HC 1691 TreasuryWritten evidence submitted by Dr Andrew Lilico, Europe Economics

Introduction

1.1 This document is offered to the Treasury Select Committee to assist in explaining my views on the sustainable growth rate (the rate of growth of potential output) of the UK economy. It explains:

(a)how I think about and model the sustainable growth rate of the economy;

(b)why I believe the sustainable growth rate of the economy is currently low—around 1.1%; and

(c)why, by around the end of the current Parliament, the sustainable growth rate might rise. Note carefully: on this point I shall not argue the economy should be expected to improve over the next five years; rather, it will be that within the next five years the medium-term outlook will improve (in particular, for the average growth rate over the 10 to 20 years from the start of the next Parliament).

1.2 Aside from Paragraphs 3.2–3.4, the material in this report was prepared in late September 2011, and the data presented here are based on market data to that time, and the references to “the government” refer to the latest government projections to that point. Thus the analysis here does not embody the most recent market data and the potential implications of a disorderly collapse of the Eurozone, and (paragraphs 3.2–3.4 aside) does not respond to or include the changes in the Autumn Statement. Thus the analysis is not a temporary reflection of recent events—it is my established view of the underlying situation.

Total Market Returns

1.3 In this section we shall argue the following points:

(a)When the economy does better, total enterprise returns are greater (and vice versa).

(b)This tends to mean that, when the economic outlook is better (ie the economy is expected to do better in the future), required total market returns to capital also tend to be higher (and vice versa).

(c)Matters can, however, be somewhat complicated by the fact that total enterprise returns are divided between returns to capital and returns to labour. Evidence suggests that labour may be obtaining a diminishing share of total returns.

(d)There is a relationship between the risk-free rate of return and the sustainable growth rate of the economy, both in theory and in statistical evidence.

(e)There is good reason to believe that, although the next few years may see quite low growth for the UK economy (indeed, perhaps the economies of many developed countries), within the next few years the medium-term outlook (the outlook beyond the next few years) may improve, raising sustainable growth rates and associated with a rise in the risk-free rate.

(f)When economic conditions are weak, the equity risk premium tends to be elevated. However, the elevation in the equity risk premium is not always as great as the fall in the risk-free rate, so total market returns often fall.

(g)Conversely, when economic conditions improve, although the equity risk premium may fall back, it should not be expected to fall back as much as the risk-free rate rises, so total market returns should be expected to rise.

(h)After a major economic and financial crisis, one might expect lasting impacts on risk appetites.

(i)A major economic and financial crisis might also be associated with changes in (a) the degree of skewness and kurtosis in returns; and (b) how much investors care about skewness and kurtosis (eg the price of skewness).

The Relationship between Market Returns and Macroeconomic Conditions
Impact of the Economy on Total Returns to Enterprise

1.4 When economic growth is higher, firms tend to have greater earnings. Demand is higher, so the gross value added by businesses increases. Faster economic growth leads to greater total enterprise returns.

1.5 So, if economic growth is expected to be higher in the future, there are expected to be greater enterprise returns. Total enterprise returns are divided between labour and capital. If the split (the ratio) can be taken as given (or indeed if returns to labour can be taken as fixed), then a rosier economic outlook implies that returns to capital will be greater. If investors, responding to a rosier economic outlook, did not demand higher returns, they would be conceding that labour would take all the benefit from faster growth. Normally, however, capital demands its share of the expected larger pie.

1.6 This is the straightforward case, but it is worth noting that there is no iron rule here. If there is a change in the capital/labour split of returns, that could in principle reverse the overall effect or enhance it. For example, poor economic times could coincide with a fall in the share of total returns taken by labour, so that total returns to capital could rise even as total enterprise returns fell—in which case our straightforward case effect would be reversed. As an alternative example, rosier economic times could coincide with labour taking a lower share of total returns—so our straightforward case effect would be enhanced.

1.7 As it happens, evidence suggests that labour has obtained a very stable share of total returns over the past decade—employee compensation was 54.5% of GDP in 2000 and 54.8% of GDP in 2010.1 The key change here occurred during the 1980s. In 1970 and 1980 employee compensation was around 59% of GDP, but by 1990 this had fallen to 55%. Since 1990 the proportion has been very stable.

1.8 If a period of elevated returns is relatively brief—for example, if it occurs only for a year or two in the recovery phase from a recession—then although actual returns to capital may be higher, the required rate of return will not. Over the lifetime of an investment, there will naturally be some years in which actual rates of return are below the cost of capital and others in which actual rates of return are higher. But overall, average expected rates of return will equal the cost of capital.

1.9 On the other hand, periods of slower or higher growth could be more sustained than this. In economics, the “long-term” refers to the period over which there are no fixed costs—when all investments must be renewed. A period of low or high growth sustained for a longer period than the lifetime of investments is not merely cyclical in nature; it is structural, and should be expected to affect not merely year-to-year actual returns but also the required rate on return on investment, because if low / high growth is sustained and economy-wide, then it affects the opportunity cost of investment; we can neither invest in something else nor can we simply wait a brief time and invest under more favourable circumstances.

1.10 Lastly, we observe that economic “shocks” affecting the sustainable growth rate can be both good and bad in nature. There might be new technologies that raise the sustainable growth rate (eg by stimulating more rapid innovation); there might be periods of sustained bad weather damaging harvests (eg for a couple of decades).

Relationship between the Sustainable Growth Rate and the Risk-free Rate

Theoretical relationship

1.11 It is common to think of the risk-free rate of return as an exogenous taste variable—if not actually constant, then at least fixed by factors outside portfolio decision-making. We think of the risk-free rate as a measure of impatience, of how much we would rather have things today than tomorrow.

1.12 However, though there is much in this, it is not quite the whole story. For the risk-free rate is not simply the return any one individual would require to hold a risk-free asset. Rather, it is the return that would be available in such an asset. As such, (a) it reflects collective tastes, rather than those of any individual—the “taste” of the Market; and (b) it reflects an (albeit notional) equilibrium condition.

1.13 In standard long-term economic growth models, such as the Ramsey-Cass-Koopmans model, a key equilibrium condition is that (absent population growth) the sustainable growth rate of the economy equals the risk-free rate.2 Indeed, in corporate finance theory the risk-free rate of return is sometimes viewed as arising from the sustainable growth rate (ie causality runs from the sustainable growth rate to the risk-free rate).

1.14 For our purposes here, we need not fully endorse either of these positions. Instead, we make the more limited claim that one should expect changes in the risk-free rate to be correlated with changes in the sustainable growth-rate.

1.15 We can make this thought more concrete by considering the likely relationship between the sustainable growth-rate and our best proxy for the risk-free rate, namely yields on government bonds. If, for example, yields on medium- to long-term government bonds are very low, we should interpret that as an indicator that the sustainable growth rate of the economy is expected to be very low. Why? Well, consider an investor that is willing to buy a government bond at a very low yield. That investor is choosing to purchase that government bond in preference to, for example, shares or bonds in any other business in the real economy. But that must indicate that expected returns for the real assets of these other real economy businesses are expected to be low or very volatile. Let us set aside the high volatility case for now, and focus on the case in which returns of these real economy businesses are low. If returns to all real assets are low, over the medium- to long-term, then the economy can only be expected to grow slowly over the medium- to long-term. But the sustainable growth rate is simply the rate at which the economy can grow over the medium- to long-term. So (setting aside issues of policy mistakes etc. that might eventually be rectified), when government bond yields are very low, one plausible explanation is that the sustainable growth rate of the economy is very low.

Statistical relationship

1.16 Consider the following graph.

Figure 2.1

COMPARISON OF NORMALISED GDP SERIES WITH QUARTERLY GROWTH (1985Q1 = 100)

 

1.17 In this graph we compare the average quarterly yield on 10-year index-linked bonds (in blue) with the actual average growth rate over the subsequent 10 years (in red). To make the relationship easier to see, we have “normalised” both series so that, as they begin in the first quarter of 1985, we call them both 100. Because they look ahead 10 years, the data in this graph ends at the beginning of 2001 (we’ll look ahead below). We can see that movements in the red graph mirror movements in the blue graph fairly well, though not perfectly. (The correlation between the red and blue graphs is 0.49, which is certainly respectable.) If we believe that the introduction of inflation targeting in the fourth quarter of 1992 can be treated as a game-changing event, we can compare the right-hand end of the blue graph with the green graph instead—seeing that the mirroring becomes even better. (The break-adjusted series has a correlation of 0.83, which is very high.) We have statistically confirmed that the series does indeed exhibit a statistically significant structural break in the fourth quarter of 1992.

Figure 2.2

SCATTER PLOT OF GDP GROWTH VERSUS GILT RATE (RAW VALUES)

 

Caveats

1.18 We focus on 10-year index-linked gilt yields and growth rates here. Five-year gilt yields can be significantly affected by policy expectations—eg in a recession policy interest rates may be set low, dragging down the five-year gilt yield. Since our data begins only in 1985, the use of 20-year values would make our dataset very short (just five years instead of fifteen). However, we acknowledge that there is a compromise here. The actual growth rate could, in principle, deviate materially from the underlying sustainable growth rate even over a 10-year horizon. For example, one interpretation of our non-break-adjusted series could be that actual growth rates were below sustainable growth rates during the 1980s but then above sustainable growth rates during the 1990s (perhaps “catching up” on the “lost growth” of the 1980s). One implication of this reflection is that it is not obvious, despite the higher correlation, that our break-adjusted series is really the better series for correlating to 10-year-ahead growth rates.

Predictions of Model

1.19 These caveats notwithstanding, the upshot of our analysis is that the close relationship that theory predicts between the risk-free rate and the sustainable growth rate appears to be borne out in practice. The sustainable growth rate of the economy appears to have been fairly stable from the mid to late 1980s, risen somewhat in the early 1990s, and fallen fairly rapidly from the second quarter of 1997 to below its late 1980s trough.

<?oasys [np ?>1.20 In the following graph, using the correlation between the break-adjusted series for the index-linked gilt rate and the sustainable growth rate to model the sustainable growth rate, we assume the sustainable growth rate was 2.5% at the start of 1985 and that changes in the risk-free rate and sustainable growth rates are proportionate to one another.3

Figure 2.3

MODELLED SUSTAINABLE GROWTH RATE VERSUS GILTS YIELD

 

1.21 So, according to our model, the sustainable growth rate peaked at about 4% in the mid-1990s, and had fallen to about 2% by the end of 2000. The rate continues around 2% until 2002, when it starts falling again. There is a brief odd blip up in mid-2007, and then the spike in late 2008 (which surely reflects a sudden rise in sovereign default risk—ie the model is breaking down as the index-linked gilt yield is no longer nearly-risk-free). From the first quarter of 2009 we also get a downward distortion, as quantitative easing is estimated by the Bank of England to take perhaps a whole percentage point off yields.

1.22 So we have some distortions from late 2008 that make it difficult to guess what happened next. The most recent major regulatory determination of the risk-free rate in the UK was that of Ofcom in July 2011, which chose a figure of 1.4%. On our model, a figure of 1.4% for the gilts yield would imply a sustainable growth rate of 1.1%. This is our preferred figure. We note that current market yields are well below 1.4%. Thus, our 1.1% figure for the sustainable growth rate should be considered subject to considerable downside risk.

2. Why the Sustainable Growth Rate is Likely to be Low

2.1 The Office for Budget Responsibility claimed in its March 2011 report that the growth rate of potential output (in essence, what we are referring to here as the sustainable growth rate) is around 2.1–2.35%.4 In its November 2011 report this was downgraded to being 1% since 2009, rising to 1.2% in 2012, 2.0% in 2013 and 2.3% from 2014.

2.2 The OBR reports a comparison between its figures and those of other agencies, as follows.

Figure 2.1

LEVEL OF POTENTIAL GDP

 

NB “November EFO” refers to the OBR Economic and Fiscal Outlook, November 2011

2.3 Broadly speaking, our view of the potential growth rate for the next few years is much closer to that of the European Commission than that of the OBR, IMF or OECD.

Five Reasons why the Sustainable Growth Rate is Low

2.4 As noted above, the interpretation of bond yields from late 2008 is problematic as they may have been subject to a number of distortions. However, is it credible that the entirety of falls in these variables reflects passing market distortions, as opposed to the sustainable growth rate having fallen? We point to five key factors that suggest it might indeed be credible that the sustainable growth rate has fallen materially:

(a)Increased public spending / taxation relative to GDP.

(b)Increased level of government debt relative to GDP.

(c)High corporate sector debt relative to GDP.

(d)High household debt relative to GDP.

(e)Increased demographic pressures.

2.5 We shall now consider each of these cases in turn. We emphasize that in each case what we propose is that a relevant factor has arisen in recent years that would tend to depress the rate of overall economic growth for long enough to affect the future long-term sustainable growth rate. Though a number of these factors might eventually be turned around, we suggest that they will persist for much of the current Parliament.

Reduced Public Spending Relative to GDP

2.6 There is extensive academic empirical literature on the relationship between levels of public spending, tax and GDP growth. Broadly stated, the conclusion of this literature is that at above about 25% of GDP, increasing public spending further reduces the long-term growth rate of the economy (especially if such increases take the form of greater government consumption expenditure, as opposed to investment expenditure or transfers).

2.7 We emphasize that it does not, of course, follow that it would be politically desirable only to spend 25% of GDP. After all, the extra spending produces potentially socially desirable outputs, such as ameliorating poverty, ill-health or poor education, enhancing social inclusion, enabling the government to project military force around the world allowing the nation to diffuse its values and fight injustice, and many other such things. Perhaps at some level of GDP spend, the reduction in growth is of greater social cost than the social benefits of the extra spending (so then there would be three zones—one in which additional spending enhanced growth, one in which spending reduced growth but was still desirable because the trade-off was favourable, and a zone in which further spending increases reduced growth and did not produce social benefits of greater value than the cost of such growth reduction). Or perhaps, even, the ideal political system would involve the government spending 100% of GDP. In this report we make no comment on these essentially political questions.

2.8 Instead, for our purposes here we focus on the well-established and long-established empirical results concerning public spending, taxation and growth rates.

2.9 Regarding the impact of public spending, two particularly important recent studies are the following:

(a)Afonso, A. & Furceri D. (January 2008), “Government size, composition, volatility, and economic growth”, European Central Bank working paper 849:

“a percentage point increase in the share of total revenue (total expenditure) would decrease output by 0.12 and 0.13 percentage points respectively for the OECD and for the EU countries”.

(b)Mo, P H (2007), “Government expenditure and economic growth: the supply and demand sides”, Fiscal Studies 28 (4), pp497–522:

“a 1 percentage point increase in the share of government consumption in GDP reduces the equilibrium GDP growth rate by 0.216 percentage points”.

2.10 The literature on the impacts of taxation gives similar results. The definitive study in that literature was that of Leibfritz, W, Thornton, J & Bibbee A, “Taxation and Economic Performance” OECD Economics Department Working Papers 176 (1997). They find that a 10 percentage point increase in the tax to GDP ratio reduces the growth rate by 0.5–2 percentage points—or equivalently that each additional percentage point reduces the growth rate by 0.05–0.2 percentage points. (The more recent Afonso & Furceri paper quoted above finds that a one percentage point increase in the share of tax in GDP reduces growth by 0.12 percentage points.)

2.11 The practitioner rule of thumb here is that each additional percentage point rise in sustained levels of public spending/tax should be expected to take 0.1–0.15% off the growth rate of the economy.

2.12 Total managed expenditure in the UK reached a trough of 36.3% of GDP in financial year 1999–2000.5 This was the lowest figure recorded since straightforwardly comparable records began in the early 1960s. It peaked at 47.6% in 2009–10—a rise of 11.3 percentage points over a decade.

2.13 During the high-public-spending period of 2008–09 to 2014–15, which is projected to involve an average level of 44.6% of GDP, growth is likely to be depressed. We note that the 10-year average was below 42% of GDP for every 10-year period commencing each year between 1985–86 and 2001–02, and levels of around 40% were typical. So 44.6% constitutes a rise of two to four percentage points of GDP. Using the practitioner rule of thumb, a two to four percentage point increase in public spending relative to GDP implies a 0.2–0.6% fall in sustainable growth rates.

A High Level of Government Debt Relative to GDP

2.14 In their August 2011 Bank for International Settlements paper, Cecchetti et al,6 analyse the impact of various forms of debt upon growth rates. Their conclusions are that, beyond a threshold level, debt is damaging to growth. That threshold level in respect of government debt is around 80–100% of GDP.

2.15 On UK government definitions, UK general government gross debt relative to GDP is projected to peak at 87.2% of GDP in 2013–14.7 This compares with 37.0% in 2001–02. The average from 1990–91 to 1999–2000 was 44.1%. The previous peak on straightforwardly comparable statistics was 64.2% in 1976–77. On Cecchetti et al’s definitions, public sector debt rose from 42% of GDP in 1990 to 54% in 2000 and 89% in 2010.

2.16 Cecchetti et al, find that an additional 10 percentage points of GDP of debt, above the threshold, reduces annual trend growth by around 0.1 percentage points. In the pessimistic case that, for the UK, the crossover threshold is at 80% of GDP, an additional seven percentage points of debt would correspond to a fall in GDP growth of around 0.07%.

A Level of Corporate Sector Debt Relative to GDP

2.17 On Cecchetti et al’s figures, UK corporate sector debt rose from 93% of GDP in 2000 to 126% in 2010. The threshold level for corporate sector debt, above which it reduces trend growth, is about 90% of GDP. Each additional 10 percentage points of debt above this level reduces trend growth by around 0.05%. So being 30% above the threshold would be expected to reduce trend growth by around 0.15%.

A High Level of Household Debt Relative to GDP

2.18 UK household debt rose from 75% of GDP in 2000 to 106% in 2010. Cecchetti et al, believe that there should be a similar threshold level for household debt, similar to that applying for government and corporate sector debt. They state that their best guess as to this level is around 85% of GDP. However, it should be noted that in their statistical tests, though 84% was their models’ highest likelihood value for the threshold, the results were far from statistically significant.

2.19 A related possibility, which Cecchetti et al, did not (directly) explore, is that household debt has its effect upon growth primarily through increasing the likelihood of financial crises. Banking sector crises have a huge effect in their model: each additional year of crisis takes 0.27 percentage points off annual growth for the succeeding five years.

Demographic Effects

2.20 In the Cecchetti et al, model, a one standard deviation increase in the dependency ratio (the ratio of the non-working to working population), or an increase of around 3.5 percentage points in that ratio, is associated with a 0.6 percentage point reduction in future average annual growth.

2.21 Dependency ratios in the UK have been projected to rise significantly. The number of people of state pensionable age was projected, by the government in 2009,8 to increase by 32% from 11.8 million in 2008 to 15.6 million by 2033, whilst the number of working age is projected to rise by just 14% from 38.1 million to 43.3 million.

Intermediate Conclusion on the Potential Depressing Effect upon the Sustainable Growth Rate

2.22 If all achieved together, the potential depressing effect of the impacts we have described could be very large:

(a)0.2–0.6% for increases in public spending.

(b)0.07% for excessive government debt.

(c)0.15% for excessive corporate indebtedness.

(d)An unclear amount for the reduction in household indebtedness.

(e)Some material amount for the reduction in the increase in dependency ratios.

2.23 Altogether, these effects suggest that it is indeed credible that the UK’s sustainable growth rate could, as gilt rate movements over the past few years imply, have fallen by more than a percentage point below the 2.5% rate commonly believed in the early- to mid-2000s and assumed in most government forecasts of that era.

2.24 If economic conditions have recently deteriorated even further, with peak levels of government and household debt likely to rise even higher, creating greater impediments to medium-term growth and making harder the task for the government to reduce public spending relative to GDP, then the risk-free rate might even have declined over the past couple of months. Following its recession of the early 1990s, Japan only achieved an average annual GDP growth rate of 1.2% in the period 1992 to 2001, and indeed still only grew at an average of 1.0% annually from 2001 to 2010.9 That compared with an average annual growth rate of 5% from 1981 to 1990—a drop of four percentage points. A fall of only perhaps 1½% in the UK’s sustainable growth rate, following the most global and most serious financial crisis in history, in a country that begins at above Cecchetti et al’s thresholds in all sectors, would be a very fortunate result.

The Sustainable Growth Rate (and hence Risk-Free Rate) is Likely to Increase

2.25 We have argued that the sustainable growth rate of the economy is likely to be around 1.1% at present. However, it is plausible—indeed, likely—that the sustainable growth rate could return to these levels during the next few years, perhaps even exceeding 2.3% by the middle of the next Parliament. That is not, of course, to say that we predict average economic growth might be well above 2% during the next few years or even over the 2010s as a whole—as we say, the risk-free rate data imply an underlying growth rate averaging perhaps only 1.1%.10 Rather, we believe it plausible that, within the next few years, the average growth rate for the next 10 years or so after that point could be in the region of (or perhaps even higher than) the 2.3% the OBR proposes. We present this thought in a stylised way in the figure below. It should be clear that if the actual growth-rate is low enough in 2011–17 or high enough in 2021–27, then it is possible for the average growth rate of 2011–21 to be markedly below the average growth rate of 2017–27.

Figure 2.2

STYLISED REPRESENTATION OF OUR CONTENTION CONCERNING SUSTAINABLE GROWTH RATES

 

Longer-term Gilt Rates Imply a Significant Rise in 10-year Yields by Late 2016

2.26  The claim that the risk-free rate should be expected to increase over the next five years is also supported by the term structure of bonds. The term structure of yields on index-linked government bonds can be used to infer forward real yields. In particular, it is possible to lock in the interest paid for borrowing and lending money in the future. Given current interest rates it is possible to receive one pound at time t by investing the amount e−rott, where t is the number of years from 0 to t and r0.t the annualised interest rate at time 0 for borrowing over the period 0 to t. This can be financed by borrowing the amount e−rott over the period from 0 to t+s. The total amount of interest that is paid for borrowing one pound over the period t to t+s is therefore e−rott.e−rot+s(t+s)−1. This implies that at time 0 the forward interest rate for t to t+s equals

ln(e−rott.e−rot+s(t+s)).
    s

2.27 As of 31 August 2011, the real implied 10-year-ahead yield on UK gilts was 0.02%.11 But the implied yield for the 10 years from August 2016 was 1.08%—a rise of more than a percentage point in the 10-year yield over the next five years.12 In the most recent regulatory determination available at the time of writing—that of Ofcom—the risk-free rate was determined at 1.4% (despite the very low rates on contemporaneous 10-year gilt yields) for a charge control applying in the period up to 31 March 2014.13 An implied rise of more than a percentage point in yields, during the period August 2016–26 versus the period August 2011–21, could be expected to imply a roughly equivalent rise in the risk-free rate.

Figure 2.3

IMPLIED 10-YEAR FORWARD YIELDS AT AUGUST 2011

 

2.28 Some of this expected rise in yields may already be implicit in Ofcom’s determination of a risk-free rate notably above contemporaneous 10-year yields. And it is also true that gilt yields are known to have a term structure that is only imperfectly understood. However, we make the following observations:

(a)Though a positive slope to the yield curve is normal, on government bonds the standard rise from around a 10 to a 20 years horizon is of the order of 20 basis points. The curve typically flattens considerably after around eight years. Here is the yield curve for US Treasuries for September 2005, showing the familiar upwards curve. The UK structure at that time showed a downward curve—a feature that was repeated several times during the 2000s.

 

Source: YieldCurve.com

(b)We see in the next figure that the term structure as of September 2011 involves a markedly more aggressive rise.

 

Source: YieldCurve.com

(c)We note that the rise in yields across the curve is considerably more and over a longer timescale than can usually be attributed to pure policy choice effects (eg decisions to keep interest rates low in the short term to smooth out economic fluctuations such as recession). An above-100 basis point rise in the six to 16 year phase (and indeed extended beyond that, even still rising materially to 30 years) indicates a significant and unusual effect. It is possible that some element of this is a rise in liquidity premia, but it seems very likely that the overwhelming majority of this effect reflects an expectation that 10-year yields will be much higher by 2017 than those yields are today.

(d)The common belief that index-linked gilt yields will, in due course, rise applies to longer-term yields as well as to 10-year yields.

(e)Though the Competition Commission has raised concerns about 20-year yields in past judgements, its view was that these were likely to be distorted downwards, not upwards.14

Why the Sustainable Growth Rate is Likely to Increase

2.29 Notwithstanding the arguments of previous sections that the OBR is too optimistic regarding how rapidly the sustainable growth rate might revert to closer to its historic norms, is it credible that in due course the long-term sustainable growth rate might rise in the way implied by longer-term gilt yields, perhaps reaching the 2.3% claimed by the OBR or even, thereafter, rising higher, perhaps to the 2.5% or so that has been the UK’s longer-term historic average?

2.30 We point to six key factors that suggest it might be:

(a)Reduced public spending / taxation relative to GDP.

(b)A reduction in the level of government debt relative to GDP.

(c)A reduction in corporate sector debt relative to GDP.

(d)A reduction in household debt relative to GDP, and an end to the financial crisis.

(e)Extension to the retirement age.

(f)An increase in the rate of productivity growth in the public sector.

2.31 We shall now consider each of these cases in turn. We emphasize that in each case what we propose is that a relevant factor has arisen in recent years that would tend to depress the rate of overall economic growth for long enough to cover an entire investment cycle—and thus, in the economist’s sense of “long term” affect the long-term sustainable growth rate—but that can reasonably be expected (as indicated in both longer-term gilt yields and official economic forecasts) to be at-least-partially reversed by the middle of the next Parliament, at least in terms of its effects upon the growth rate for the 10 years ahead from that point.

Reduced Public Spending Relative to GDP

2.32 Total managed expenditure peaked at 47.6% in 2009–10—a rise of 11.3 percentage points over a decade. Had such a level of expenditure been maintained, with taxes raised to match it, the rate of GDP growth could be expected to be reduced as a consequence. However, the government plans to reduce spending back to 39.9% by 2015–16. If, for the 10 years following that point, spending were maintained at around 40% of GDP, the sustainable growth rate could be expected to be materially higher than during the high-public-spending period of 2008–09 to 2014–15, which is projected to involve an average level of 44.6% of GDP. If we assume that taxes would have to be set on average no more than 3% below spending (eg according to the Maastricht sustainability criteria), a five percentage point reduction in long-term spending relative to GDP would imply around a five percentage point reduction in taxes. At the Leibfritz et al, figure of 0.05–0.2 percentage points off growth for each percentage extra taxes, a five percentage point reduction in long-term tax rates implies a 0.25–1% rise in sustainable growth rates.

2.33 To see whether a sustained cut in average long-term spending on this scale is plausible, we note that public spending was 40.9% of GDP in 2007 and the 10-year average was below 42% of GDP for every 10-year period commencing each year between 1985–86 and 2001–02. It thus seems entirely plausible that public spending will be materially lower, relative to GDP, from 2017-on than has been the case in recent years.

A Reduction in the Level of Government Debt Relative to GDP

2.34 On UK government definitions, UK general government gross debt relative to GDP is projected to peak at 87.2% of GDP in 2013–14, falling to 83.5% of GDP by 2015–16.15 This compares with 37.0% in 2001–02. The average from 1990–91 to 1999–2000 was 44.1%. The previous peak on straightforwardly comparable statistics was 64.2% in 1976/7. On Cecchetti et al’s definitions, public sector debt rose from 42% of GDP in 1990 to 54% in 2000 and 89% in 2010.

2.35 Cecchetti et al, find that an additional 10 percentage points of GDP of debt, above the threshold, reduces annual trend growth by around 0.1 percentage points. If government plans to reduce the deficit take debt below the UK’s threshold value from 2015–16 onwards and keep it there, that could increase growth by a further 0.1%.

A Reduction in Corporate Sector Debt Relative to GDP

2.36 The UK corporate sector has already materially deleveraged during the recession. It is natural to expect further deleveraging over the next five years, as, relative to 2005–07, corporate debt spreads have risen dramatically increasing the relative attractiveness of equity versus debt.

2.37 If corporate sector debt were to return to its 2000 level by around the middle of the next Parliament, that could therefore be expected to add a further 0.15 percentage points to trend growth.

A Reduction in Household Debt Relative to GDP, and an end to the Financial Crisis

2.38 Household debt in the UK has been falling back since its 2007 peak.16 Further falls by 2015–16 could take it below growth-damaging levels, reducing the risk of further financial crises and reducing the growth-depressing debt overhang.

Extension to the Retirement Age

2.39 The government has announced plans to accelerate rises in the state pension age—reaching 66 in 2020 instead of between 2024 and 2026 as previously planned,17 and 67 in. It seems plausible that announcements of further subsequent increases in pension ages will follow by 2015–16, reducing peak dependency ratios from those currently projected.

An Increase in the Rate of Productivity Growth in the Public Sector

2.40 From 1998 to 2007 average annual public sector productivity growth was 0.3%, whilst for the private sector it was 2.3%.18 It is perhaps natural that in a period in which public spending rose rapidly, it was difficult to absorb large increases in spending whilst also increasing productivity.

2.41 With government consumption constituting around 22% of GDP, if the value of outputs over inputs grew 1% more rapidly from 2015–16 onwards than in 1998–2007—plausible given the tighter spending growth, and the opportunity to catch up on private sector productivity growth as the spending rises of 1998 to 2007 are finally adapted to—then that could add around 0.2% to GDP growth.

2.42 We observe because of the ways in which GDP is measured, increased productivity growth in the public sector might not lead to rises in measured GDP growth on anything like this scale. However, of course, gilt rates reflect the true underlying economic situation, not simply that measured.

Intermediate Conclusion on the Scope for a Rise in the Sustainable Growth Rate

2.43 If all achieved together, the potential impacts we have described could be very large:

(a)0.25–1% for reductions in the long-term trend tax rate.

(b)0.1% for the reduction in government debt.

(c)0.15% for the reduction in corporate indebtedness.

(d)An unclear amount for the reduction in household indebtedness.

(e)Some material amount for the reduction in the increase in dependency ratios.

(f)Perhaps 0.2% for increased productivity growth in the public sector.

2.44 All told, these values sum to more than 0.7–1.5 additional percentage points of average growth. Perhaps it is ambitious to believe that the top end of this range could really be achieved in practice, and without any offsetting other factors reducing sustainable growth. Nonetheless, we believe that the factors above do suggest that the government’s own projections could be credible by the middle of the next Parliament. That is to say, by the middle of the next Parliament, it is not totally unreasonable to believe that the sustainable growth rate for the UK economy could have returned from the recent very low values implied by risk-free rates (perhaps as low as 1.2%) back towards the 2.3% projected by the OBR or even perhaps to the 2.5% longer-term value for the UK.

December 2011

1 Source National Statistics, UK Economic Accounts, Table A3: Gross domestic product: by category of income

2 Ramsey, F P (1928), “A mathematical theory of saving”, Economic Journal, 38, 152, pp543–559. Cass, D (1965), “Optimum Growth in an Aggregative Model of Capital Accumulation”, Review of Economic Studies, 37 (3), pp233–240.

3 Our model explains movements in yields by a constant, the change in regime occurring in 1992Q3, and GDP, as set out in the following table.
MODEL
 
Dependent Variable: YIELD
Method: Least Squares
Sample: 1985Q1 2001Q2
Included observations: 66

Variable Coefficient Std. Error  t-Statistic     Prob.
C 0.020568  0.002454 8.380193  0.0000   
BREAK −0.010731 0.000983 −10.91737 0.0000   
GDP 0.725478  0.095041 7.633279  0.0000   
 
R-squared 0.840297  Mean dependent var      0.034323 
Adjusted R-squared 0.835227  S.D. dependent var      0.006840 
S.E. of regression 0.002776  Akaike info criterion      −8.890969
Sum squared resid 0.000486  Schwarz criterion      −8.791439
Log likelihood 296.4020  Hannan-Quinn criter.      −8.851640
F-statistic 165.7408  Durbin-Watson stat      0.733382 
Prob(F-statistic) 0.000000       

Technically, this is a model of levels. In the model represented in Figure 2.3, we assume that the sustainable growth rate in 1985Q1 is equal to the actual 10-year growth rate for the next 10 years ahead (2.50%, versus a value of 2.0 generated by the model in the table). Changes in the level of yields from our model then constitute changes in the level of yields from this 2.50% startpoint. The effect is that the levels in the model represented in Figure 2.3 are around 0.5% above those generated from the model in the table. For this reason the modelled sustainable growth rate in Figure 2.3 is described as “Normalised”.

4 See, for example, Economic and Fiscal Outlook, March 2011, Office for Budget Responsibility
http://budgetresponsibility.independent.gov.uk/wordpress/docs/economic_and_fiscal_outlook_23032011.pdf

5 Source: public finances databank: http://www.hm-treasury.gov.uk/d/public_finances_databank.xls

6 Cecchetti, S G, Mohanty, M S & Zampolli, F (2011), “The real effects of debt”, prepared for the “Achieving Maximum Long-Run Growth” symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 25–27 August 2011—http://www.kc.frb.org/publicat/sympos/2011/2011.Cecchetti.paper.pdf

7 Source: Public Finances Databank, August 2011 version: http://www.hm-treasury.gov.uk/d/public_finances_databank.xls

8 http://www.ons.gov.uk/ons/rel/npp/national-population-projections/2008-based-projections/statistical-bulletin-october-2009.pdf

9 Source: IMF World Economic Outlook 2011

10 Of course, if there is an “output gap”, then in addition to the underlying trend rate of growth, the economy might have the capacity to “catch up”, also, growing faster than its trend rate.

11 Source: Bank of England

12 For February 2017 the figure is 1.09%.

13 http://stakeholders.ofcom.org.uk/binaries/consultations/823069/statement/statement.pdf

14 eg see paragraph 70, http://www.competition-commission.org.uk/rep_pub/reports/2010/fulltext/558_appendices.pdf

15 Source: Public Finances Databank, August 2011 version: http://www.hm-treasury.gov.uk/d/public_finances_databank.xls

16 Source: Household Indebtedness in the EU, Report prepared by Europe Economics for the European Parliament’s CRIS committee, April 2010.

17 http://www.dwp.gov.uk/consultations/2010/spa-66-review.shtml

18 See Basset D, Cawston T, Haldenby A, and Parsons, L (April 2010), Public sector productivity, Reform

Prepared 29th February 2012