Howard Davies - The Chancellors

Unsurprisingly, Gordon Brown and Ed Balls, then Chief Economic Adviser in the Treasury, reject the idea that they had left the UK in a vulnerable position. In his memoirs Brown asserts the contrary: ‘We entered the crisis with debt and deficits low by historical standards. There was no profligate pre-crisis spending spree.’ 7But he acknowledges that there were different views in the official Treasury. Nick MacPherson, then Permanent Secretary to the Treasury, ‘considered everyone too soft on the deficit and debt’. From the perspective of 2021, the figures look almost insignificant, but their influence on policy was important, as we can see from the spending policies of the Coalition government.

It is reasonable to conclude that, while all Western governments, central banks and regulators should shoulder a share of the responsibility for the imbalances and financial excesses that led to the GFC, the particular role of the spending and regulatory policies of the Labour government does not feature prominently in considered analyses of its causes. 8So the thirteen years of Labour governments from 1997 to 2010 were a relatively successful period for the British economy, during which its long catch-up phase, closing the GDP gap with comparators, continued at roughly the same pace as in the previous two decades.

The crisis was, however, extremely severe. The economy shrank by more than 6% between the first quarter of 2008 and the second quarter of 2009, and took five years to recover fully. Unemployment, always a lagging indicator, rose from 5% to 8.4% by the end of 2011. The government’s deficit reached 7% of GDP in 2009 and was still 5% in 2010. Real incomes fell sharply in 2009 and did not begin to rise sustainably until 2015. With household, business and financial debt at 420% of GDP, the UK was the most highly indebted developed country in the world.

That was the difficult background against which the Coalition government was formed in May 2010. George Osborne, who had been Shadow Chancellor since David Cameron became leader of the Conservative Party in 2005, was the inevitable choice for 11 Downing Street. The complex negotiations over the leading positions in government led to the appointment of Liberal Democrat MP David Laws as Chief Secretary to the Treasury (CST), soon replaced by Danny Alexander, making him an unusually powerful holder of that post, as one of the ‘Quad’ of key decision-makers in the government.

The economy had, in fact, begun to recover in the first quarter of 2010, though that was barely perceptible to the electorate while unemployment continued to rise, as it did for another year or more. Although the recovery was steady, without a second recession, triggered in other parts of Europe by the Eurozone crisis, there was no post-recession boom as had typically been seen after earlier downturns. The economy returned to growth, but on a lower trajectory than before. The Institute for Fiscal Studies (IFS) estimated that in the summer of 2018 GDP was 11% higher than it had been at the pre-crisis peak in 2007–08, so the economy was 16% smaller and GDP per head was £6,000 lower than they would have been had growth remained on its pre-crisis trend. 9

Surprisingly, employment growth remained strong, and there were 2.7 million more people in work in 2018 than a decade before. So average household incomes were higher than in 2008, and household income inequality had fallen a little. But the worst news was that productivity per hour grew by a mere 0.3% a year compared to a long-term trend of 2% a year. Output per hour worked was 18% below the average for the G7, and the current account deficit in 2015 was at a record high of 5.2%. The IFS summary stated:

The UK economy has broken record after record, and not generally in a good way: record low earnings growth, record public borrowing followed by record cuts in public spending. On the upside employment levels are remarkably high and, in spite of how it may feel, the gap between rich and poor has actually narrowed somewhat, but the gap between old and young has grown and grown. 10

That may seem to be a definitively negative verdict on the Coalition government’s performance. But through an international lens the position looks rather different. The immediate recession hit to the UK economy was large by international standards, reflecting the high relative size of the financial sector. In 2011, growth in UK GDP remained below the average for the other advanced economies. But by the end of 2012 the UK was expanding a little more rapidly than the average, and that remained true until the middle of 2016, except for a brief period in 2015. 11That average was, however, reduced by the impact of the Eurozone crisis of 2010–12.

Economic opinion was divided on the extent to which Osborne could claim any credit for the recovery. Simon Wren-Lewis has argued that the government’s austerity programme unnecessarily cut 1% from the growth rate in 2011 and 2012, while Nicholas Crafts considered that the deficit reduction programme made little difference to the speed of the recovery. 12

The underlying problem, however, which preoccupied economists and policymakers alike, was stagnant productivity. Productivity has flat-lined since 2010, a performance unprecedented since 1860. 13As Paul Krugman of Princeton observed: ‘Productivity isn’t everything, but in the long run it is almost everything. A country’s ability to improve its standard of living … depends almost entirely on its ability to raise its output per worker.’ 14After 2010, productivity growth slowed almost everywhere in the developed world, but it fell more sharply in the UK than elsewhere in the G7, except Italy. In the last decade of the twentieth century German and British productivity growth rates, measured as the change in output per hour worked, were similar, at about 2.5% a year. In the second decade of the twenty-first century German productivity growth was around 1% a year. The UK rate had fallen to just below 0.4%.

Unpicking the causes of this differential is not straightforward, but two other measures are relevant. The UK has invested a lower share of GDP than Germany. Since 2007, UK investment as a share of GDP has consistently been the lowest in the G7. In the EU, only Greece invested less. UK fixed capital formation was a little over 16%, while German investment was over 20%. And the comparisons on R&D expenditure are even less favourable. The UK typically spends about 1.7% of GDP on R&D, compared to 2.8% in Germany. 15

So the second of the three periods, from 2010 to 2016, shows a mixed picture: a slow start, a catch-up to roughly the average growth rate of comparator countries, but underlying weakness in investment and productivity, which suggested continuing sluggish growth, unless performance in those areas picked up.

The third period needs some disaggregation. The Covid-related lockdowns beginning at the end of the first quarter of 2020 confuse the picture. It is too early to say how the economy will recover from a highly unusual health-related government intervention. Also, at the end of 2020 the post-Brexit era began, initially with a very large impact on trade volumes with the EU. Exports to the EU fell by 40% in the first two months of 2021, then stabilized somewhat as firms became more accustomed to the new arrangements.

These immediate post-Brexit trade figures are volatile and may be misleading. But we can assess the period from 2016, when the referendum campaign was announced, to the beginning of the Covid recession. The data strongly suggest that there was a significant change of trend. Up to the referendum, UK GDP growth remained above the average of the other advanced economies, except for a brief period around the end of 2011. Since the referendum, UK growth has been lower than the average. The IFS has constructed a ‘doppelgänger’ of the UK economy, based on a weighted average of the OECD economies that performed most similarly to it up to the end of 2015. The doppelgänger tracks the UK closely, apart from a period during the financial crisis when the UK underperformed. That was not surprising given the UK’s, and especially London’s, exposure to trends in global finance. But, as the IFS says, ‘since 2016 a sustained divergence has opened up between realised GDP and the level implied by the synthetic model’. 16By the end of 2019 the economy was 2.5% smaller than expected had the predicted pre-referendum growth trend continued. The differential is closer to 3% if one takes account of the unexpected increases in global growth since 2016. The doppelgänger grew more rapidly than before. The IFS acknowledges that ‘the estimates from this model cannot provide a perfect indication of what would have happened had the Brexit referendum gone the other way’, but they are strongly suggestive. What can we learn about why this change of trend occurred?