Recovery or Renewal? Cyclical, Structural & Secular Trends
Following last week’s new OBR forecasts there has been active debate as to whether the UK is currently experiencing a cyclical or a structural recovery. This is a highly technical but also potentially politically important debate given the nature of the Chancellor’s self-imposed fiscal rules.
(Summary in italics below on the nature of structural and cyclical issues – feel free to skip).
In non-technical terms if something is described as cyclical (whether that is a cyclical deficit or a cyclical unemployment) it is assumed to be related to the state of the economic cycle. In a recession and in the early stages of a weak recovery then one would expect, for example, the deficit to be higher than at the peak of a boom.
‘Structural’, on the other hand, refers to something which will not be as affected by the rhythm of the economic cycle. A structural deficit is a deficit that will remain even when the economy is growing at trend rate – when unemployment is at a more ‘normal’ level and tax revenues are growing as one would expect.
In theory then a certain portion of the UK’s deficit could be regarded as cyclical (simply there because the economy is weak) and some as ‘structural’ – reflecting a larger imbalance in spending and tax.
So, the government’s argument over the last few years is that they have had to make cuts and raise taxes to deal with the structural deficit which, unlike the cyclical deficit, will not simply fall away as growth returns.
In theory this makes sense – in practice it is far from straight forward because we can never really measure the structural element, only estimate it.
To estimate the structural deficit requires an accurate estimate of the ‘output gap’. The output gap is the difference between actual output and potential output if the economy were operating at full capacity. A large (negative) output gap implies that the economy is operating well below capacity and there is plenty of room for a cyclical pickup that would not increase inflation. There is in effect plenty of supply capacity standing idle.
The problem though is that output gaps are notoriously hard to estimate – the OBR has shifted its own estimates other time and so have other forecasters.
But, as I’ve often argued, given the current fiscal rules target eliminating the structural deficit – then the estimated size of that deficit is hugely important in guiding fiscal policy. So if the OBR changes its views on the output gap, this can have important ramifications for policy.
Last week the OBR revised up growth forecasts but basically decided that this was merely a cyclical pick-up, so whilst the headline borrowing numbers came down the structural deficit forecasts were actually revised slightly up.
For what it’s worth I continue to expect downward revisions to the structural deficit in the months and years ahead, but today I want to blog on a wider topic.
But before doing so it is worth noting that what starts out as cyclical can become structural if left to fester for long enough. Persistently high cyclical unemployment can lead to the unemployed losing vital skills and when the cyclical upturn comes the long term unemployed find it harder to get jobs and often earn less than would have been the case.
One the stronger arguments can against the Coalition’s macroeconomic policy that by delaying recovery for several years they prolonged a cyclical downturn, possibly doing structural damage to the economy.
On the bigger picture most conventional macroeconomics (until very recently) has focused on cyclical and structural factors but I’m starting to think we might need a third level of analysis – secular trends.
Last month Larry Summers made a major intervention in the macro debate arguing that many Western economies face ‘secular stagnation’. The basic thrust of the argument is that growth for decades has depended on a series of bubbles. As Paul Krugman explained:
We now know that the economic expansion of 2003-2007 was driven by a bubble. You can say the same about the latter part of the 90s expansion; and you can in fact say the same about the later years of the Reagan expansion, which was driven at that point by runaway thrift institutions and a large bubble in commercial real estate.
So you might be tempted to say that monetary policy has consistently been too loose. After all, haven’t low interest rates been encouraging repeated bubbles?
But as Larry emphasizes, there’s a big problem with the claim that monetary policy has been too loose: where’s the inflation? Where has the overheated economy been visible?
So how can you reconcile repeated bubbles with an economy showing no sign of inflationary pressures? Summers’s answer is that we may be an economy that needs bubbles just to achieve something near full employment – that in the absence of bubbles the economy has a negative natural rate of interest. And this hasn’t just been true since the 2008 financial crisis; it has arguably been true, although perhaps with increasing severity, since the 1980s.
As I argued last month:
We have stumbled into a system whereby corporations are often run not for their own long term benefit but for the benefit of top staff. As Mariana Mazzucato has argued with are all too often rewarding value extraction rather than value creation.
Corporations are incentivised to focus on the short term leading to lower investment and weaker growth than would otherwise be the case. A greater share of the wage packet is grabbed by those at the very top and, as Ranciere & Kumphoff have convincingly argued there is an casual link between this rising inequality and the propensity for bubbles.
As they argued the decline in the bargaining power of labour seen in the 1980s allowed the large rise in inequality of the 1980s and 1990s. This has, in the authors’ model, two impacts. First, it creates a demand for credit from those lower down the income scale to sustain their standard of living. Second, and just as important, it creates a supply of credit to meet that demand. Those at the top of the income scale accumulate wealth, as they are more likely to save rather than spend additional income. In effect they build up financial assets, increasing the size of the financial sector and then boosting the availability of credit. As inequality rises, so too does the size of the financial sector and the amount of personal debt in the economy. This leaves the economy more vulnerable to financial crisis and makes recovery from recession harder as households have debt to service.
Take together the declining bargaining power of labour and the rising short-termism of corporate run for their managers and you have a model that explains rising inequality, the propensity for bubbles, the declining investment share of GDP, the wage stagnation that has hit many and the rise in leverage.
As long as these trends hold we don’t have a viable economic model, we have a slow moving doomsday machine. Look at long term trends in the UK economy and you see (as the ONS pointed out last week) an ever-rising dependence on household consumption together with a slow process whereby median earners have become detached from the proceeds of growth.
Add these trends together and you have recipe for growth dependent on a falling household savings ratio and ever rising household debt levels. Which gets you an (often property) related cycle of consumption and household debt driven booms followed by nasty busts. And each bust has the potential to be worse than the last one as the household debt ratio is higher each time.
The path to recovery has set out by the OBR last week is consistent with the Summers secular stagnation thesis.
There are a variety of possible responses to this. One is that chosen by the government– accept that this is the growth model we’ve got and shrink the state further. This is a grim vision of the future in which people earn less, the state is meaner and no fundamental attempt is made at ‘rebalancing’.
Of course the Chancellor was once upon a time very keen on rebalancing – the problem was he thought it was easy, just a case of slashing corporation tax and getting the state out of the way. After this approach led to (cyclical) stagnation in 2010-2012 the plan was quietly dropped. Instead the Chancellor appears to have decided to return to a turbo charged version of the old growth model.
Another response would be to assume that the UK faces a shortage of aggregate demand and either though looser monetary policy or a fiscal stimulus seek to rectify this. This strategy would be vast improvement on what we currently have but by itself alone would not succeed. Growth might be faster but the pattern of that growth could all too easily resemble that of the pre-crisis period – consumption intensive, not reaching many in the middle and below and associated with rising household debt.
The third potential strategy would go beyond this. Alongside a capital spending intense stimulus it would seek a supply side revolution to use new institutions to combat the secular trend. Such a programme would aim less for recovery and more for national renewal it is essentially about taking the steps required to move us to a longer term, more inclusive model of growth, in short – a high wage, high productivity economy.
This outcome is not achievable through the pulling of monetary and fiscal levers alone. It’s not just a case of putting a foot on the accelerator but off taking up the bonnet and fixing the engine. This is what a progressive supply side policy should be aiming to achieve – looking at factors such as the banking system, corporate governance, training systems, industrial policy and the investment share of the economy. All of these factors determine the institutional framework of our economy and explain a great deal about the kind of growth we get and how it is distributed. All of these factors can be changed through political action.
The OBR thinks this is a cyclical upturn, it may well decide in the fullness of time that the picture is structurally better than it currently assumes but what we really need is the start of a process of reversing secular trends. That requires serious economic reform.