On the eve of the crisis, the growth performance of the United Kingdom economy was generally seen as quite satisfactory (Van Reenen, 2013). A long period of relative economic decline vis-à-vis other European economies seemed to have come to an end under the auspices of the supply-side policies initiated under the Thatcher government, and continued in most respects by New Labour. Subsequent developments during the financial crisis and its aftermath have come as a rude shock. Labour productivity growth over the period 2007–2016 was just 0.09 per cent per year and growth of real GDP per person was only 0.19 per cent per year, in each case at least 2 percentage points below the rates achieved in 1995–2007 (cf. Table 6.2).
In the context of an optimistic account of late twentieth century British economic growth, the early twenty-first century productivity slowdown raises several related questions. Was pre-2007 growth performance unsustainable? Is slow growth post-2007 mainly a result of the financial crisis?
Does the very fact of the crisis imply that seemingly decent growth was actually a ‘mirage’?
The Office for Budget Responsibility believes that the trend rate of labour productivity growth continues to be 2.2 per cent per year, i.e., more or less what was achieved pre-crisis. A less- optimistic interpretation might be that the average productivity growth rate of 2.1 per cent per year over the period 1995–2007 was a bit above the medium-term trend rate at the end of the period.
Nevertheless, there is every reason to think that growth of output per hour worked around 1.5 to 1.75 per cent per year was sustainable – enough to keep pace with the major European economies and way ahead of the actual rate since 2007.
When Labour won a landslide victory in the 1997 election, it was possible to wonder whether in government it would revert to ‘Old Labour’ policies. The answer soon became apparent and was a resounding ‘No’. 1970s-style policy was conspicuous by its absence: there was no nationalization programme, no move to subsidize manufacturing investment, no counterpart of the National Enterprise Board, no return to high marginal rates of direct tax, no attempt to resist de-industrialization by supporting declining industries and no major reversal of industrial relations reform. Implicitly, the Thatcher supply-side reforms had been accepted. The changes that Labour made were to strengthen some aspects of horizontal industrial policies with a new emphasis on education, R & D, investing in public capital and strengthening competition policy. There was a strong element of continuity in supply-side policy in terms of strengths (competition, regulation), weaknesses (innovation, infrastructure) and areas where further improvement was desirable (education, tax system). There is no reason to think growth was being undermined by policy errors.
The economy probably had a small positive output gap in 2007 but not big enough seriously to distort perceptions of pre-crisis performance.8 It can fairly be pointed out that a more heavily regulated and somewhat smaller financial services sector may well contribute less to productivity growth in future than in the pre-crisis years but, it is not correct to see its pre-crisis contribution as a mirage.9 It is also apparent that productivity growth weakened somewhat after 2003 to a pre-crisis average of about 1.7 per cent per year compared with 2.6 per cent per year in the previous five years.
It is well-known that financial crises can have permanent adverse direct effects on the level of potential output. Thinking in terms of a production function or growth accounting, there may be direct adverse effects on capital inputs as investment is interrupted, on human capital if skills are lost, on
labour inputs through increases in equilibrium unemployment and on TFP if R & D is cut back or if innovative firms cannot get finance. The transition period while the levels effect materializes and during which growth rates are depressed may be quite long. Moreover, recovery is often slow;
Reinhart and Rogoff (2014) estimated that the median length of time before real GDP per person returns to its pre-crisis level is 6.5 years.
This could imply that recent labour productivity performance basically reflects a large levels effect resulting from the financial crisis but does not imply that long-term trend growth has been reduced, in which case log labour productivity would maintain a trend path parallel to what would have been expected in 2007.10 Oulton and Sebastia-Barrel (2017) found a long-run impact on the level of labour productivity of 1.1 per cent per year that the crisis lasts. There is good reason to think that the crisis also had significant temporary effects on productivity performance which may not yet have completely evaporated. Exit of low productivity firms has been slowed down by a period of exceptionally low interest rates.11 Misallocation of labour appears to have been a key issue as new hires and employment growth have been disproportionately concentrated in low productivity sectors with an impact estimated to account for as much as two-thirds of the shortfall in labour productivity compared with a pre-crisis projection (Patterson et al., 2016).
Banking crises reflect market failures in the banking sector combined with a failure of regulation to address them effectively. The problems arise from moral hazard and coordination failures in a context of asymmetric information. The typical pre-crisis symptom is rapid expansion of credit coupled with excessive risk-taking. The likelihood of bank failures increases as leverage goes up and the ratio of equity capital to assets falls. Banking crises happen even in economies with very strong growth fundamentals if banks are badly regulated and under-capitalized. The classic example is the United States where about a third of all banks failed in the years 1929–1933 but nevertheless, as was noted in Chapter 4, TFP growth in the 1930s was impressive.
The financial crisis of 2007–2008 in the United Kingdom matches this familiar pattern.
Regulation was deficient and leverage soared following the deregulation of the 1980s with the median ratio of total assets to shareholder claims increasing from around 20 in the 1970s to almost 50 at the pre-crisis peak (ICB, 2011). In effect, there was a huge implicit subsidy to risk-taking by banks that were too big to fail and were allowed to operate with inadequate equity capital. This was a major failure of the policy reforms undertaken in the 1980s. That said, it should not be inferred that pre-crisis growth was predicated on unsound finance even though the cost of capital would have been higher with resilient bank balance sheets. Miles et al. (2013) offer an illustrative calculation which
suggests that the lower capital intensity entailed by the introduction of appropriate capital-adequacy regulation would have reduced the level of GDP by about 0.2 per cent.
In sum, the financial crisis does not imply that pre-crisis growth was somehow illusory. The crisis was a result of inadequate financial regulation rather than weak productivity performance. The shock of the near collapse of the banking system has led to a ‘lost decade’ in terms of economic growth but it is too soon to tell what its implications for future long-term trend growth will be.