John McLaren: Which way to growth?

ONLY bold strokes will free us from the economic mire we’re in.

While the world is, rightly, concentrating on how to restart economic growth, there is another question that needs to be considered – how much growth can we expect to generate in the future?

It is clear that the depth of this recession far exceeds that of any of the preceding downturns back to the 1970s. In fact, prior to 2009 (when output fell by 4 per cent), at no time, back to 1970, did the Organisation for Economic Co-operation and Development (OECD) area suffer an annual fall in output.

This gives some clue as to why the current Great Recession has proved so difficult to recover from. It is both deeper and more widespread than before. Only those OECD countries with close trading links and/or control of sought-after raw commodities, like Australia, have managed to avoid recession. Most “advanced economies” lack such strong links with the faster-growing BRICS (Brazil, Russia, India and China) and other “emerging market economies”.

However, there is another aspect of advanced economies’ growth that poses difficult questions with regards to whether we might reasonably expect a return to historical growth rates. This relates to the general slowing of economic growth over recent decades in the OECD.

This slowing is seen for the OECD as a whole, but is even more pronounced in many EU economies, including: Belgium, Finland, France, Germany, Italy, Portugal and Spain.

Such a finding had been highlighted in research by the OECD itself. In 2003, the OECD said that “For the OECD area as a whole, cyclically adjusted GDP growth was, on average, lower in the 1990s compared with previous decades, continuing the well-documented long-run slowdown in growth rates.”

This slowing down of growth would appear to have continued, indeed, worsened, in the 00s.

Whereas most governments are seeking ways of returning to historical average growth rates, it may be that such a rate is no longer relevant. How can we seek to improve prospects?

The sources of growth can generally be taken to be: hours worked, in terms of both the average hours per worker and the proportion of the population working; capital deepening; an improvement in labour quality; or a factor known as total factor productivity (TFP), the organic “extra” output that is generated by the way that a particular set level of skills and capital are combined.

Unfortunately, we do not have the same level of information available for these elements of growth over time as we do for growth as a whole, so it is difficult to be precise in explaining the sources for the general slowdown. However, we can look at each of these elements to try and understand how to better promote growth.

With regards to productivity, due to public sector investment constraints, future capital deepening is more likely to involve the private sector, or joint public-private (P-P) sector ventures. This extended degree of P-P collaboration will be a test for the willingness and creativity of OECD governments in making such alliances work effectively and efficiently.

Opportunities arise from the expansion of capacity in export activities that are geared towards the rapidly expanding middle classes in emerging market economies such as China and South America, although this will be challenging for the UK and Scotland as more OECD countries begin to target these high-growth economies.

On labour quality, the improvement of schooling and expansion of higher education experienced over the past 40 years may not be realisable again, or at least to the same degree, in future years.

Nevertheless, research shows that opportunities exist in the UK and Scotland on the schooling side in terms of reducing variation in standards – as seen in OECD national Programme for International Student Assessment reports – and in terms of improving vocational/further education outcomes, for example in our position in relation to Germany.

The biggest gains from IT may have already been taken up, but more and better use of IT in Europe, in particular catching up with the US’s use of IT in market activities, seems realisable.

Better use also, or greater uptake, of IT in public services seems possible, in order to reverse the nil, or even negative, TFP that has been found in this sector over recent decades.

Other, non-IT related, areas of consideration, include: planning rules, competition and regulation, and the potential for a greater degree of international marketisation of public services like healthcare and tertiary education.

Recent policy changes, such as raising the retirement age, for example in the UK, in line with rises in (healthy) life expectancy, should improve growth via more hours worked. However, to some extent this increase in hours will be partially offset by the worsening demographics, whereby more of the population falls outside the statutory working age limit.

Lower unemployment and reductions in other forms of non-economic participation, such as long-term sickness, will also be needed. This could involve a raft of potential policy areas, including some relating to labour quality mentioned above, as well as greater income related incentives.

Clearly these are issues that have been around for some time and in relation to which past policy responses may have been inadequate or unworkable. For this reason, current policymakers need to better understand and address the growth challenges and not simply rely on variations of old policy measures.

If all this seems challenging enough, to make matters worse there is a further factor which makes policy decisions on growth much more difficult at present. This relates to the debt overhangs that affect many OECD countries.

The latest research by Reinhart, Reinhart & Rogoff has highlighted the long-run damage that this can have on economic growth rates. They find that countries with a public debt overhang (defined as an episode where the gross public debt/GDP ratio exceeds levels 90 per cent for five years or more) have lower annual growth rates, by more than 1 per cent a year, for more than 20 years, “implying a massive cumulative output loss”. They also find that such growth effects are significant even when debtor countries have access to capital markets at relatively low real interest rates.

Known debt positions suggest that a number of countries currently fall in, or very near to, this category. As well as the “usual suspects” – Belgium, Iceland, Greece, Japan, Italy, Ireland, Portugal – other countries that may similarly suffer include the UK and the US.

This finding highlights the key dilemma facing governments at present: just how quickly, and by how much, debt levels need to be reduced in the coming years. In other words, does lowering debt now improve the chances of medium-to-long-term growth or would continued fiscal stimulus be more successful?

While many academic economists are in favour of more stimulus for the economy, some are not and many non-academic economists worry more about rising debt levels. Unfortunately as we are in largely unknown territory on this, so it is difficult to judge who is likely to be right.

However, if we get this rebalancing wrong then the next generation may be saddled with not only the debts of their parents, but also a slow-growth future.

None of this detracts from the need, in both the UK and in Scotland, to urgently begin to overhaul the basic building blocks of growth with regards to labour skills, capital and infrastructure needs and innovation and export opportunities.

• John McLaren is and independent economist researcher, affiliated to the Centre for Public Policy for Regions at the University of Glasgow.

A full version of this analysis can be found in the latest edition of the Fraser of Allander Quarterly Bulletin