Economic growth is at the heart of the current political debate. And yet growth is a complex aggregate statistic, and few people take the trouble to pick apart what is actually happening to it, as opposed to speculating what in theory might be happening. That has created a vacuum into which think tanks, economic commentators and politicians project their own hobbyhorses without fear of serious challenge. So what really is going on?
The main mistake people make is to assume that the main driver of growth is productivity. This is exemplified by the famous quote from American liberal economist Paul Krugman: ”Productivity isn’t everything, but in the long run it is almost everything.” Cue a furious debate on a “productivity puzzle” or “gap”, especially here in Britain – supported by unreliable productivity measurements. Productivity is such a heterogeneous and hard-to measure phenomenon that measurements depend heavily on assumptions – and it is hard to understand their significance anyway. Prior to the crash, for example, improvements to Britain’s measured productivity depended almost entirely on two narrow sectors: financial services, whose profits proved largely illusory, and “business services” a shadowy sector the real value of whose output is hard to be sure of.
But help is at hand. American economist Dietrich Vollrath decided to pull apart growth figures to settle the debate on why American growth had slowed so much in the 21st Century compared to second half of the 20th – this debate isn’t just a British thing. As it happened, he had his own hobby horse which he was convinced was behind the issue – the growing market power of large companies. Vollrath found that two thirds of the decline in growth rates (1.25% per annum per capita at the time he was doing the work – a very similar figure to the UK) was down to demographics – the proportion of working people to the population as a whole, which has been declining as the dynamics of the baby boom work themselves out. Nearly half of the rest was down to what economists call the “Baumol effect” – named after an economist who pointed out that increases in productivity lead to a shift to economic sectors with lower productivity. As we get more efficient at making mobile phones, for example, we don’t buy more mobile phones – we spend the surplus on things like healthcare or designer clothes instead. Incidentally, he found little evidence that his own hobby horse, market power, had much effect, and none that tax changes and deregulation did – except changes that restricted worker mobility, and especially restrictions to house building. He called the two principal phenomena the problems of success and published his findings in a book: “Fully grown: Why a Stagnant economy is a Sign of Success.” This was rated as one of The Economist magazine’s books of the year for 2020, though its writers have failed to take its findings to heart.
There is no reason to think that Professor Vollrath’s findings do not apply to the UK too, as the same demographic trends are visible here. There are two important lessons for policymakers. The first is, to adapt Krugman: demographics aren’t everything, but they are almost everything. If you want to do something about growth, you need to increase the number of people working. You need working-age immigrants, people to retire later, more stay-at-home parents coming back into the workforce, fewer people absent with chronic health conditions, and so on. To be fair, the government has been nibbling at these things, but not with a conviction that will make much difference. The second lesson is that, while productivity improvement is a good and useful policy objective (usually), don’t expect it to have a big impact on overall growth. Its effects on the economy at large will be diluted by the Baumol effect. But don’t worry! More spending on lower productivity things is a sign of improved wellbeing.
And there is something else: given the demographic headwinds, we should reduce our expectations as to what level of growth is feasible in a developed economy such as ours. An annual rate of 2.5%, as suggested by the government, is out of the question, except as an outlier.
* Matthew is a Lib Dem activist who blogs at thinkingliberal.co uk.
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22 Comments
Matthew, could you describe what economic growth actually is. Does it have something to do with the valuation of a country’s stuff that it produces from people working ? . Or is something to do with how much money gets spent by the final user Is it just something just produced by inflation. It seems to be a Truss economic mantra but does she understand what it is,and is it a desirable thing to have in any case ?
The goal of economic policy should be to maximize the standard of living and foster the conditions for stable economic growth. That goal is achieved by focusing on key objectives such as minimizing unemployment, increasing productivity, controlling inflation, and maintaining the purchasing power of the currency.
The four key economic indicators by which we assess macroeconomic performance are Gross Domestic Product (GDP); inflation; unemployment and interest rates/exchange rate.
Sustained real growth (after discounting the impact of nominal price increases) in GDP is often used as the primary indicator of economic health. GDP growth is normally measured by increased spending across the economy by households buying goods and services from firms; investment by firms in long term assets and increases in inventory; government spending and net exports/imports.
Typically, increased spending means increased consumption. That is probably going to be incompatible with a resource constrained planet and the climate crisis. Technological advances have been the main driver of increased productivity in the past i.e., allowing a greater volume of goods and services to be produced with a lower input of man hours and more efficient use of energy and raw materials. Achieving the kind of economic growth seen in a manufacturing economy in the services sector of an economy appears much more difficult as has been seen with Japan’s stagnation in recent decades. While Macro GDP growth can be achieved with a larger workforce; per capita GDP growth (i.e. standard of living) requires productivity increases.
As Matthew concludes in his article. “An annual [growth] rate of 2.5%, as suggested by the government, is out of the question, except as an outlier”. Macroeconomic policy will need to be conducted in the expectation of a low growth environment and existential climate change crisis.
Thank you Matthew for improving my understanding of the concept of economic growth and how it is measured.
But what is growth ? Can it be measured in merely material terms ?
Can the planet cope with the demand for continued material growth ? Billions of people who now have disposal incomes are demanding (understandably) all manner of electrical goods, cars, luxuries – items that we take for granted. Should climate damage be a negative part of the equation ?
In my experience, improving the quality of life has always been a vital part of the Liberal credo. We should be proud of that, and we should not be shy in expressing it politically.
@Joe Burke – Thanks Joe for a really excellent commentary on what government policy on ‘economic growth’ should be Also thanks to Matthew for bringing up an interesting subject.
“Should climate damage be a negative part of the equation ?”
This seems to me a key issue all too often ignored in this growth debate.
What is the point of my buying things I don’t need? Purely as an example – I don’t need to be replacing my laptop every few months. The one I’m using does what I want perfectly well. I don’t need more of the planet’s non-renewable resources to be devoted to replacing my laptop!
Energy, and the cost (in energy terms) of obtaining it is the limiting growth factor. The industrial revolution powered by coal & steam led to increasing growth over more than a century to 1913. Peak coal in the UK was around that time. Growth from the end of WW2 to around 1970 was driven by the oil boom in the USA, and followed by more muted growth to around 2000. Thatcher, of course benefited hugely from the discovery and use of North Sea Oil – her policies would have failed (as Ms Truss’s will) without it. The financial crash of 2008 was due to politicians trying to maintain growth by effectively printing money. We can probably run an economy on renewables, but I doubt very much whether renewables will run this rather profligate one.
You can see the effect of eliminating probably the last major energy supplier – Russia. If there were plenty other suppliers to pick up the slack, a few “elephant” gas fields like Groningen waiting for exploitation, it might be ok. Ofc, climate change….but fossil fuel demand has been rising 2%pa for a long time, and it needs to start dropping. Renewables so far only seem to be allowing a faster rate of growth in energy supply, rather than cutting fossil fuel demand.
Truss’s assumption that ‘supply side’ reforms consist solely of cutting taxes and having bonfires of regulations is also risible. Low productivity also reflects limits on education and skills in the workforce and in infrastructure (transport, broadband, etc.), as well as insufficient investment in replacing old equipment. Education and infrastructure require public investment, not tax cuts – as we should be saying, loud and clear.
Thanks for the comments. Some quick responses.
Chris: in principal it is a change to the aggregate value of all production in the UK, adjusted for inflation. According to way economists look at these things income, consumption and production should always be the same, when looked at across the whole economy. One person’s consumption is somebody else’s income or production. Looking at a single country in adds a level of complexity. In principle GDP is based on the amount that is produced within the country’s borders, rather than what is consumed, etc. To be fair on truss I expect she does have an idea of what it is – but she and her fellow ideologues have a very libertarian way of thinking about how the country should be run, and growth is a convenient way of explaining it.
Joe. I take issue with your assertion that “per capita GDP growth (i.e. standard of living) requires productivity increases@. All Vollrath’s work is based on per capita figures. What it shoes that the proportion of workforce to total population is more important than productivity in explaining changes in per capita GDP growth in developed economies, at least medium and long term. By about two to one in the US.
Michael. Growth doesn’t have to be explained in terms of the consumption of stuff – human services that we provide to each other count too, and they are becoming much more important. It is based the real value of everything we buy – though what is meant by “real” is a can of worms.
Nonconformistradical: yes climate change should trump everything – it is among many reasons why we should be careful about promoting growth – it must be sustainable. And if it can’t be, we shouldn’t be doing it.
Jenny. Energy is very important to understanding growth – but there has been a strong trend for GDP to become less energy intensive as time goes by, especially in developed economy. The same amount of fuel generates much more income than before. That makes transition to renewables more feasible. Fossil fuel demand has been falling in many economies – but the situation is different in less developed economies.
Matthew,
Volrath’s research makes sense. In an aging society with a greater proportion of non-producing consumers you would expect GDP growth to slow both in aggregate and per capita. While immigration and greater partipation of women in the workforce can help offset some of the impact, it is adoption of advanced technology that has mitigated the severe impacts (at least on a per capita basis) in advanced economies like Japan. China is likely to experience similar effects in the not-too-distant future. In a service dominated economy like the UK it appears more difficult to generate the kind of productivity increases seen when the economy was more focused on manufacturing.
Matthew: “Michael. Growth doesn’t have to be explained in terms of the consumption of stuff – human services that we provide to each other count too, …” Yes, that is what I mean by quality of life.
Correct me if I am wrong, but intangibles, for example social justice or individual acts of kindness, are not included in GDP measurement. Whereas the production of war materials are.
William Wallace 1st Oct ’22 – 10:35am:
Low productivity also reflects limits on education and skills in the workforce and in infrastructure (transport, broadband, etc.), as well as insufficient investment in replacing old equipment.
Indeed. Tax ‘cuts’ (mostly cancelled increases) are only part of the plan…
‘The Growth Plan 2022′:
https://www.gov.uk/government/publications/the-growth-plan-2022-documents
Hi Matthew, thank you very much for a really interesting article.
Michael. “…intangibles, for example social justice or individual acts of kindness, are not included in GDP measurement. Whereas the production of war materials are.” Indeed so. Polluting the environment is not deducted, but cleaning up the mess is. There are many other examples of such nonsenses. GDP is best thought of as the aggregate of stuff you can tax (not counting capital) – and on that basis it is quite useful – especially when you are thinking about how to fund public services and benefits. But aggregate wellbeing it isn’t.
Thanks everyone for an informative post
Matthew: “GDP is best thought of as the aggregate of stuff you can tax (not counting capital) …” Yes, that’s very succinct.
So in your view, should we be thinking about a new measurement/index that takes account of pollution and all these other intangibles ?
Michael – I have always been sceptical about a supplementary measure taking into account environmental degradation, etc. It’s methodology would be contentious and could distract from its purpose. Still I gather the Biden administration is working on something – and that might set a world standard.
The math says GDP will always tend towards zero – patently obvious to anyone with basic mathematical analysis skills.
However, look closer and we see different sectors of the economy behaving differently
; hence we can have growth in some, decline in others, ticking along nicely in others etc.
So yes stagnation of the headline GDP figure, probably is the sign of a stable mature economy.
I think from the budget, we can see that to Truss et al, the economy and growth is all about finance and home construction/property. I.e. traditional Conservative service sectors.
> An annual rate of 2.5%, as suggested by the government
Looking ahead, this is obviously a government scared of looking the doing decades in the face – the economy is going to nose dive, we can either plan and manage it or just let it happen…
“in principal (growth) it is a change to the aggregate value of all production in the UK, adjusted for inflation. According to way economists look at these things income, consumption and production should always be the same, when looked at across the whole economy.”
The other challenge is that it is very difficult to apply this definition to the modern world where frequently the productive process is spread across different virtual teams which work across the globe. For example I was once responsible for designing and developing a product where my team was spread across the UK, Croatia and India – any attempt to objectively split the value added across the different team members working in different countries (necessary to apportion national GDP figures) would have been purely arbitrary.
As far as I can tell (but happy to be corrected) it is not possible to produce an accurate assessment of GDP for any country for this reason (in addition to the arguments that GDP isn’t a good measure of useful growth anyway).
“An annual rate of 2.5%, as suggested by the government,”…would lead to doubling the economy every 28 years. So even if we use less energy per unit of GDP, by 2050 we would need to nearly double our energy consumption. Some 70% of our energy consumption is fossil, half the rest is nuclear. https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1032260/UK_Energy_in_Brief_2021.pdf
I remember a LibDem conference in Brighton – quite a while ago now- where one of the main hall sessions asked everyone to put their hands up to commit to a 10% reduction in energy use over the next year. I know how difficult that kind of reduction would be, so didn’t – but nearly everyone else did. I wonder how you all got on!
Matthew Green 2nd Oct ’22 – 11:20am: “a supplementary measure taking into account environmental degradation, …” Sure, it would be difficult and to a very large extent somewhat arbitrary – but it is needed.
At the very least the GDP figures ought to come with a ‘health warning’.
If indeed the Biden administration is working on something, then that is encouraging.
The ONS does actually attempt to measure wellbeing Measuring national well-being in the UK
“In February 2019, we introduced a new series on “people and prosperity” as part of our “Beyond GDP” initiative bringing together personal and economic well-being for the first time. In measuring economic growth, we want to know the extent to which it benefits different groups in society.”
As Matthew Writes in his article “given the demographic headwinds, we should reduce our expectations as to what level of growth is feasible in a developed economy such as ours.” That does not mean however that innovation and technological development (the drivers of productivity) are not an important factor in maintaining and growing GDP per capita, even if aggregate GDP is stagnant as a consequence of an aging population. Technological development is likely to be the key to transitioning to renewable energy sources and both artificial intelligence and robotics are increasingly integrated into the services sector (particularly important in those economic sectors with lower productivity).
Japan is a good case study of the impact of an aging population on aggregate GDP growth as this FT article notes How Japan’s ageing population is shrinking GDP
While aggregate GDP has been stagnant for some time, GDP per person of working age has grown in line with other G7 economies. As the dependency ratio (age-population ratio of those typically not in the labor force) rises there will surely be a need to focus on Total Factor Productivity improvements to maintain the standard of living (both quantitatively and qualitatively) of the population as a whole.
Changes due to demographics are one thing, those due to productivity (whether per worker or per working age person) are surely another. They have different causes and create different challenges so why fold them together?
That said, I do believe the UK has a monster productivity problem with several roots.
The first is that not everything economists measure as ‘value’ is, in fact, valuable. For instance, much banking activity is ‘extractive’, that is its overall cost to the economy is greater than its benefit (but it does make a handful very, very rich).
In a 2010 paper Andy Haldane, then Executive Director, Financial Stability at the BoE, compared the result to car pollution and found the effect to be HUGE.
https://www.bis.org/review/r100406d.pdf
Also, the City works as the mothership for a flotilla of offshore tax havens/secrecy jurisdictions enabling tax evasion on an epic scale so the rest of us have to pay more tax. What’s the real value of that?
Separately, there is the education and training dimension. I recently spoke to a friend who runs a smallish business (circa 25 people) involving a lot of technical skills. Three years ago, he employed a graduate with 1st class honours in a highly relevant technical discipline from a local university. Oh dear! It turns out he can only do simple tasks and was kept on only because the firm also needed a dogsbody. Grade inflation rules!
So, what’s the ‘productivity’ of education? How much real value per pound spent are we getting?