Prospects for Economic Growth in the UK April 2014

Monday, April 7, 2014

Question 1

The long period of slow or negative growth might imply that there is a substantial output gap in the UK economy. Do you agree that there is currently a larger output gap than the OBR estimate to the extent that the shortfall in output relative to capacity is 3% or greater?

Question 2

Do you agree that, in the wake of the financial crisis, any downward adjustment to the expected average annual long-term growth rate of the UK economy is likely to be by less than 0.25 percentage points?

Summary
Fears that the financial crisis will have a significant negative impact on long-term UK economic growth are unfounded, according to a majority of the UK macroeconomics profession surveyed by the Centre for Macroeconomics (CFM). What’s more, the CFM survey indicates some optimism of the UK’s immediate capacity for higher growth: while roughly half of the respondents share the views of the Office of Budget Responsibility, the other half is substantially more optimistic about the capacity for the economy to recover.

Introduction
The global financial crisis has both exposed and contributed to the vulnerability of many financial institutions and markets, as well as that of private and public balance sheets. The UK economy seems to be finally gaining some momentum after years of negative or low growth. Real gross domestic product (GDP) grew by 1.8% in 2013. The Office of Budget Responsibility (OBR) forecasts growth of 2.7% in 2014, followed by 2.3% in 2015 and settling down to 2.6% over the subsequent two years.

There are many factors that have to be considered when assessing the state of the economy. This survey deals with two such factors.

The first is the size of the current output gap, and
the second is the long-term potential growth rate of the economy.

Output gap
The output gap measures the extent to which the level of output is below the potential level of output of the economy. According to the OBR the output gap in the last quarter of 2013 was 1.7%.¹ And the Bank of England’s measure of spare capacity is currently estimated to be around 1-1.5% of GDP.²

These estimates imply that the drop in GDP, relative to its pre-crisis trend, which may be as much as 10% on some estimates of trend, is for the most part permanent.³

Survey results on the output gap
The CFM survey indicates a broadly positive view of the UK’s immediate capacity for higher growth: UK macroeconomists either support the OBR view, or support the view that there is more spare capacity, indicating that part of the loss experienced during and after the financial crisis and recession could be recovered.

It is important to note that the assertion in the question is that the shortfall in output relative to capacity is noticeably larger than the OBR estimate of 1.7%, namely 3% or more. Nevertheless, 46% of the respondents either agrees or strongly agrees. An equal number disagrees or strongly disagrees, but in this latter group, there is extensive support for the OBR estimate as indicated in their comments.

Among those who agree with the assertion, the following arguments are given. Jonathan Portes (NIESR) points out that unemployment remains high and that there is little or no sign of unsustainable wage inflation. Regarding the possibility of the economy recouping losses experienced during the financial crisis and the recession, Morten Ravn (UCL) may be the most positive: ‘I find it hard to identify key reasons for why there should have [been a] permanent decline in the level of output’. A similar view is expressed by Andrew Mountford (Royal Holloway): ‘the hypothesis that the UK economy returns to trend after recessions looks reasonable’.

Costas Milas (University of Liverpool), who disagrees with the assertion that there is a large output gap, points out that quite a few different analytical techniques lead to low output gap measures. Similarly, George Buckley (Deutsche Bank) points out that the OBR estimate is consistent with estimates made by others and consistent with surveys of spare capacity indicating that firms are operating around normal levels.

Long-term potential growth and the financial crisis
Even though the UK economy is gaining momentum, it is possible that these vulnerabilities will have long-term consequences for the economy, for example, because of increased awareness of financial market risk and/or the response of policy-makers. It is also possible that the economy will be influenced indirectly, for example by long-lasting consequences of the financial crisis on the Eurozone.

Although, it seems likely that these developments will have a persistent effect on the level of GDP, it is less clear that they will have a long-lasting effect on the growth rate. In the following question, long-term growth refers to growth over a decade. Note that agreeing with the assertion allows you to think that the financial crisis will have a negative effect on future growth rates as long as it is not substantial.

Survey results on the impact of the financial crisis on growth
The CFM survey suggests that fears that the financial crisis will have a significant negative impact on long-term UK economic growth are largely unfounded. Among the respondents, 61% think that the financial crisis will either have no effect on long-term UK growth rates or a small negative effect that pushes GDP down by less than 2.5% in total over a ten-year horizon. In comparison, 31% disagrees or strongly disagrees. When we weight the responses by confidence levels, then the support for the assertion intensifies (67% agreeing and 25% disagreeing).

Martin Ellison (University of Oxford) and David Cobham (Heriot Watt University), who agree with the assertion, point out that past UK recessions did not seem to have had a long-term impact on growth.

Although respondents that disagree with the assertion are a minority, several reasons are given why the impact of the financial sector may be more severe. Tony Yates (University of Bristol) does not think that the financial crisis has an impact on long-term growth rates, but points out that this is conditional on intermediary balance sheets being repaired. George Buckley (Deutsche Bank) and John Driffill (Birkbeck College, London) say that growth before the financial crisis was unsustainable: the financial crisis can have then an impact on growth rates by bursting this bubble.

Luis Garicano (LSE) and Marco Bassetto (UCL) note that financial services have played an important part in past GDP growth in the UK. Marco Bassetto writes: ‘if the crisis leads to a prolonged decline of the industry, it could have an impact on growth for several years to come.’ Finally, Marco Bassetto (UCL) and Wouter Den Haan (LSE) highlight possible negative consequences related to the uncertainty of policy reform in the financial sector.

Notes:
(1) OBR, 2014 http://cdn.budgetresponsibility.org.uk/37839-OBR-Cm-8820-accessible-web-v2.pdf. (2) BoE, 2014. http://www.bankofengland.co.uk/publications/Documents/inflationreport/2014/ir14feb.pdf.
(3) We find that current GDP is 15% below the pre-crisis trend path when a log linear model is used to estimate the trend.

How the experts responded

Output gap

Participant	Answer	Confidence level	Comment
Luis Garicano London School of Economics	Agree	Confident	The level of uncertainty about the output gap in the UK is particularly high given that during the last 10 years the economy has been running in ways that may not be sustainable, given the large share of the economy in finance and on real estate. Thus any calculation of potential output is by necessity subject to enormous uncertainty.
Sushil Wadhwani Wadhwani Asset Management	Disagree	Confident
Wendy Carlin University College London	Neither agree nor disagree	Confident	I remain puzzled by the productivity performance and wage behaviour of the UK economy over the past 5 years, which makes it difficult to take a strong view about the size of the output gap.
Gianluca Benigno London School of Economics	Neither agree nor disagree	Confident	I think it is hard to measure output gap following a crisis event. Crises event might imply permanent drop in the level of potential output and it might well be that the current output gap measured without taking into account nonlinear effects might be overestimated.
Angus Armstrong Rebuilding Macroeconomics, IGP, UCL	Disagree	Confident
Tony Yates University of Birmingham	Disagree	Not confident	Defined as the difference between actual output and output under flexible prices, no, because if that were the case then inflation would be falling markedly. There's some evidence that it is falling a touch. But this is after five years of quite high inflation. Defined as the gap between actual output and output once the deleterious effects of the financial crisis has worked through: yes, output is probably substantially further below that. Recognising that the pre-crisis trend was probably distorted up by what proved to be unsustainably low spreads and high demand.
David Smith Sunday Times	Agree	Very confident
Michael Wickens Cardiff Business School & University of York	Disagree	Not confident	Based on time series analysis the output gap is greater than 3% but based on the aggregate production function it is about 1%
Sir Christopher... London School of Economics	Disagree	Very confident	The only satisfactory definition of an output gap in my view is one that gives the percentage by which output could rise without creating bottlenecks that could lead to inflation. In light of that if, for example, the recession led to lower investment rates, the output gap that could be closed without inflation risks is less that the gap between current output and trend. I suspect the OBR fear that a rise in output by more than 1.7% would lead to bottlenecks and I sympathise with that view.
Alan Sutherland University of St. Andrews	Agree	Confident
John Driffill Birkbeck College, University of London	Disagree	Not confident	there is, in my view, a lot of uncertainty surounding these estimates of the output gap. productivity may stay low, relative to earlier predictions, or it may bounce back. and how far will unemployment fall before bottlenecks begin to appear, and pressures for wage and price increases re-emerge. the pre crisis productivity figures may have been flattered by apparent productivity in financial services which was never really there.
Patrick Minford Cardiff Business School	Strongly Disagree	Confident	The situation is complex. The crisis has generated genuine reductions in 'capacity' ie ability to produce with available capital stock, labour supply willing to work and current technology. Thus simple 'demand stimulus' would be largely ineffective. Thus OBS-style output gap measures seem about right, reflecting mainly ease of employing more labour. However, policy is capable of restoring much capacity/productivity growth so that in the longer term the growth rate could be higher for a long period to come. Such policy includes cutting back aspects of the new bank regulative system that is both too burdensome on small banks, and weighted heavily against lending to SMEs; restoring competition in energy and cutting back misdirected renewable subsidies and associated taxes/regulation; other general supply-side reforms of a standard pro-business type.
Michael McMahon University of Oxford	Neither agree nor disagree	Not confident	I tend to be pessimistic that, at least in the short- to medium-run, the UK's supply potential has been reduced as a result of the financial crisis. Together with persistence of the 8% drop in GDP from 2008-2009, I have expected weaker growth to persist for some years, and still expect growth to be weaker in the near term than in the period from 1995-2007. However, I remain very uncertain about the true size of the output gap and my best guess would probably be a very wide range of 2-4% which straddles the 3% value in the question.
Jagjit Chadha National Institute of Economic and Social Research	Disagree	Confident	Even though growth has been very low relative to the typical year to year numbers observed prior to the crisis, there has been loss of capacity since the start of the crisis and not yet sufficient re-building of that capacity by firms.
Martin Ellison University of Oxford	Disagree	Not confident	The somewhat sluggish downward adjustment of UK inflation suggests that the current output gap is not huge. However, recent monetary policy such as quantitative easing may well have caused shifts in the relationship between measured output gaps and (dis)inflationary pressure. It is difficult though to imagine that this justifies an output gap of 3% compared with what the OBR estimates.
Paul De Grauwe London School of Economics	Agree	Confident
Morten Ravn University College London	Agree	Confident	I think we are seeing a deep and long recession due to unusual strong propagation of the shocks to the economy that derived from the financial crisis. I believe that these propagation mechanisms derive from financial and labour markets in combination with the fiscal adjustments. I find it hard to identify key reasons for why there should have permanent decline in the level of output. There might be some uncertainty towards the long run growth rates to the extent that the growth in the 1990's and early 2000's were related to IT/Internet boom (and housing).
Paolo Surico London Business School	Agree	Confident
George Buckley Deutsche Bank	Strongly Disagree	Confident	This would be quite a departure from current thinking were the output gap to be 3% or wider. The EC, OECD, OBR and BoE all think it is somewhere between 1% and 2%; even the IMF thinks it is less than 2.5%. Surveys of spare capacity (for example the CBI quarterly report) show that firms are operating around normal levels - though admittedly it may be the case that firms have mothballed plant & machinery which makes it more likely that they are operating at or beyond full capacity to the extent that they cannot "un-mothball" this in the very short-term. Over a longer time period, however, they may be able to - so these surveys may be telling us something about capacity only in the short-term. The unemployment rate at 7.2% is currently exactly in line with its long-run average. That is not to say we are operating at normal rates - after all, changes to the labour market in the 1980s and 1990s make it likely that the equilibrium rate is lower than its long-run average. But we may not be operating sizably below full capacity. Growth rates of domestic inflation and wages will be crucial to monitor as they may provide good indicators of spare capacity in the past.
Ethan Ilzetzki London School of Economics	Agree	Not confident	The output gap is not an exogenous object. Public policy could potentially affect whether the loss in output is permanent or temporary. My (very casual) conjecture would be that it is still not too late for public policy to prevent the loss of output being permanent. But short of such measures, the loss will eventually be permanent.
Andrew Scott London Business School	Agree	Confident
Francesco Caselli London School of Economics	Agree	Not confident
David Cobham Heriot Watt University	Strongly Agree	Very confident	A note of caution is that this greater than 3% output gap could not be closed overnight, but it is still a shortish term matter rather than a medium or long term one.
Jonathan Portes KIng's College, London	Strongly Agree	Very confident	Unemployment remains high relative to the sustained period of high employment b rates in the 2000s and there is little/no sign of unsustainable wage growth
Wouter Den Haan London School of Economics	Disagree	Not confident	The main indication that the UK economy may have quite a bit of spare capacity is that labor productivity is very low. That is, although the number of employed is not that low, workers do not produce very much. However, the reasons for the low productivity are far from understood. For example, labour hording cannot be a very important part of the explanation, since the strength of employment since mid-2010 is due to greater flows into employment not due to reduced flows out of employment. There are other candidate explanations, but at least an important part remains unexplained. (A useful discussion can be found at http://www.bankofengland.co.uk/publications/Documents/inflationreport/ir12nov.pdf, page 33). Until we understand better what is behind the low productivity, I think it would be better not to count on a substantial amount of spare capacity.
Marco Bassetto University College London	Disagree	Confident
Tim Besley London School of Economics	Disagree	Not confident	The output gap is a difficult concept in times such as these. If lack of available of credit is responsible for lower output/productivity, it is particularly difficult to measure potential supply.
Silvana Tenreyro London School of Economics	Agree	Confident	The UK has potential to tap into growing markets in Africa and Asia, positioning itself as a leader in services' provision. Considering its international potential, the gap may be well above OBR estimates.
Costas Milas University of Liverpool	Disagree	Not confident	One would hope to get a fairly reliable answer to the question by looking at the historical performance of the UK economy over 1830-2013 (data from the "correct" excel file of Reinhart and Rogoff). To this end, I pool together information from different filters. I proxy the output gap by the median and/or the average of (i) the output gap using a Hodrick-Prescott trend, (ii) the output gap using a cubic trend and (iii) the output gap using the full sample asymmetric Christiano-Fitzgerald (2003) filter. From 1955 onwards, I also include (in the median/mean) the OBR output gap measure. For 2013, the median output gap is estimated at -0.5%; the average output gap is estimated at -4.7%. In my view, this big difference flags the difficulty in answering the question even by digging deep into the history...
Christopher Martin University of Bath	Agree	Not confident at all	In "normal" times the output gap is hard to measure as the equilibrium level of output depends on a range of unobserved variables. These are not (yet) normal times, so the gap is even more uncertain. My suspicion that the output gap is larger than the OBR thinks is only based on the observation that inflationary pressures remain low
Andrew Mountford Royal Holloway	Agree	Confident	I have to say I am finding the "Framing" of the questions quite distracting. A part of me thinks I am taking part in a behavioral experiment. Is there a control group of economists that are asked the same questions but without the introduction?!!! Anyhow, pressing on regardless:- Yes I agree: if the data are to be believed - e.g. series IHXW - then the hypothesis that the UK economy returns to trend after recessions looks reasonable, although as Rogoff and Reinhart point out the long run implications of recessions associated with banking crises are not clear and I would also say, will be policy dependent. This together with Japan's recent experience following a banking crisis means there must be some uncertainty about the answer to this question.

Long-term potential growth and financial crisis

Participant	Answer	Confidence level	Comment
Luis Garicano London School of Economics	Agree	Confident	Again, I think the degree of uncertainty here is large. Business services accounted for 42% of GDP growth in the UK according to KLEMS between 1970 and 2007, and 37% of all employment growth. While the financial crisis itself will not cause a very large downward adjustment, we may see a change of tendency with the disappearence of many office jobs through computerization and the slow down (or reversal) of growth in financial services. In other words, technological innovation may not play to the UKs advantages.
Kevin Daly Goldman Sachs	Agree	Confident
Sushil Wadhwani Wadhwani Asset Management	Disagree	Confident
Wendy Carlin University College London	Disagree	Not confident	The exit of an economy from a financial crisis is not well understood (the cases of Japan and Sweden in the 1990s provide strongly contrasting examples - and there was not the complication of global effects at that time). The recent UK recovery is unbalanced but we have seen unbalanced growth continue for many years before.
John VanReenen London School of Economics	Strongly Agree	Extremely confident
Gianluca Benigno London School of Economics	Disagree	Confident	Conditional on policy choices, I don't see why there has to be an adjustment to the long-term growth rate. I would think that a financial crisis has impact on the level but the growth rate would be influenced by different structural factors.
Angus Armstrong Rebuilding Macroeconomics, IGP, UCL	Disagree	Very confident	The implication is a fall in productivity growth which I expect due to the failed financial structure and the lack of clear policy to resolve this.
Tony Yates University of Birmingham	Neither agree nor disagree	Confident	On the assumption that intermediary balance sheets are repaired, I see no reason why the long run growth rate should be any different in the future from the past. That's a big if.
David Smith Sunday Times	Agree	Confident
Michael Wickens Cardiff Business School & University of York	Disagree	Confident	History suggests that average growth could easily deviate by more than 0.25% as average growth since 1970 has been 2.7% with a 95% confidence interval of 1.8% to 3.6%. This assumes that growth fluctuates in the future as in the past and in the next years we are not free from the business cycle.
Sir Christopher... London School of Economics	Strongly Agree	Extremely confident	I don't think the confidence in the financial sector has much of an influence on 10-year growth prospects and I see revival in confidence, anyway.
Alan Sutherland University of St. Andrews	Agree	Confident
John Driffill Birkbeck College, University of London	Disagree	Not confident	The pre crisis growth path may have been boosted by unsustinable growth resulting indirectly from asset price bubbles and measured output in financial services, all of which was ephemeral. long term potential growth may be more than 0.25% p.a. below the pre-crisis rate.
Patrick Minford Cardiff Business School	Agree	Confident	In line with my previous answer about the output gap, I think the long term growth rate can be maintained at the previous recent (fairly solid) rate provided that policy is altered in a liberal market direction. The reaction to the crisis has been in the form of a 'regulative backlash' which has had highly damaging effects, especially visible in the collapse of lending to the vital SME sector. The reaction has overlapped with a general associated movement to regulation in other areas, especially energy. As usual this is also related to EU initiatives; thus EU policy too needs to move in a liberal reform direction. My assessment is that this is likely.
Michael McMahon University of Oxford	Agree	Confident	While I expect growth to be weaker in the near term than in the period from 1995-2007, I do not expect that GDP growth in the longer term (5+ years) will be hugely affected by the financial crisis. There are other factors, such as developments in demographics, which will mean growth rates are affected, but I do not believe the financial crisis will have induced permanently lower growth in supply capacity. This is despite my pessimism that that most the sharp drop in the level of output may be persistent.
Jagjit Chadha National Institute of Economic and Social Research	Agree	Not confident	It is quite hard to work out what the rate of productivity growth will be over the longer run after the crisis and in the new financial worlds, so I will stick close to the very ong run UK average but there are many imponderables here.
Fabien Postel-Vinay University College London	Agree	Confident
Martin Ellison University of Oxford	Agree	Confident	The average growth rate of real GDP in the UK has been stable and close to 2% p.a. since 1830. The average UK growth rate in the ten years after a recession has been less than 1.75% p.a. only once, which happened after the 1974 recession because of the recession that followed hot on the heels in 1975. If anything, the UK economy often appears to "bounce back" after a recession, with higher than average growth rates. For example, UK real GDP grew on average at 3.36% p.a. in the ten years after the end of the Great Depression.
Paul De Grauwe London School of Economics	Agree	Confident
Morten Ravn University College London	Neither agree nor disagree	Confident	I think there are two issues. The first is related to the financial crisis. The financial crisis and its impact on banking may be impacting negatively on the growth rate both because of misallocation of bank lending across different types of projects / entrepreneurs (towards less risky but also lower return projects) and because of reluctance of banks to lend. But there is a second layer of uncertainty which I pointed towards above which is the extent to which the boom in the 1990's - early 2000's were driven by IT/internet and whether those days are gone now - and, whether there are new drivers of growth coming (such as biotech, nanotech etc.). Thus, I find it hard to make an informed guess on the growth rate in the years to come. there is certainly a need for research into this.
Paolo Surico London Business School	Agree	Confident
George Buckley Deutsche Bank	Disagree	Not confident	Prior to the financial crisis, economists were talking about long-run growth of around 2.75% in the UK. The average rate of growth in the 15 year run-up to the credit crisis, in fact, was close to 3.5%. Basically, it was thought back then that we could continue to grow at rates far beyond what we used to in the very long run. There are a number of reasons that long-run growth may be far lower than this: i) very long-run (past 200 years) average growth has been much lower at 2.1%, ii) the productivity puzzle remains - some of this weakness could prove permanent or semi-permanent (falling oil output requiring greater manpower to extract, forebearance/zombie firms, lack of investment and fall in marginal product of labour as a result etc), iii) there may be some truth to Robert Gordon's arguments - that the bar may be very high to achieving the same rates of growth-enhancing technological progress going forward as has been the case in the past. As a result, long-run growth could easily prove to be more than a quarter point less than what we had begun to expect during the Great Moderation. The reason I have answered "not confident" is that forecasting long-term growth rates is an inherently difficult thing to do. It requires us to have a good idea of things like future inward migration and growth in technology, both of which are highly uncertain over the long-run.
Ethan Ilzetzki London School of Economics	Disagree	Not confident
Andrew Scott London Business School	Strongly Disagree	Confident
Francesco Caselli London School of Economics	Agree	Confident
David Cobham Heriot Watt University	Strongly Agree	Very confident	Advanced economies such as the UK's have highly persistent growth rates. Politicians usually turn out to be mistaken when they think they have introduced radical reforms such that the economy can and will now grow faster, and there is no obvious reason to think that growth rates are less inertial on the downside.
Kate Barker British Coal Staff Superannuation Scheme and University Superannuation Scheme	Neither agree nor disagree	Confident	There is a very long-term underlying productivity trend in the UK which I would not expect to fall by more than 0.25 pts. Meanwhile labour force participation might rise a little to offset any slowdown in labour force growth.
Jonathan Portes KIng's College, London	Agree	Confident	Predicting future technological progress is impossible. But I don't see why it should have slowed. If financial sector dysfunction reduces growth that represents a policy failure more than a reduction in underlying potential.
Wouter Den Haan London School of Economics	Disagree	Not confident	I am afraid that the financial crisis could cast a shadow for a substantial period on UK economic growth and I would not be surprised if this lingering impact would reduce UK growth by more than 2.5 percentage points over the upcoming ten-year period. In addition to the effects through continued problems in the Eurozone, I am thinking of (i) negative effects due to the unwinding of unconventional monetary policies (either direct negative effects or negative effects induced by the related uncertainty) and (ii) lack of serious regulatory reform and other substantial changes in the financial sector, which means that we cannot exclude other disruptions in the foreseeable future.
Marco Bassetto University College London	Agree	Not confident	I agree that the long-run impact on growth of what happened so far is limited, but there are two potential dangers: 1. Given that financial services are such an important component of UK GDP, if the crisis leads to a prolonged decline of the industry, it could have an impact on growth for several years to come. 2, There is still great uncertainty about the policy response, in terms of restoring long-run fiscal balance, potentially establishing a new regulatory framework for the financial industry, industrial policy (e.g., the renewed emphasis on manufacturing) and even trade policy (e.g., the EU). Long-run growth will depend on the policy choices.
Tim Besley London School of Economics	Agree	Confident
Silvana Tenreyro London School of Economics	Strongly Agree	Confident	I don't think the financial crisis will have long-term consequences on the growth rate of the UK.
Costas Milas University of Liverpool	Agree	Not confident
Christopher Martin University of Bath	Disagree	Not confident	Anyone who has confidence in this is exhibiting hubris rather than knowledge We have a lot of evidence to say that financial crises are very damaging for an economy in the short-medium run. There is some evidence that they are damaging in the long-run as well; there is no evidence I know of that suggests they are beneficial in the long-run. More than that we cannot say
Simon Wren-Lewis University of Oxford	Agree	Confident
Andrew Mountford Royal Holloway	Agree	Confident	Again the framing of the question! But Yes I agree: if the data are to be believed - series IHXW - the trend growth rate of real GDP per capita doesn't seem to have been greatly affected in the past by recessions, exchange rate regimes, or changes in industrial structure, although again as Rogoff and Reinhart point out the long run implications of recessions associated with banking crises are not clear and will be policy dependent, hence again there must be uncertainty about this.

How the experts responded

Output gap

Long-term potential growth and financial crisis

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