 174 per cent to 155
per cent on the latest available statistics, but further de-leveraging seems almost
certain and this in turn will limit consumption growth. Concern is based on the fact
that UK household debt to income ratios are probably still the highest in the world.
Economic commentators such as Fathom Consulting(6) have argued that the US is one
third the way down the deleveraging road, but the UK has much further to go. Time
House prices – The IoD has forecast a second leg to the housing downturn for some
time. This view was based on affordability measures. Debt servicing costs were not
the trigger but the house price to earnings ratio (HPE) was. Using the Halifax
measure for the HPE we can see a long-term average of 4.1. In the late 1980s boom
the ratio rose to 5 before falling back to a trough of 3.1 in the mid 1990s. In the most
recent cycle the HPE ratio reached 5.9 and fell back to 4.4 in mid 2009, before edging
up to 4.6 in 2010. This implies that a fall of around 10 per cent might be needed to
restore the long-term average, but we also recognised the uncertainties. Firstly,
asset price measures seldom mean revert, tending to overshoot or undershoot
instead. This might suggest a fall of more than 10 per cent in house prices.
Countering this view is the long-term tendency for the ratio itself to trend upwards
owing to the impact of land and house supply constraints, rising household
formation and inward migration. Balancing out these effects suggests to us that a 5
and possibly 10 per cent fall in house prices is possible as part of the second leg to
Labour market flexibility & inflexibility – Despite the Q2 acceleration in
employment doubts remain as to whether such growth can be sustained. The past
decade has seen an explosion in employment regulation, which raises the cost of hiring and firing. There are few signs of a reversal in the burden of employment
regulation under the Coalition. But it is not only employment market inflexibility
which could lead to a relatively jobless recovery. Aspects of labour market flexibility
might bring about the same effect as well. One striking feature of the recent
recession was the relatively low level of employment loss given the fall in output.
Part of the explanation is thought to be the trade-off between employer and
employee. Heavily indebted employees wanted to keep their jobs (and houses) and
so agreed to less pay and/or fewer hours during the downturn. This means that
faced with demand uncertainty during the upturn, companies might be more
inclined to reverse the decline in hours – at least initially – before ramping up
employment. However, we don’t want to overstate this argument. Recent research
from the NIESR(7) has shown that the relatively benign increase in unemployment
over recent years has been the result of a large upswing in job losses being offset by
much more modest reductions in rates of job finding – suggesting that labour
hoarding has been limited. NIESR speculates that this could be the result of more
active labour market policies to aid job finding. Another possibility is that job search
costs have been reduced by the Internet.
Fiscal multipliers – There is an obvious possibility that the fiscal multiplier does turn
out to be both positive (a decrease in spending leads to a fall in GDP) and significant
beyond the immediate impact. In other words the second round gains from a lower
budget deficit on reduced risk premia on gilt yields and higher business and
consumer confidence are lost. There is an interesting scenario here whereby an
independently generated private sector recovery proves sufficiently strong to rule
out QE2, whilst also leading to expectations of a reversal in QE (and higher gilt yields)
and higher short-term interest rates. The end result could again be a levelling off in
Financial or political shocks – This is really shorthand for the unknown. Financial
markets are a world away from the dark days of 2007-08 but the potential for
surprises remains. Perhaps most worrying is the threat from the interface between
politics, public debt and financial markets. The lesson of recent years is that markets
can shift from stability to violent change in quick time. If financial markets perceive
political instability as leading to fiscal impotence the impact on gilt yields could be
swift and severe. At present there is no sign whatsoever of this threat in the UK,
quite the contrary, but if the Coalition was to unravel – never say never – there could
be an exponential rise in financial market instability. The mere possibility of such a
scenario will deter some investment plans.
At the beginning of this article we stated that economic forecasting is more an
exercise in judgement and feel than a precise science. Our call is that the forces of
acceleration are being undermined by the forces for deceleration, though not so
much as to cause a double-dip recession.
Moreover, even if GDP growth outperforms expectations in the short-term, this
process will lead to a reaction function which then brings about a slowdown – due to
a tightening in monetary policy. Clearly the IoD’s UK GDP forecast is below that used
in the June Budget fiscal projections, implying that the Chancellor will have to find
more spending cuts (or tax increases) in order to meet his budget deficit targets. The
IoD thinks that any further fiscal tightening must be based on less spending not more
(1) Although there are concerns around the sector contributions to recent employment growth and also the
reliance on self-employment growth, which may be a good sign but might not be if the business model is poor,
owing to forced entrepreneurship in the wake of redundancy.
(2) See previous editions of Big Picture for literature reviews.
(3) The macroeconomic consequences of banking crises in OECD countries, OECD working paper No. 683, March
(4) The difficulties have been added to by fears around the potential expiry of the special liquidity scheme and
credit guarantee schemes in 2011-12 and 2012-14 respectively. The vulnerability of the funding structure
remains even though the intensive peak of the financial crisis has passed.
(5) G. Tang & C. Upper, “Debt Reduction after crises”, BIS Quarterly Review, September 2010.
(6) Monetary Policy Forum, Fathom Consulting, 2nd November 2010.
(7) M.W. Elsby & J.C. Smith, “The Great Recession in the UK labour market: a transatlantic perspective”, National
Institute Economic Review, No. 214, October 2010.
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