‘UK economy growing at fastest rate since 2007’ is the BBC headline this morning, following the release of the latest GDP figures showing 0.7% growth in the fourth quarter of 2013, bringing the annual growth rate to 1.9%.

Last night, Lib Dem business secretary Vince Cable delivered a major speech to the Royal Economic Society assessing the current state of the economy – and in particular how the current growth figures can be sustained in the long-term. There will be lots of glib sound-bites today from politicians and pundits trying to make the facts fit their outlook. As ever, Vince’s contribution to the debate looks beyond this simplistic knockabout to ask the searching questions and suggest some answers…

There has been a positive change in economic sentiment over the last six months or so. A real recovery is taking place. The big question now is whether and how recent growth and optimism can be translated into long term sustainable, balanced, recovery without repeating the mistakes of the past. We cannot risk another property-linked boom-bust cycle which has done so much damage before, notably in the financial crash in 2008. I am confident that with the policies I and my colleagues are putting in place, we can succeed.

The immediate outlook is very encouraging. On the eve of the next set of GDP statistics, the economy has grown over three quarters, following stagnation in 2012, and is plausibly predicted to have grown by 1.6% over 2013 as a whole. The current annualised rate is over 3%, more than the US. Manufacturing and even the battered construction sector have recorded two quarters of growth. Indications of consumer and business confidence are almost uniformly positive – the best since before the 2008 financial crash. Unemployment has been falling for the last two years to 7.1% (from a peak of 8.4%) and 1.3 million more people are in employment compared to the trough of the recession in 2010. The number in work, close to just over 30 million, is the largest ever. The jobs story is a striking one, in contrast to a comparable period, between the wars, when unemployment reached 20%.

The immediate reason for this improvement is a revival of demand, led by consumer spending. Despite a fall in real earnings, consumers have had the confidence to start spending again – dipping into their savings held for a rainy day and making use of rising house prices, at least in London and the South East, to borrow more easily. Improved jobs prospects have also probably helped demand. And the strong growth in company start ups suggests that there is a strong, positive entrepreneurial spirit.

However, despite these encouraging signs, the shape of the recovery has not been all we might have hoped for. Exports are still too weak and the trade balance has deteriorated as import demand has outstripped export demand, leaving a current account deficit of 4% of GDP. Too many businesses – which often have healthy balance sheets – are sitting on their cash and not investing it. And while the OBR has upgraded forecasts of household spending, it has downgraded its business investment predictions. Perhaps related to this, productivity per hour worked has fallen 2% since 2008, while it has risen 7% in the USA. And there are big variations across the UK, with recovery (and housing inflation) most marked in London and the South East.

So, like the Chancellor, my message is that recovery is welcome, but much hard work remains. My particular focus is how we progress from a short term bounce back to sustainable, balanced, long term recovery.

Money and demand

Getting the economy moving requires higher demand. Contrary to the charge against the Coalition, government policy has been significant in supporting demand. Immediately following the economic ‘heart attack’ we suffered in 2008 the economy was put on life support in the form of ultra-loose monetary policy – near zero interest rates and quantitative easing – where it has remained.

There has been an academic debate as to whether, as some ‘Keynesians’ have argued, monetary policy is largely ineffectual, or as I and also the Chancellor have repeatedly argued, it will work now, as it did in the UK in the 1930s. Indeed, Keynes himself attached considerable importance to low interest rates, while recognising that there was a limit to their impact. The exact determinants of how our current, unorthodox, use of aggressive monetary policy actually work are imperfectly understood – and there are certainly negative side effects, notably on asset inflation – but monetary policy at least has succeeded in its objective of avoiding a collapse in spending.

The great efforts made in the monetary sphere do not imply that financial policy has been without blemish. One of the disappointments of the last few years has been the credit famine for smaller companies. There are now a lot of interesting innovations in the market place, offering alternatives to the big four banks, like peer-to-peer lending. The Business Bank, which I set up last September, is now supporting new providers. Funding for Lending has also been refocused to reduce the high cost of credit for SMEs. But small business lending remains the point at which the broken banking system has done the most serious damage to money transmission.

Fiscal policy has been constrained by the government’s determination to manage down a large structural (current) deficit arising from the collapse of revenue in the wake of the banking crisis. My party and I have fully supported that policy which is now roughly half completed. I believe that the Opposition has now subscribes to it .

But the Government (contrary to the popular political narrative) has also used counter-cyclical stabilisers to offset the downturn in 2011 and 2012. Some of our critics accuse us of ignoring the lessons of Keynes – of having a naïve and simplistic aversion to the use of public debt to support the economy. They could not be more wrong.

Consider this. In the first Coalition Budget, we anticipated borrowing £37bn in 2014/15; down from the £150bn we were borrowing in 2010. In the next two years, we were hit by a slowdown, such that the taxes that the OBR predicted for 2015 fell by £60bn. The government’s reaction was to increase expected borrowing for 2014/15. In the latest Autumn Statement, we now expect it to be £84bn, or £47bn more than before.

This is not the policy of a government fundamentally allergic to borrowing. Keynes would have said: let borrowing take the strain when a weak economy causes your finances to deteriorate. That is what we have done.

There is however an emerging debate over the scale of spending cuts in the next Parliamentary term. Undoubtedly some on the Conservative side of the Coalition see fiscal consolidation as a cover for an ideologically driven, ‘small state’ agenda. Indeed, it is one thing to respond to a record deficit after a long period of rising public spending, as we have since 2010. It is quite another to continue cutting hard from a position where the debt burden is falling and when spending has been under pressure for half a decade.

Some of the proposals to extend deep spending cuts on departments and welfare far into the next parliament have more than a whiff of ideology: slashing for its own sake. There is no reason why an exact pathway of fiscal consolidation should be concluded this early after the current structural deficit has been eliminated. We currently expect debt to be on a downward trajectory as a share of GDP from the beginning of the next Parliament – an achievement for which the Coalition should take considerable credit. But the subsequent path of borrowing is a matter for political debate. And even if there was agreement on the pace of fixed consolidation there is still the question of the mix of fiscal measures between higher taxes and spending cuts.

There is a fiscal rule which requires the current structural deficit to be eliminated over a five-year time horizon, which currently means by 2017/18. That is in line with the original Alistair Darling plan. My party and I believe in finishing the job we started – eliminating the current structural deficit which we inherited from the financial crisis and the last government. However, there are different ways of finishing the job – the totals set out in the OBR do not reflect anything concrete as yet. Not all require the pace and scale of cuts set out by the Chancellor. And they could allow public spending to stabilise or grow in the next parliament, whilst still getting the debt burden down.

The Chancellor by contrast appears to choose cuts of an additional £30bn over and above those needed to run a structural surplus on the current account of the budget. It is a case which he is perfectly entitled to make in a party capacity; but let us all be quite clear that this is a political and ideological commitment. All parties have a duty to continue to get national debt under control after we have eradicated the current structural deficit, but the Chancellor’s plan is not the only one. The Liberal Democrats will reduce the debt burden but ensure this isn’t done at the expense of public services and the most vulnerable in society.

The challenges

The recovery is real. But can it last? The current consensus is that GDP growth will accelerate from 1.7% this year to 2.6% in 2014 and 2.4% in 2015 – restoring trend growth. It is certainly possible to envisage a virtuous circle in which confidence grows, growth accelerates and increasingly secure banks with stronger balance sheets lend more to business, including small and medium enterprises. Productivity, real wages and employment all rise together.

Recovery has, for the moment, silenced those who have argued that there is little or no spare capacity; and that aggressive monetary policy will fuel inflation. Consumer inflation is actually falling as output increases.

Recovery has also silenced those who thought that it required business to be relieved of restraints on firing workers. On the contrary, what does seem clear is that fear of unemployment and job insecurity is a key factor in consumer confidence. Britain’s already very flexible labour markets have helped to keep employment high and so reassure people about their job security. They are an area of competitive advantage for us. A move to a ‘hire and fire’ culture, as some have advocated, would almost certainly aggravate the immediate problem by engendering fear. That is one of many reasons why I have resisted moves in that direction.

However, a major challenge, looking forward, is how consumer demand growth can be sustained in the face of weak real earnings. Earnings growth is currently 1.0% per annum – well below inflation – and real earnings have fallen 6 to 7% since the financial crisis in 2008. The Institute for Fiscal Studies has concluded that the fall in household incomes has been less, though it also predicts that there may well be a further fall in real earnings this year and next. Faster recovery and lower inflation brought about by sensible macroeconomic policies will change things favourably, and I’m keen to see this reflected in the current debate over the cost of living. However, a sustained growth in earnings will not happen without increased productivity, which is falling at present.

In the short run, there are two plausible ways of mitigating weak consumer demand. One is to continue offsetting falling pay with increases in disposable incomes through lower income tax. My party’s policy of raising the income tax threshold is central to this approach – and it has had a positive impact for the majority of people in work. For example, 60% of individuals working on the minimum wage have seen their take-home pay increase in real terms since 2007. As a result, the IFS has concluded that, since 2007, household income inequality has actually fallen. There is still more we can do. If further income tax cuts are to be revenue neutral, they can be offset by taxes – like the ‘mansion tax’ – on wealthy individuals, who have a lower propensity to consume. Such a shift would not only be fair but could be economically desirable and support growth.

A second approach is to assist those below the tax threshold who cannot easily be helped through targeted tax credits and benefits, because of wider public spending restraints. One step to help low earners in work could be to increase in the minimum wage faster than inflation, provided that it is not so big and sudden as to create substantial job losses. I have encouraged the independent Low Pay Commission to look at this possibility when framing their forthcoming recommendations on the minimum wage and there is now a wider political consensus that this should happen.

As the recovery gathers strength conventional macroeconomic policy would be to tighten monetary policy. That would be the correct response to a healthy recovery. The timing would depend on the ‘output gap’ before capacity is utilised and increased demand produces inflation rather than output. The official output gap is around 2% of GDP but estimates vary greatly mainly because of difficulty in assessing underemployment rather than unemployment.

There is so much distortion in the economy that a return to normal interest rates would be a welcome development. But in current circumstances rising interest rates (or merely the prospect of them) could derail the recovery. Confidence could be hit by a wave of companies or households who are just maintaining debt service at low interest rates facing insolvency or repossession. And the exchange rate might appreciate, discouraging exports and import-competing industries. But these are not conventional times; we are living with the long-term fallout from a major banking crisis. The Governor of the Bank of England has indicated that he favours a postponement of monetary tightening; so this risk is mitigated, at least for the immediate future.

If the recovery is to be sustained it will need to be balanced, geographically and sectorally, to correct the bias against traded activities and against investment – and to ensure we do not return to boom-bust cycles around property markets. A unifying theme is the industrial strategy which provides a long-term framework for investment and growth. Indeed, unless our government put long term rebalancing at the heart of economic decision-making I believe the recovery will prove short-lived.

Exports

The top priority is exports and import-competing industries. After years of underperformance, we are finally hearing some encouraging anecdotes of improved performance by exporters in emerging markets like China and Russia. And there are positive signs of the supply chains of manufacturing and service companies coming back to the UK. Yet one disappointing feature of the five years since the financial crisis is that a large devaluation – of around 25% in trade-weighted terms – has seemingly done little to improve our trade position. Exports have only grown by around 3% in real terms since 2008. And there is a current account deficit of 4% of GDP in the year to quarter 3.

One explanation is that Eurozone weakness has severely affected half of our exports linked to that market. That problem continues with the risk, now, of prolonged deflationary stagnation there.

Another factor is that British tradable activities may have become less price sensitive, both for good reasons (a move into upmarket, luxury goods and specialised, niche services) and bad (the hollowing out of domestic supply chains in the long period of de-industrialisation and, subsequently, during the financial crisis). And, a related point, there are some deep-rooted supply issues, notably the availability of credit and skills, and the task of rebuilding UK supply chains which the industrial strategy is designed to address. That said, all parts of government have now ‘got’ the importance of exports and from the PM down, there is an impressive drive to boot sales in growing emerging markets. That must continue alongside a focus on productivity and investment which is what drives long-term trade competitiveness.

Investment

One of the key features of recovery in a better balanced economy would be an emphasis on private and public investment over consumption. Investment is a key driver of productivity growth and of innovation. But Britain went into the financial crisis with a relatively low business investment rate (8.7% of GDP) and low business R&D rate (1.1% of GDP). Business investment collapsed by 20% following the 2008/9 recession, without recovering since. Despite the cost of capital being at historic low – large companies can borrow at close to zero real interest rates in capital markets – investment growth hasn’t yet happened. Companies have been choosing to rebuild balance sheets, distribute profits to shareholders or invest overseas.

The position is necessarily complex: there have been similar trends in other developed countries; and there are some sectors such as cars where substantial investment is taking place. Also, Britain continues to remain a popular destination for foreign investors. Flows of inward investment in the first half of the year were greater than in any other country except China, according to the OECD. It is still attractive to invest in Britain.

One obvious, and comforting, explanation for the disappointing investment overall, is that there is a time lag between recovery of demand and production, and more investment. Companies will use up existing spare capacity until they are confident more will be needed.

Often the easiest course is to sweat the current assets rather than invest in new capacity.

Another explanation could be that the availability of flexible, low-cost labour has reduced the incentive to automate. For small and medium sized companies, the risks and difficulties of getting access to finance from the banks and lack of access to equity is also an issue. The British Business Bank is a crucial step towards improving access to finance.

But a deeper problem appears to be that, even in a clearly recovering economy boasting an internationally competitive business tax regime, the overall risk–reward factors influencing investment are challenging. Political uncertainty does not help. While the Coalition has ensured stability within a fixed term parliament the prospect of a referendum and possible exit from the EU is deeply unsettling for businesses trading in the European Single Market, from the car industry to financial services. The actual risks of leaving may be small but one of the most useful contributions to recovery our coalition partners could make, in the national interest, would be to do more to remove this unnecessary risk.

If the Conservatives are creating unnecessary business uncertainty around our future in Europe, Labour are doing so in relation to regulated industries which require stability and inducement to invest. The proposal to freeze energy prices – regardless of prices in wholesale markets – is a recipe for killing investment. At the same time, our reforms in regulatory appeals are now being brought forward in the telecoms sector where there has been too much disruptive litigation. And, after a damaging hiatus, the new regulatory framework in the wholesale electricity market is being implemented.

A further approach is to de-risk private investment by using public sector investment alongside it: ‘crowding in’ rather than ‘crowding out’. That is the aim of the Regional Growth Fund which is expected to generate just under £15 billion of private investment commitments on the back of government funding of £2.6 billion which is, moreover, concentrated in the North of England, where the recovery and investment have been relatively weak.

A parallel initiative is the Green Investment Bank which aims to generate around £15 billion of “green” investment on the back of £3 billion of government capital and has so far committed around 30% of its capital. And one very successful feature of the Industrial Strategy is the 50:50 public-private funding of investment in new technologies in the car, aerospace and agri-business sectors.

Another technique for de-risking private investment is government guarantees. Some progress is being made in negotiating the £40 billion of government guarantees for infrastructure and the £10 billion committed to housing associations.

And of course the public sector can invest directly. The concern here has been the risk of large scale government borrowing – even for productive capital investment – undermining the Government’s own credit worthiness, pushing up long-term interest rates and thereby “crowding out” private investment. We are not in that world at present. The need for more public investment to trigger an economic recovery in the short run has been overtaken by events, but the argument for using the current glut of savings to support investment with or through the public sector is a strong one.

There is one crucial respect in which public investment must be supported if growth is to be sustained. Training and innovation are major contributions to long-term economic growth as shown in a recent major study by LSE economists (they estimate that half of growth can be explained in this way). This government has created a strong architecture for training and innovation: the first through apprenticeships and HE reform; the latter through a big increase in investments in the Technology Strategy Board, including the Catapult system and through protecting science spending. The architecture only creates strong foundations, though, with a commitment of public funding alongside private. The current system of protecting large areas of public spending for political reasons and concentrating cuts on around 20% of the total seriously undermines a strategic commitment to economically productive spending.

The Property Boom and Bust

One of the most serious threats to sustained recovery derives from a continuation of the boom-bust cycle in property prices.

After the financial crisis the construction industry suffered a quadruple whammy – with bubbles burst in residential and commercial property, an end to bank financed PFI and government capital cuts costing 420,000 jobs.

There has been a revival of activity, and prices. In the last year the ONS index (November-November) of house prices rose 5.4% – but 11.6% in London. Inflation in house prices is clearly accelerating, as up-to-date indices and forward-looking surveys show. Property is attracting not just homeowners but international investors in pursuit of yield.

House price increases provide short-term comfort. They increase the wealth of owner occupiers (and the net wealth of mortgage borrowers), which revives consumer confidence. They give an incentive to developers by increasing the margin on their sales. And they boost the value of property collateral underpinning banks’ willingness to lend to business customers. There are parallel signs of strengthening in commercial property prices and the rental market for residential and commercial use.

But the spurt in prices is also a symptom of a deeper malaise and a warning of potential threats to stability.

The malaise is a chronic imbalance between supply and demand. Housing starts were running at around 125,000 in 2012/13. The current quarterly figures are 3%, up on last year but still 47% below the 2007 peak. The Government’s own estimates of demand, albeit largely based on latent demographic pressures, suggest that a figure of around 240,000 a year is necessary to maintain a long term equilibrium in the market – far, far beyond what is currently seen as plausible.

As a consequence, average house prices in 2012 were 4.3 times greater than the average income of borrowers – compared to 2.9 times greater in 1997, and during the 1970s and 1980s. (There are of course difficulties in measuring ‘average’ prices and considerable regional variations, but most surveys suggest a similar trend.)

Since prudent lenders will not lend more than three times income, and demand a cash deposit of 10% or more, the effect of the price trends is to confine first-time purchases to those in upper income groups and/or those with inherited or accumulated wealth. Attempts to buck the trend of un-affordability so as to help low earners by permitting higher loan to value – as with the infamous 125% Northern Rock mortgages – or higher income multiples, risks plunging families, or their lenders, or both, into dangerous financial instability. A third of mortgage debt is now held by households who have borrowed more than four times their income. The US subprime mortgage crisis and its British equivalent were built on the shaky foundations of encouraging mass home purchase in inflating markets and we know where that led. It must not happen again.

One way out of the dilemma would be a massive and rapid increase in house construction. There is a happy precedent in the 1930s, when house building shot up from 130,000 in 1931 to 300,000 in 1934. However, these were much more permissive days with minimal planning controls, no green belts, modest building standards and a larger pool of unemployed labour.

Our Coalition has sought to ease some of the planning restrictions. The Industrial Strategy is seeking to address supply constraints around skills and low-productivity practices. And attempts are being made to boost the contribution of the social housing and private rental sectors. It would be fanciful to expect a re-run of the 1930s in terms of private housing but there is no reason why social housing should not be increasing greatly in scale if (necessarily limited) government subsidy is matched by guarantees for housing associations.

Unlike in the rest of the economy, where the problem is insufficient demand, the challenge for the Bank of England is to manage mortgage demand for housing so as not to run ahead of supply. Unlike in the build up to the 2008 crisis there is now an awareness of the risks: banks are better capitalised and the Bank of England (through the FPC) has the tools to manage down mortgage demand by curbing guarantees and restricting mortgage availability. The joint decision with the Bank to withdraw mortgage lending from the Funding for Lending scheme was a sign of this problem being recognised and attention has now switched to the best way of managing the next phase of Help to Buy.

But I fear that the problem is more than technical: it is a deep seated, almost ideological, attachment to property not just in a perfectly understandable wish by families to own their own home but as a speculative asset and as the main source of collateral for borrowing. It leads to the belief that rising house prices are a sign of prosperity when, in fact, they represent a neglect of enterprise and a diversion from productive activity.

Conclusion

This year’s sudden economic revival is greatly encouraging and reflects the success of aggressive monetary policy as a response to recession and the use of counter-cyclical fiscal policy to the extent that the Government’s critics have yet to acknowledge. This recovery is, to use the language of wartime, the end of the beginning rather than the beginning of the end of our economic problem.

I have identified four major areas of policy action required to make the recovery balanced and sustainable: boosting the disposable income of low and middle earners; stimulating business investment (with the help of public investment); taking action, including through the industrial strategy, to tackle bottlenecks in skills, business finance, exports and UK supply chains; and building lots of new homes. The Coalition government has put the key elements in place but it will require a commitment well beyond the current political cycle to deliver the results and achieve a recovery that lasts. This must be the coalition government’s real legacy.