Why I expect a weak recovery
On Thursday we’ll get the first look at GDP figures for the third quarter and the signs are pointing to the official end of the longest double dip recession since the Second World War. NIESR for example have growth at 0.8%, subject to the caveat that much of this is due to temporary factors and underlying growth is around 0.2%.
Now, I’ve long warned that the bar for success isn’t simply any level of growth/avoiding outright contraction. While the end of the recession (if it comes to pass) is welcome, this is still an historically weak ‘recovery’. But in this post, rather than concentrating on the immediate term outlook, I thought it might be interesting to take a slightly longer term look at our economic prospects.
What will growth look like in 2013, 2014 and 2015?
I won’t try to make an exact forecast, any such forecast would no doubt be wrong but I think something can be said about the trend – and it doesn’t look great.
Before proceeding though it is worth bearing in mind a post from Jonathan Portes back in July on which macroeconomists are worth listening to. As Jonathan said:
policymakers and the public should listen to economists who fulfill two critera: first, they have made empirically testable predictions (conditional or unconditional – see Krugman here) that have proved, by and large, to be broadly consistent with the data; and second, they base those predictions on an analytic framework (not necessarily a formal model) that is persuasive. In other words, getting it right alone is not enough; it should be possible to show your workings – to explain why you got it right. Otherwise, your predictions may be interesting, but they tell you little about how to formulate policy.
I think Jonathan’s criteria are exactly right and so, before offering my own medium term (and highly conditional) views, I thought it might be worth briefly explaining the framework I use in thinking about the economy in the medium term.
First I tend to agree with Chris Dillow that it is better to think in terms of mechanisms than models. As Chris recently explained:
To see what I mean, let’s concede that the pre-recession evidence pointed to lowish or even negative (pdf) fiscal mulipliers. Mechanism-based thinking would ask: what mechanisms could generate such a result? Answers would include:
– Fiscal tightening can be offset by lower interest rates.
– Cuts in the government wage bill reduce workers’ bargaining power and hence expected profit margins, which can encourage capital spending.
– Lower government spending leads to anticipations of lower taxes, which might encourage increase household and corporate borrowing and spending.
This automatically draws our attention to reasons to doubt that low mulipliers would exist now. Monetary policy is less effective now we are at the zero bound; and an inability or reluctance to borrow limits how far private spending can rise to fill the space left by public spending.
We’d therefore expect to see higher multipliers now, not because Keynesians are always right and Austerians are always wrong, but because the mechanisms generating low multipliers happen not to be powerful here and now.
To me the best answer to the question ‘what is the fiscal multiplier?’ is probably ‘well, it depends…’ (and at the moment they are probably rather high).
Second, I tend to agree with Andy Haldane that thinking about the modern macroeconomy means taking money and credit seriously.
Third, and related to this, I strongly believe that balance sheets matter. Rather than concentrating on flows, economists should also closely watch the balance sheets of firms, the financial sector, government and households. This approach, as Bank of England research has highlighted, would have been more likely to spot the financial imbalances building up in the UK economy before 2007 and its increasing vulnerability to a shock.
So, what does this approach suggest is likely for the UK economy over the next 3 or 4 years?
It starts with the simple fact for all the (necessary and correct) talk of the need to ‘rebalance’ the UK economy (which is not happening yet!) the primary factor making the difference between a weak recovery and ‘proper’ recovery will be what happens to household consumption.
The chart below (tweeted today by Faisal Islam) demonstrates not only that the UK’s recovery has lagged but also the very strong link between household consumption and overall growth.
It is such a large component of the economy that even rapid growth in business investment and exports are unlikely to offset weak household spending. Simply put, to add 1% to overall GDP growth, household consumption needs to increase by just 1.6%. To do the same, business investment needs to rise by 12.6%. Even if business investment booms ahead with growth of 15% a year, it won’t be enough to secure a decent recovery unless household consumption is doing better than it is now – especially against the headwinds of fiscal austerity and a tough export environment.
Estimating the overall growth profile of the UK economy over the coming three or so years is really an exercise in estimating the profile of consumption growth. Better than expected, or worse than expected, export and investment performance will affect overall growth but the difference between a weak recovery and a stronger one will be found in consumption.
Interestingly enough – the OBR forecasts since March 2012 (and in contrast to those of June 2010) now appear to accept this logic, with household spending being the major driver of growth.
Given that, and thinking in terms of mechanisms, we are asking two sequential questions – how will household incomes change and how much of that income growth will be spent or saved?
As I wrote back in June that means two charts hold the key to forecasting which way GDP will develop. They are Real Household Disposable income and the household savings rate.
Starting with income (below), we see a gradual rise until late 2007 followed by stagnation as incomes failed to keep up with prices. These trends may now finally be starting to ease, but even the most optimistic forecasters believe that growth in real incomes is likely to be very weak in the next few years. No one expects a sudden boom in household earnings.
Actually the picture is even worse than this chart, and the gloomy forecasts, suggests. Projections from the Resolution Foundation suggest that income growth for those in the middle and at the bottom (the most likely to spend their cash) is likely to be even weaker:
A typical household close to middle income could expect to see an income of £22,100 in 2020 – a 3% fall from £22,900 in 2009.
Income growth then is likely to be very weak and this suggests consumption growth will be equally weak and hence the recovery will be a weak one.
The complicating factor, and where credit comes into my thinking, is – what happens to the household savings ratio?
I think the savings ratio is a hugely important factor. The gradual decline in the percentage of their incomes that households save coincides rather neatly with the long boom of 1992 to 2007. The sudden upswing in 2008/09 came with the sharp recession and it has been bouncing around since as the UK has stagnated.
If the household savings ratio starts to fall (and the OBR expect it to) then growth will pick up, if it remains flat or increases then growth will be weaker.
But remember that balance sheets matter. And whilst the household balance sheet of the UK strengthened from 1997 until 2008 (which may have underpinned some of the falling savings ratio), it has flat-lined since.
So I foresee three possible scenarios for the UK economy in the next three or four years (in the absence of rapid rebalancing towards a net trade or investment led recovery and in the absence of a change in fiscal or monetary policy):
- First, and most preferable but most unlikely, we get strong growth in real incomes as inflation falls back towards 2% and wage growth increases. If that happens consumption growth will be stronger and the economy will grow at a decent pace.
- Second, and what I think is the most likely outcome – my central ‘forecast’ if you will – household income growth will be weak and the savings ratio will not drop by much. The result will be weak consumption growth and an economy that is growing, but growing slowly – in the order of 1-1.5% a year. In historical terms of recovery from recession this is pretty much a disaster.
- Third, it is possible that we still get weak income growth but that the savings ratio drops rapidly. In this scenario we’d see faster consumption growth and hence faster overall growth. This however would be accompanied by a big increase in household debt. It might give us 3 – 4 years of decent growth, but at the risk of increasing the financial imbalances that got us into trouble in the first place.
I hope for the first outcome, expect the second and worry about the third.