Reposting: Why Economic growth matters. Much more than Michael D thinks. This is why he is dangerously wrong

Chris Johns

Liz Truss wasn’t wrong about everything. There, I said it.

Specifically, when the shortest lived Prime Minister in British history said ‘growth, growth, growth’, she was on to something very important More important than many realise.

Growth matters for obvious reasons. Jobs and living standards are, of course, front and centre. It’s the economy, stupid. But too few of us appreciate the connections between economic growth and the nature of the societies we live in. It’s not just the economy, stupid.

Ben Friedman, a Harvard economics professor, once did a literature search trying to find the classic papers and books that explain why we devote so much effort to managing the business cycle. Why do we try so hard, via all the tools of economic policy, to stop downturns from happening? After all, they rarely last long and any lost output is, historically at least, usually recovered quite quickly. Friedman couldn’t find any modern explanation about why we get so exercised about temporary GDP drops of a small few percentage points.

18th century economists published books like ‘The Theory of Moral Sentiments’, before they wrote ‘The Wealth of Nations’. Adam Smith and David Hume understood the connections between a country’s economy and its character. Economic growth, for the classical economists, had a clear moral dimension - not in the sense of whether an individual is a saint or a sinner, but more about society as a whole. Economic prosperity is a necessary condition for society’s character to prosper. Ben Friedman noticed that we don’t talk about this stuff any more: we measure what we can and disregard the rest. So he wrote a book called ‘The Moral Consequences of Economic Growth’.

The clue is in the book’s title. Friedman describes how economic growth doesn’t just enable some of us to buy a fancier car. It allows a country’s political, social and moral character to flourish. The ideas deserve more discussion than I can give them here - I’ll reserve that for another post. For now I will confine myself to a few short observations.

Keynes once observed that it is better for people to trade on the floor of a stock exchange than to kill each other. Economic progress has many dimensions and for Keynes one possibility is that “The ultimate object of economic progress is to make possible the abolition of war”.

Anyone thinking about ‘Broken Britain’ will notice the squabbling, the poisonous politics and the social divisions that dominate our national discourse. We also know that the economy hasn’t grown by much for 15 years. People in the bottom half of the income distribution (not just the bottom 10% or 20%) are doing really badly. In a sense, the nation’s character, defined in that 18th century way, is under threat. It’s not just about measurable prosperity, or lack of it. Something else is changing - degrading - as well.

Anyone looking at ‘Broken Britain’ from overseas should think about all this. Radical policies often have radical outcomes. Economic policy is always consequential, often with profound economic and non-economic outcomes. Nothing is pre-ordained. Argentina and the US were once very similar in economic terms. One country pursued growth friendly policies, the other did not.

Ireland’s journey to today’s tolerant, pluralist, diverse modern country is a story well told. But without economic growth the path that led to equality legislation, improved women’s rights, gay rights - and many other markers of social progress - would have been a much rockier one. It may well have been impassable.

Ireland’s social, political and moral character has been enhanced by economic growth. Tamper with it at your peril. A government led by Sinn Fein will be radical. That’s their raison d’etre. I refer the reader to what radicalism has done to Britain. I also argue that Sinn Féin’s economic policies will not be growth friendly. That’s because their interests lie elsewhere. Promoting economic growth isn’t part of the radical agenda. Just look at their economic policies, planned for the Republic and implemented where they do have power. Always look what is done, not what is said. The state of the Northern Irish economy suggests no signs of a governing party interested in growth. Sinn Fein’s stated intention to increase taxes on prosperity will lead to less of it.

Nothing is pre-ordained. Economies can and do stagnate or go backwards. Growth can happen for reasons purely to do with chance and circumstance. The U.K. is not fated to go the way of Argentina. But if it continues to make poor choices about growth, it might. The country’s character will do likewise. Economic growth is much more important than measurable, monetary progress. Let’s take a deeper look at what has gone so wrong in the U.K.

The U.K. and disappearing growth

The drivers of economic growth are much studied and not fully understood. Economists are coming to the conclusion that ‘it all depends’. That may seem feeble but it happens to be true. Policies that positively impact on growth in one place and/or time might not work elsewhere or at a different time. We know that capital investment is usually a good thing, especially in skills - spending on education often pays handsome dividends. We know that investing in these areas does offer benefits but of varying size and often over long periods. There are few short-term boosts to growth that don’t amount to a sugar high.

There are many causes of Britain’s poor economic performance. The Atlantic article that I discussed in Part 1 of these linked posts pretends that it is all very simple. UK citizens somehow ‘chose’ to be poorer. Framing it as an explicit choice rather a complex emergent process is silly. No mention is made of the careful work done by hundreds of economists into the all-important determinants of productivity growth: we know a lot but not everything. For example, an important factor in Britain’s productivity debacle, not mentioned by the Atlantic, is the poor quality of UK management. Productivity growth is complicated.

‘Path dependency’ is another important point. Duncan Weldon’s excellent book, ‘Two Hundred Years of Muddling Through, A Surprising History of the UK Economy’ describes how policy decisions taken decades ago have shaped today’s economy. And the role played by serendipity, pure chance and circumstance.

In a thoughtful (substack) piece, Sam Bowman starts with a version of the chart that should begin every deep dive into the UK economy. It’s taken from the FT and shows how UK productivity is now 25% (!) below its pre-crisis trend. In the last 15 years it has eked out a paltry 0.4% a year growth, compared to 2.3% from 1980 to the onset of the financial crisis.

We are fond of saying ‘you can’t live the counter factual’ but most people have a rough idea of what 25% more might mean.

GDP and productivity are often thought to be too abstract, or perhaps too narrow, for non-economists to understand what they mean for everyday lives. In a famous exchange during the EU referendum, an economist who explained to a group of people in the North of England about the probable GDP losses from Brexit, was told “that’s your GDP, not ours”. That could be a reference to everything that GDP does not capture: community, volunteering and many other things that are important. Even so, most of us are able to grasp that if GDP was significantly bigger, our taxes might not be going up and proper funding of the NHS might actually be possible. So many of the economic problems afflicting Britain today would not have occurred. Nor would many of the accompanying social issues.

Paul Krugman’s famously said: “Productivity isn't everything, but in the long run it is almost everything.” When productivity doesn’t grow by very much, or at all, our living standards, on average, don’t grow. Cue lots of talk about the poisonous politics driven by trying to share a cake that isn’t growing in size.

Not all of Britain’s problems are caused exclusively by lack of economic growth. But most of those problems have economics lurking somewhere in the background.

What can be done?

Bowman argues there is a debate between ‘doomsters’ and ‘boosters’; essentially one group thinks there is something that can be done about this and the other does not. He admits that the demarkation lines between the two groups are blurred - he doesn’t make the mistake of over simplification. Doomsters might accept that there are policies that can boost growth but they take so long to work they have little political relevance today. This, I think, is important: if you don’t have a political class willing to think about policy consequences beyond their term of office, even if only once in a while, you will be cursed by short-termism. Any country can be afflicted by this but I think the British have perfected it. What chance would the UK, today, replicate the far reaching green transition bill just enacted by Joe Biden?

There is not one set of policies that always and everywhere will boost growth. I doubt whether economists will ever be able to build a model based on ‘a theory of everything’. Too much is context dependent: where you start from, where you have come from and where behaviour - government, personal and corporate - can be unpredictable. We think raising interest rates will bear down on inflation but can we imagine circumstances where higher interest rates lead to higher inflation? Amazingly, yes. And so on.

What has gone wrong? A proper answer would be book length. I’d recommend Duncan Weldon’s work, referenced above. A useful primer that summarises what economists typically think about all this is contained in an LSE sponsored survey, conducted a couple of years ago, that asked what caused the productivity slowdown - and hence the growth slowdown - and what can be done about it.

There have been two broad categories of explanations for the productivity slowdown. The first focuses on supply-side factors. This category includes employee skills, with the UK among the worst in Europe in terms of mismatch between skills and field of employment, sluggish investment in research and development (R&D), and global factors, including increases in market power.

The second category of explanations focuses on demand-side factors, implicating the financial crisis, austerity and other causes for slow demand growth in the past decade. There is a separate, longer-term UK productivity puzzle. UK output per hour has underperformed its G7 peers for several decades.

That latter point, about the longer term trend, is indeed a deep puzzle. Attention often focuses on lack of investment by both the private and public sectors. I think this is right but is only part - albeit a big part - of the answer. There are probably socio-economic factors at work: why is there so much short-termism in British industry? Professor John Kay wrote a report about this a decade ago. Its focus was the equity market but had much wider applicability.

The report finds that short-termism is an underlying problem in UK equity markets, principally caused by a misalignment of incentives within the investment chain and the displacement of trust relationships by a culture based on transactions and trading.

Kay produced a whole series of recommendations that have, for the most part, gathered dust.

One thing that few people ever talk about is the link between capital investment, productivity and the asset management industry. For much of the past two decades, British pension funds have been encouraged by regulators and sponsoring employers to sell equities and buy government bonds. In the jargon of the investment industry, asset managers have been forced to sell growth assets and buy safe assets. They are called growth assets for a reason.

The FTSE100 share index is essentially unchanged for over two decades: the constituents of the index have not, on average grown. There are lots of reasons for this but one finger of suspicion must be pointed at the forced selling by pension funds of company shares that has had the effect of raising the cost of capital for the businesses concerned. In a world of perfect capital markets they should have found willing buyers of their equities in overseas markets. But the world ain’t perfect. Put simply, British firms have not had as much access to equity capital as they would otherwise have done. The push to sell equities and buy bonds did attract some attention in the wake of the financial crisis induced by Kwasi Kwarteng’s first and last budget: the LDI debacle. But, to my knowledge, nobody has ever joined the dots between LDI and chronic under-investment.

There is plenty of evidence that suggests the quality of British management is relatively low. Maybe that’s a function of the education and class systems. Perhaps the starting position of the British economy at the end of the second World War has something to do with it. Some speculate that the end of Empire is also a contributing factor. In the end though, for reasons that are only partially understood, Britain invests less than its peers in productive capacity, including in skills-based education.

Under-investment is a common theme across most, if not all studies of Britain’s low growth. That’s investment in high tech equipment, many other types of capital spending, as well as money spent enhancing education and skills. The post-2008 slowdown has also been accompanied by disappointing capital spending. But two (at least) other drivers have also been identified: the unnecessary austerity of the Cameron/Osborne era and Brexit.

Brexit

The size of the Brexit effect is debated but its sign is not. The British economy is smaller because of the decision to leave the EU. Only cranks and a small number of extremist, ideologically driven, economists dispute this. It is hard to disentangle Brexit, the pandemic and the energy crisis. But a broad consensus amongst economists is that all three are important. Two of those factors are common to all economies so attempts can be made to isolate the impact of Brexit. The Centre for European Reform (CER) does this on a quarterly basis.

John Springford of the CER reckons the economy is already 5.1% smaller because of Brexit. That equates to tax revenues being smaller by around £40 billion. The recent Sunak/Hunt budget raised taxes by almost the same amount - £46 billion. Investment is lower by £11 billion. Springford tackles (convincingly) the dwindling (three, one of whom chooses to remain anonymous) band of Brexiteer economists who have publicly attacked both his methods and his conclusions. More seriously, he responds to those reasonable economists who suggest his estimates of Brexit effects are on the high side.

… there are a few analysts who think my estimate is based upon legitimate methods but is on the high end of estimates for the cost of Brexit. This is perfectly reasonable – counterfactuals are notoriously difficult, because they are based on “branching histories”, as Boris Johnson’s former advisor Dominic Cummings put it. (If only we could visit the universe in which Brexit did not happen.) Jonathan Portes, Professor of Economics at King’s College London, says that a plausible range for the cost of Brexit is between 1 and 5 per cent of GDP, with my estimate at the top of the range. For its part, the Office of Budget Responsibility (OBR), the British government’s fiscal watchdog, assumes that, over 15 years from 2016, Brexit will reduce GDP per capita by 4 per cent. That number is based on a range of forecasts made by reputable institutions. The OBR also thinks that by the time the Trade and Co-operation Agreement (TCA) came into force in January 2021, the cost of Brexit was 1.6 per cent, thanks to uncertainty and depressed investment.

Springford tackles head on those who think his estimates are on the high side. This economist thinks his arguments are reasonable but it is important to acknowledge the debate - the most important point is that we are only discussing how negative Brexit has been.

Tim Hartford on policies to promote growth.

I mention Britain’s education and class system. This is speculative and probably reverses more about my own prejudices but here goes. British Prime Ministers, other senior ministers and civil servants are drawn from a pool of men and women who were often privately educated and studied PPE (or geography) at Oxford. Not all of them but a lot of them. From this pool of talent we have drawn David Cameron, Teresa May, Boris Johnson, Liz Truss and Rishi Sunak. Sunak is unproven but I’m willing to bet he is as incompetent as the rest of the politicians on this list. And will preside over another disaster of one kind or another.

I think it’s partly down to the ‘essay crisis’ education system. All of these people grew up having to meet essay deadlines at Oxford. The way Oxford undergraduates typically approach these deadlines is not via careful planning, preparation and deep research. It’s all done the night before, preferably so you can boast a good mark for an essay knocked our between midnight and 4.00 am. At the very least, this lack of seriousness, lack of attention to detail, lack of interest in boring matters of governance, is consistent with the British education system. It’s what these po-Eli were taught so it’s probably a bit harsh to judge them for their deficiencies.