If you think the economy is performing well, your standards are much too low

Last month the ONS estimated that our GDP grew by an estimated 0.4 per cent between May and July. The government celebrated these results as a vindication of their strategy. Compared to 0.2 per cent, 0.4 per cent looks like an achievement. But it only shows how far our expectations have fallen.

During the last ten years the average growth rate in the UK has been 1.4% per annum. The world average over the same period is 3.5%. Why is the UK economy performing so relatively poorly compared with the average elsewhere?

Broadly speaking, those on the left of centre say that the reason for this is that the UK lacks an adequate industrial strategy. Our education and training systems are poor. Industry is starved of finance for investment. Expenditure on infrastructure is inadequate and we spend much too little on research and development. Too many people have a “short term” view, so we lack patient shareholders. If only we could reform these supply side deficiencies away, they claim, the economy would perform much better.

By contrast, those on the right tend to think that the problems lie elsewhere. Taxes are too high. The state tries to do too much and doesn’t do what it does do very well. There are too many regulations. More ought to be run by the private rather than the public sector. We don’t rely sufficiently on market forces. The state is too big and too obtrusive. If only we could get the state off our backs, leaving it to private enterprise, all would be well.

Maybe, however, both these approaches are wrong. What if all the shortcomings pinpointed by the left, however significant they may be, are much more consequences than causes of our poor economic performance, while those from the right are more or less irrelevant? Then we ought to look elsewhere for what has gone wrong. We then might come to very different conclusions about what to do to put things right.

Suppose that the real fundamental reason why the UK economy grows so slowly is that it is uncompetitive. The overhead costs of running internationally tradeable businesses in the UK, especially in manufacturing, are charged out to the rest of the world at much too high a rate because the exchange rate is too strong. The fact that we have deindustrialised so drastically – from nearly a third of our GDP coming from manufacturing as late as 1970 down to less than 10% now – very strongly suggests that this is the case. We then forego all the increases in productivity which manufacturing is so much better than services in providing, investment goes down and productivity stagnates.

Now we can begin to see why on the supply side things have gone wrong. The quality of our education and training is a major problem because our economy lacks the right sort of jobs for many people for which working for good qualifications is worth the effort. There is not enough money to lend to industrial companies because too many of them are unprofitable and are therefore a poor credit risk, or they lack investment opportunities worth backing. There isn’t enough money available to the government to pay for the infrastructure improvements which everybody wants. Companies pay money back to shareholders rather than investing it in the future because too high an exchange rate makes too many projects unprofitable.

And how about the critique from the right? There the problem is that there is very little evidence that significantly lower taxes than we have in the UK now, deregulation, privatisation and a smaller state would make any difference to our economic performance. None of this has any real bearing on our competitiveness in world markets. By and large, the UK economy is much more liberalised now than it was fifty years ago, when our growth rate was considerably higher than it is at present. There are plenty of economies throughout the world, with higher taxes and more state control than we have, which are doing much better than we are.

So what can we learn from this approach? The key lesson is that we need to be very careful to analyse correctly causes and effects, remembering that correlation is not the same as causation. Supply side reforms won’t work unless they are matched with changes on the demand side. And some policies which are widely advocated, particularly on taxation and related matters, although dressed up with claims that they will increase the overall growth rate, are really much more orientated towards how the cake should be divided up than they are to making it larger.

And as to getting the economy to perform better with demand-side reform, the key requirement is that we need a low enough exchange rate to make investment in the UK profitable – particularly in mechanisation, technology and power, which are the real keys to higher output per hour. Then we can put in place complementary supply side reforms, while at the same time we make sure that the resulting increased output is fairly shared out.