The British economy after the coalition

In what condition does the coalition government leave the UK economy? Needless to say, its members are fighting the general election on the proposition that they have done a fine job of rescuing the crisis-hit economy they inherited. It seems, at the moment, that this argument is not playing that well in the polls. Does it deserve to? Here is a scorecard.

Let us start with the simplest measure of overall economic performance. In the last quarter of 2014, UK real gross domestic product per head was 4.8 per cent higher than it had been in the second quarter of 2010 when the coalition took office, and 6.2 per cent above the trough of the "great recession" in the third quarters of 2009. But it was much the same as in the first quarter of 2007 and below its pre-crisis peak. In the fourth quarter of 2014, real GDP per head was close to 16 per cent below where it would have been if the 1955-2007 trend had continued. Even the recovery has not shrunk this gap. This largely explains the disappointment over living standards. (See charts.)

Moreover, this huge shortfall cannot be explained by a pre-crisis boom. On the contrary, the economy was close to its long-term trend in 2007. Booms had been far bigger in the early 1970s, late 1970s and late 1980s. Data on inflation tell much the same story. The argument that the UK economy was in a grossly unsustainable state in 2007 is largely ex-post rationalisation. Even house prices turn out not to have been unsustainably high. What nearly everybody missed was the vulnerability of the UK's financial sector to a global crisis.

Jobs performance has been remarkable. In February 2015, 73 per cent of the population between the ages of 16 and 65 was in employment, slightly above the pre-crisis peak. Overall unemployment was 5.6 per cent of the labour force. According to Eurostat, 27 per cent of UK workers between the ages of 15 and 74 were in part-time employment last year. We do not know how far this reflects underemployment or voluntary part-time employment.

Yet the good employment performance is the mirror image of the collapse in growth of output per worker and output per hour: in November 2014, output per hour in the economy was 1.7 per cent lower than it had been in February 2008. Such a long period of stagnation appears unprecedented at least since the 19th century. Recently, the FT revealed that much of the explanation lies in professional services.

In the short run, stagnant productivity allowed the economy to combine weak expansion of overall output with decent jobs performance. In the long run, however, productivity determines standards of living. If the former stagnates, so will the latter. What is needed then is both fast productivity growth and fast employment growth. The necessary ingredient is buoyant demand.

Consider, now, the structure of the economy. In the fourth quarter of last year, manufacturing was 4.9 per cent smaller than at the pre-crisis peak, while services were 8.1 per cent bigger. The current account deficit grew to 5.5 per cent of GDP in the last quarter of last year. The rise was due to a large negative swing in net investment income. But, given a 21 per cent appreciation of JP Morgan's measure of the real exchange rate between early 2009 and March 2015, the balance on trade in goods and services might also deteriorate further.

Turn to the public finances. Initially, the government talked as if the main challenge was the fiscal deficit, not the need to foster the nascent recovery. George Osborne, the chancellor of the exchequer, set himself the objective of eliminating the structural current fiscal deficit by this financial year. In fact, the structural current deficit will be 2.1 per cent of GDP this financial year, down from 3.9 per cent of GDP in 2010-11, the coalition's first year in office, according to the Office for Budget Responsibility. Similarly, cyclically-adjusted net borrowing is forecast to be 3.7 per cent of GDP this year, down from 6.5 per cent in 2010-11. The coalition's fiscal bite was less bad than its bark. The argument it offered for tightening faster than Labour had promised was that it was necessary to stop the UK from being hit by a crisis similar to those hitting countries such as Greece. We know now that this was wildly exaggerated for a country in the UK's position. Despite failing to hit its fiscal targets, interest rates on UK public debt have remained astonishingly low: 30-year and 50-year gilts yield 2.4 per cent, while yields on comparable index-linked gilts are close to minus 1 per cent. Why should one be desperate to avoid a free loan? What is needed instead is growth-promoting borrowing.

In sum, the UK economy has enjoyed a weak, yet job-creating, recovery. Productivity growth has been dire. According to the International Monetary Fund, UK GDP per head at purchasing power parity was 72 per cent of US levels in 2014, behind Germany's 84 per cent and even France's 74 per cent. The claim by Mr Osborne that the UK might be the most prosperous major economy in the world by 2030 is fantasy. The risk, instead, is that it is going to fall further behind. Furthermore, the imbalances in the economy are going to make future growth more difficult and less sustainable. If the fiscal deficit were eliminated, while the current account deficit remained large, the private sector would have to run a large financial deficit. That is a frightening possibility.

The still bigger point, however, is that supply-side constraints now outweigh those of demand. We will never know whether a greater willingness to use the public sector balance sheet would have avoided that outcome. In the next parliament, however, the fundamental economic necessity is to find policies and programmes able to produce a better-balanced and more dynamic economy. These are the challenges against which the parties' programmes must be measured - and will be found wanting.

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